What’s Driving Gold Futures Higher, and the Outlook for 2006
Spot gold closed at $850 per ounce in January of 1980, and shortly thereafter, the market entered a steady decline that lasted nearly two full decades, finally bottoming at 252.80 on July 20, 1999. After nearly two years of forming a base, the present bull market began in April of 2001, and the market has been vaulting higher ever since. For those of you fortunate to get in at the bottom, congratulations! However, for the rest of us who might be evaluating the Gold market and contemplating trading opportunities now, let’s examine some of the reasons behind Gold’s latest move and consider what may be in store for the yellow metal in 2006.
Putting Gold’s current prices in context, consider that the price of February Gold futures, now trading around $570 per troy ounce, represents a 25-year high. The last time the price was over $500 level was in 1987. In 1999, Gold traded at $252. As the continuous long-term chart below shows, the real run-up has occurred over the past 6 months.
At first glance, the recent bull market in Gold seems to be primarily a speculative rally, as many of the traditional drivers for Gold are absent. Gold is most often seen as a reliable hedge against inflation, but inflation was especially tame in most parts of the world last year. Inflation (or the fear of inflation) seems not to have played a role in the recent rally, especially when you consider that a big part of the demand for Gold is coming from Japan, a country battling deflation.
It’s also true that Gold is often seen as a safe haven in times of war, and again the drivers do not seem to hold true. Although the continuing conflict in Iraq is indeed a war, it is generally thought of as being rather limited in scope; surely not capable of fueling a fear-based rush to Gold. If it were, the rally should have started in early 2003, not late 2005. The idea that Gold rallies during times of war is, in truth, a part of the more general view that Gold thrives in times of investor caution. Here again, we are no closer to the underlying causes of this rally. The problem with this line of reasoning is that 2005 was not a year of caution. A barometer of investor caution is widely thought to be the performance of the Swiss Franc, which lost roughly 15% relative to the U.S. Dollar in 2005. The strength of the Dollar against nearly all of the majors, itself, is a testament to voracious global risk appetites. Add to that, roaring equity markets (with the notable exception of the U.S.), record investment banking profits, and brisk private equity activity, and the case becomes clear that the investors of 2005 were not particularly risk averse.
The next logical place to look for clues on this rally would be China. Indeed, 2005 was the year that factored China into nearly every economic and political story. Business writers are now programmed to look to China every time there is mention of market “imbalances.” In the case of Gold, however, there seems to be only the slightest case. It’s true that China has demonstrated a seemingly insatiable appetite for industrial metals, which has greatly contributed to the metal’s rally this past year, most notably in Copper. The problem, though, is that Gold has no significant industrial use, and dealers report very little buying from Chinese accounts. It may be true that Chinese buying in the wider metal markets has affected Gold as well, using the theory that a rising tide lifts all boats, however this cannot have been a significant factor. It seems the Chinese like Silver, Platinum, and Copper, but for Gold we must look to the other emerging giant, India.
India and the Middle East
In India, we do find one piece to the puzzle. Traditionally, Gold has always been seen as a store of safe and secure wealth in India. It was, is, and seems likely to remain so for the foreseeable future. As India continues to develop economically, and as a burgeoning middle class demands more consumer goods, Gold will likely remain a trusted and in-demand commodity. Cash jewelry sales were reported to be have been brisk in 2005, although they have moderated at the current high prices. Even still, it seems cash demand in India is one solid factor behind the recent rise.
Another factor can be found in the Middle East. With Oil prices rising rapidly in 2005, money managers in this region were especially busy devising portfolios to suit the current investment climate. Thankfully for U.S. government officials, given the ballooning U.S. current account deficit, the “recycling” of petrol-dollars was big business in 2005. The investment equation did, however, change slightly at the end of October, when the Dollar made its last big push against the Euro, taking the EUR/USD down to the 1.18 level. At this level, many investors began to feel that the Dollar had reached a medium-term high. It may not be coincidence that the peak of the U.S. Dollar coincides with the real drive in Gold. Middle Eastern demand is thought to have played a large role in this part of the equation. It also should be noted that, aside from Middle Eastern investment flows, cash demand for Gold in the Middle East is helping drive the market. The recent rally in oil prices has spurred a consumer demand for gold jewelry, similar to that seen in India.
