The Dynamics of the Gold Market, Forecasting the Gold Price and the Risk that is Associated with Owning "Non-Physical" Gold

According to economic theory, the price of a good is a function of its supply and demand. Otherwise stated: to be able to accurately forecast price movements in the market for a named good, one would need to understand the dynamics that shape its supply and demand.

In this blog post, I will discuss the demand for gold and a reliable method for forecasting changes in the price of gold. I will go on to discuss "gold leasing" transactions that central banks enter into, and, the "black-swan" risk that these transactions create for owners of non-physical gold.

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Illustration 1, below, deconstructs the demand for gold into its core elements and it expositions the key driver of each core element:

Illustration 1 (click on illustration to zoom in)

According to Illustration 1, the world demand for gold can be deconstructed into the following core elements:

1. Jewellery / Jewelry (makes up ~ 50% of the demand for gold): This element is largely driven by the demand for jewellery in the most populous countries in the world, i.e. India and China, which account for a 63.2% share of this demand sub-category.
2. Industrial and Dental (makes up ~ 11% of the demand for gold): This element is largely driven by the use of gold in the manufacture of electronic goods, which account for a 63.64% share of this demand sub-category.
3. Investment (makes up ~ 39% of the demand for gold): This element is largely driven by the demand for gold by Exchange Traded Funds (ETFs), which account for a 46.15% share of this demand sub-category.

...Forecasting the gold price

Hence, to be able to forecast the price of gold, one simply has to understand; the demand for golden jewellery in China and India, the demand for electronic goods with golden components and the demand for gold by ETFs, as these entities and demand categories account for an aggregate 56.6 % share of the demand for gold. Right?

The answer to that question would be a qualified "Yes". Why? Because in India, the supply chains for jewellery tend to be multitudinous and informal, and, they tend to evolve constantly. This makes it difficult to accurately aggregate / forecast the transactions that occur in the said supply chains.

Thus, analysts generally prefer to use the size of central bank balance sheets to predict future movements in the price of gold. When analysts employ this methodology, they examine the growth of the balance sheets of the 5-6 largest central banks in the world, including; the US FED, the People's Bank of China, the Bank of Japan, the European Central Bank and the Bank of England, as is shown in Illustration 2 below:

Illustration 2 (click on illustration to zoom in) Adapted From: Sprach Analyst

They then make assumptions about the degree of looseness of monetary policy in each of the 5-6 largest economies. (The general rule of thumb can be abbreviated as follows: the greater the degree of monetary looseness the larger the size of a central bank's balance sheet and, ceteris paribus, the higher the gold price.)

By and large, the degree of looseness of monetary policy increases when:

• An economy is experiencing a cyclical downturn, and accommodative policies are put in place to bolster the economy.
• An economy has an onerous debt burden, which largely consists of debt that is denominated in its currency, and monetary authorities elect to inflate away the debt.

Once the projections of the change of each central bank's balance sheet have been mapped, the analysts go on to use regression analysis, as is shown in Illustration 2, to project the overall trend of the change of the balance sheets of the 5-6 largest central banks. They then infer the change in the gold price from this overall trend.

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This is one of the most accurate methods for forecasting changes in the gold price. However, it is far from perfect...


...Gold Leases

Gold is an inflation-hedged alternative to fiat currency. In every country, the central bank holds a certain amount of gold in its vaults as a reserve currency. If the central bank seeks to generate income streams from the gold in its vaults it could lease-out its reserves to bullion banks as is shown in Illustration 3 below:

Illustration 3 (click on illustration to zoom in)

Bullion banks are members of the London Bullion Market like; Barclays Bank PLC, ScotiaMocatta, Deutsche Bank AG, HSBC Bank, JPMorgan Chase Bank and UBS AG. They serve as intermediaries in gold market transactions.

As Illustration 3 shows, bullion banks go on to sell that leased gold, as futures contracts with varying durations, to multiple buyers. For instance, in Illustration 3, if a bullion bank borrows 600 kilogrammes of gold from the central bank, it will draw-up two futures contracts, i.e. Futures Contract 1 and Futures Contract 2, each for the same 600 kilogrammes (kgs) of gold. The counterparties in each of the futures transactions would be Buyer 1 and Buyer 2 respectively.