The dilemma faced by Arab investors in 2005 gets to one of Gold’s real strengths – its universality, or in other terms, its absence of country risk. Throughout 2005, every major currency battled its unique weaknesses. The U.S. Dollar is perceived, rightly or wrongly, as vulnerable to its “twin deficits.” So when the Dollar reaches an assumed peak, where does the savvy investor turn? To the Euro, with its own deficits, anemic growth, political gridlock, and structural concerns? To the British Pound, with its slowing growth, slacking industrial sector, and touchy consumer and housing sectors? To the Yen, which spent most of 2005 in a veritable free fall?
For many global investors, the safe answer was Gold, and this is likely the basic, though predominant, case for why Gold has done so well of late – a lack of other alternatives at the end of a good year. There are three other contributing factors:
Regarding speculative demand for Gold, Japanese investors deserve special mention. Japanese investors are frequently mentioned as being large buyers in the recent Gold rally, but they are not buying Gold as an inflation hedge. Instead, they seem to have found Gold in 2005 partly by accident. As a county currently in a zero interest rate environment, the Japanese have had to seek out higher-yielding investments overseas. A great amount of Yen gets converted into U.S. Dollars when they purchase U.S. treasuries and other agency debt. Increasingly though, over the last few years, large sums have been invested with their high-yielding trading partners, Australia and New Zealand. In recent months, these carry-trades had been working well. The Japanese would sell their Yen and buy high-yielding New Zealand Dollar deposits. The shock, however, came in early December, when Standard and Poors expressed concern about New Zealand’s current account deficit. The news sent cautious Japanese investors scrambling to closeout their NZD positions. With the Dollar pricey, the Yen not offering any yield, and the Australian Dollar perhaps too similar to the NZD, many thought the booming Gold rally might continue to hold promise. Those who bought into the rally on December 7, 2005, when S&P made its announcement, would have received prices around $514.
Hedge Funds and Central Banks
There is little doubt that hedge funds have recently played a central role in the Gold market (as have speculators of all shapes and sizes), but detailed analysis is hard to find. Yes, it’s true that any time a financial market is hot, you can bet that the “smart money” players are actively involved. But how much, when, and exactly who? Answers to these questions are often unknown.
Here’s what we do know: The recent up-move has pitted hedge funds (aggressive speculators) against so-called “commercials” (mining companies). Funds are the quintessential momentum players. The old adage of buy low and sell high has been changed to buy high and sell higher. As long as the trend continues higher, these players will continue to accumulate long positions. Mining companies have always been the traditional “short hedger,” locking in prices over the cost of production. Under normal conditions, higher prices should cause producers to continue to hedge production. However, if prices continue to rise, these hedges start to get expensive, as losses on short hedges total into the billions of dollars! At that point, continued short hedges may be curtailed or even covered. It would be quite interesting to see how the market would react to having one of its main “sellers” out of the market.
Another murky element to this market is the role of Central banks. Although current thinking seems to hold that modern central banks no longer “need” to hold large gold reserves, many still do, and in large quantities. Few analysts mention any over-arching reason for the world’s central banks to add more Gold to their reserve portfolios. On the other hand, like hedge funds, many central banks to do not disclose their exact holdings to the public, and a hot market is a hot market, regardless of who you are.
The Outlook for the Year to Come
So what can Gold traders look forward to in 2006? Now that Gold has returned to the spotlight, we should expect increasing volatility as both bulls and bears jockey for position. Some of the themes that drove the Gold market higher in 2005 remain valid in the early part of 2006. Political unrest, especially in the Middle East, remains a concern. Iran’s intention to resume its nuclear program, new leadership in Israel, and the potential for civil war in Iraq should provide investors ample reasons to turn to Gold for a safe-haven investment. Keep in mind, too, that the 1980 high of $850 per ounce equates to roughly $2,200 in current Dollars, so there may well be plenty of room for Gold to move higher. On the other hand, if some of these issues cool down or are resolved smoothly, and if momentum begins to slow as new highs are made, Gold may indeed reach a peak in the coming year. It’s up to individual traders to draw their own conclusions as to where Gold futures will head in 2006. But one thing’s for certain: Gold futures will be active and will present excellent trading opportunities.