...Fleshing Illustration 3 with numbers

Gold lease transactions are best explained using numbers. I will draw those numbers from Illustration 4 below:

Illustration 4 (click on illustration to zoom in)

If the bullion bank leased 600 kgs of gold from the central bank for $90 (i.e. 2012 dollars) per ounce per year in 1980, for a period of 10 years (see point a in Illustration 4), and entered into a futures contract with:

• Buyer 1 to sell the 600 kgs of gold at the 1980 price ( ~ $2,300 per ounce in 2012 dollars) in mid 1982 (see point b in Illustration 4);
• Buyer 2 to sell the 600 kgs of gold at the 1980 price (~ $2,300 per ounce in 2012 dollars) in 1988 (see point c in Illustration 4);

The bullion bank would have to buy gold at the spot price on two occasions:

• In 1988 at  ~ $1,000 per ounce (in 2012 dollars) to meet its obligations to Buyer 2 (see point c in Illustration 4).
• In 1990 at ~ $750 per ounce (in 2012 dollars) to meet its obligations to return gold to the central bank.

...Profitability of the transactions

Using the figures that were drawn from Illustration 4, the profit that the bullion bank would earn, from the lease and futures transactions, can be computed as follows:

Table 1 (click on table to zoom in)

Table 1 shows that the transactions would earn the bullion bank close to $41 million (in 2012 dollars).


 ...The Black Swan risk that is created by gold leases

If there is ever a reason to doubt the stability of the bullion bank, the holders of gold futures contracts, i.e. Buyer 1 and Buyer 2 in Illustration 3, would each concurrently demand 600 kgs of physical gold from the bullion bank, or, they would both demand some form of "guarantee" / collateral.

In such a scenario, the bullion bank may fail to meet the new demands; which would trigger or magnify the "run on the bullion bank". This would reverberate across gold futures markets and cause them to seize up. Succinctly stated: the holders of gold futures would be left holding nothing but "paper assets".

While this has never happened in recent history, there is no guarantee that it would never happen in the future. And if this ever happens, most entities would be caught off-guard.

The Gold Standard Fallacy

Citizens of the U.S.A. (and foreigners alike, especially those who hold U.S.-Dollar denominated securities that are not inflation hedged) are becoming increasingly concerned about the United States of America's exponentially increasing supply of money, which grew 12% in 2009, and the nation state's ballooning budget deficit.

A crescendo of voices from academia are proposing a diverse range of fixes to curtail this growth of money supply and the budget deficit. Generally, the remedies that have been put forward to assuage the U.S. society's pains from the said 'money supply ailment' include; limiting the government's financial intervention in private sector affairs, and a return to the "gold standard" of fiat currency supply management.

In fact, it appears that a growing number of academics and policymakers assert that the specie gold standard is the panacea for the tendency of central banks to debase currencies (through ill-conceived policies and the inept regulation of money supply).

In my opinion, that assertion only holds for countries that have a limited accessible endowment of gold, and or, 'thin' reserves of gold. And, it becomes a fallacy when it is applied to countries that have a readily accessible large endowment of gold, and or, abundant reserves.

In this post I want to illustrate, using examples that I have cherry-picked from history, that hyperinflation cannot be prevented by just pegging a currency to something "real", as some economists assert. If governments fail to keep the money supply's growth at rate that is at par with GDP growth, hyper inflation will materialize. I'll borrow one example from Malian history and the other from Spanish history:

Story 1: Mansa Moussa / The Emir of Melle / Lord of the Mines of Wangara / Conqueror of Ghanata / Futa-Jallon / Kankou Musa / Kankan Musa / Kanku Musa / Mali-koy Kankan Musa / Gonga Musa / the Lion of Mali goes to Mecca

According to the writings of a fourteenth century Arab scholar called Messr. Abu-sa'id Uthman, Mansa Moussa was the King of imperial Mali, and its colonies that stretched from Ghana to Songhai, when Mali was at its Zenith. It is estimated that Mansa Moussa's reign lasted for a total of 25 years. Historians assert that his reign did not begin before AD 1307 and that it had ended by AD 1337.

Mansa Moussa was a Muslim, and is credited with building centers of learning throughout the Malian empire, and it was during his rule that the first university in the world was built at a location in Timbuktu.

In 1324, i.e. around the time when the Aztecs commenced the construction of Tenochtitlan and approximately when the Ottoman Turks began the creation of their empire, he took the hajj, an obligatory pilgrimage (for Muslims) to Mecca that earned him a spot in history as one of the world's most extravagant rulers.

On his hajj, he took with him:

• An entourage of sixty-thousand people adorned in the finest silk,
• Eighty camels carrying over two tonnes of gold,
• Twelve-thousand servants, of which five hundred carried staffs of gold that each weighed four pounds.

And he dolled-out most of the gold he had with him to poor people he encountered as he was traveling. In fact, he was so generous that he didn't have the wherewithal for his return journey and had to borrow money to finance the 'homeward trip'.

A concomitant of these unprecedented acts of generosity was inflation. His massive generosity undermined the value of gold and caused inflationary pressures that plagued Egypt for twelve years. Inflation is too much money chasing on too few goods, and Mansa Moussa's generosity flooded Egypt with gold, whilst production was left unchanged.

Story 2: The Spanish search for El-Dorado (The realm of the gold-covered King)

Note to Reader: This story isn't about gold, it's about silver. Just pay attention the dynamics: they would exist, in their exactitude, if gold was used as the unit of exchange in those times.

During the middle-ages, there were many tales of fantastical realms that had extreme wealth, could enable men to regain lost health and lands in which men could forever live a Utopian existence. One of these fantastical lands was El Dorado, the realm of the gold-covered King, and the Spaniards believed that it was somewhere in Latin America.

In 1524, i.e. 208 years after Mansa Moussa made his inflationary pilgrimage to Mecca, Francisco Pizarro González, a Spanish conqueror, went to what they termed upper Peru, which is now part of modern-day Bolivia, in search of El Dorado, the realm of the gold-plated King.

With him were forty horses, and eighty men who were armed to the teeth and ready for combat. After defeating the Incas, who were the indigenous owners of that territory, in the battle of Catarmarca, González discovered the Cerro Rico (which literary translates to the 'rich hill') silver deposits in a mountain located in Potosi. There they extracted silver, using forced labor, and shipped it to the Spanish crown. This mine was one of the many mines that shipped over two billion ounces of silver over period of 250 years of Spanish colonial rule.

To quote the celebrated Economic Historian and author, Professor Niall Ferguson, "they thought that they had become rich beyond the dreams of avarice". But they were wrong.

With their increased supply of money they couldn't buy more things, as they thought, because the flood of silver that they had created was chasing on a fixed amount of goods. Simply put, they had caused inflation.

Conclusion

In a system where the specie gold standard is used to manage fiat currency supply, which is analogous to a system wherein gold coins and ingots are used as an official unit of exchange, the amount of currency in circulation is equivalent to the amount of gold held in the reserves of its central bank. This means that the market dynamics that occurred 700 years ago when Mansa Moussa made his hajj, and 500 years ago when Spain had discovered silver deposits in its colonies, can occur in such a system.

Thus, this implies that if a country, that employs the gold standard, has an abundance of gold reserves, and a declining base of production, there will be inflation. And, conversely, if the country has a rapidly growing production base, and declining gold reserves, it will experience either a recession or a gut-wrenching depression.

It doesn't matter whether a country uses the gold standard, silver standard or nothing at all. If the growth in money supply outpaces the growth in productivity by a wide margin, inflation will always materialize.

So instead of talking about returning to the gold standard to preserve the value of a currency and to ensure price stability, people should be saying that "the increase in money supply should move in tandem with the GDP most of the time."