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Gold prices: Bubbly, but not yet explosive
Precious Metal Market Update:
Gold prices have risen 30% year-to-date after rallying 20% since July on safe haven demand.
Our base case is that gold is not yet at extreme levels, but would be so around 2,200 USD/oz.
Investment demand to stay strong until a normalisation of Western monetary policy is in sight.
Gold sky-rocketing to ever new highs
Gold set a new record-high price in dollar terms this Tuesday at 1,913 USD/oz. 2011 is on track to be the eleventh straight year of gains in the gold price. Gold has risen 30% year-to-date and an astonishing 20% since July 7, the recent peak in equity markets. The yellow metal’s remarkable rally has raised questions about how high prices can go and if a gigantic “bubble” is in the making, which this update tries to shed some light on.
Gold reclaiming its place in the financial system
It’s been 40 years since the collapse of the Bretton Woods agreement, under which fixed exchange rates were linked to the value of gold (at 35 USD/oz.). Since gold prices became freely floating in the beginning of the 1970s, gold has seen 5 major rallies, the current one being by far the longest in duration of 11 years. Since the global financial crisis in 2008-09 gold is reclaiming its place at the heart of the financial system again. In 2010 central banks were net buyers of gold for the first time since 1981 (see Chart 1).
Central banks will most likely add demand instead of supply to the gold market also in 2011. This behaviour, probably part of a long-term process of diversification away from the US dollar as the dominant reserve currency, has undoubtedly altered gold market dynamics the past two years.
Gold prices are, like all commodity prices, driven by supply and demand. Gold supply is vast as gold is not consumed in the same way as most commodities. The gold market is thus very different from most commodity markets since supply/inventories increase every year. 85% of the 165,000 tonnes of historically mined gold is available as above-ground stocks. New gold supply every year equates to only 2-3% of above-ground holdings of gold.
Gold is also special in the sense that investment demand for gold bars, coins and exchange-traded funds (ETFs) make up over 40% of total demand – by far the largest investment share among commodities. China may become the world’s biggest investment demand market this year. China and India combined now account for over half of the world’s jewellery and investment demand (Chart 2).
Gold ETFs have seen an 85% increase in holdings since the end of 2008. The SPDR Gold Trust is now the world’s largest ETF by market value (Chart 3) and global holdings in ETFs are close to the official sector holdings of France and Italy. As long as the conditions for increased investment demand are present, gold will stay in favour and prices stay high.
Which are the main driving forces behind the recent gold price rally?
In our view, the six factors below are the most important:
- Increased investment demand, particularly from China and India, as gold is seen as a hedge against inflation and a weakening US dollar
- Extremely loose Western monetary policy and a long-term weakening US dollar
- Negative real interest rates which reduce the appeal of cash and lower the opportunity cost of holding gold
- Central bank net buying of gold as diversification away from US dollar reserves
- Investor perception of gold as an ultimate store of value and a hedge against both inflation and deflation
- Worries over sustainability of the global financial system
How high are current gold prices and how high can prices go?
All of the above mentioned arguments for a rising gold price are convincing enough that gold should benefit in the current monetary environment. But how high can prices go and is gold already in “bubble territory” after a 30% rise year-to-date?
How high a gold price of 1,900 USD/oz. is all depends what you compare it against. We have looked at gold’s valuation against its own history, relative to a number of related commodities and economic variables and relative to mine production costs.
Gold in nominal versus real terms
In nominal terms, prices are 1,000 USD/oz. above the previous gold spike in January 1980. In real terms, deflated by the US CPI, prices would have to rise to 2,492 USD/oz. to match the 1980-spike. Using US producer prices as inflation indicator, the corresponding level today is 1,990 USD/oz. (see Chart 4). Even though gold prices in real terms are not yet at historical extremes, levels above 2,200 USD/oz. must also be considered extreme. In 1980 prices only stayed at the extreme level for one day, before falling back sharply in just a couple of weeks.
Relative to platinum, copper and oil
Gold’s purchasing power compared to platinum is currently close to extreme valuation – at almost parity with platinum. Gold has since 1987 only traded higher than platinum 1.8% of the time. A new all-time high versus platinum would imply a gold price of 2,040 USD/oz. at current prices.
Relative to copper prices, gold is not at extreme valuations at all. To match the historical extreme from 1987, the equivalent gold price today is around 3,000 USD/oz.
Relative to crude oil prices, gold is still very cheap at current levels. The historical extreme was reached in 1986 when crude oil was at USD 8/bbl. At current high oil prices, gold would have to rise to 4,700 USD/oz. to be considered extreme.
Relative to equities and global GDP
Gold’s relative valuation versus the US stock market cannot be considered extreme, either. Measured as the all-time high against the S&P 500 index (not adjusted for dividends) of the 1980s, gold’s equivalent today is above 8,500 USD/oz.
Finally, the value of gold relative to global GDP was significantly higher during the early 1980s than it is today. Based on IMF data, gold would have to be 3,700 USD/oz. in 2011 to be considered as extreme as in 1980 compared to global GDP.
We find that gold is not yet at historical extremes when compared to several other commodities and relative to equity markets and global production (GDP). Compared to average levels around previous price spikes, current prices are much closer to extremes.
Relative to production costs of new mine supply
Average production costs for gold mines are around 500 USD/oz. while marginal production costs are estimated as high as 1,000 USD/oz. With gold prices currently at 80-90% above marginal cash costs, one can definitely argue that prices are high. But since gold supply is ample and new supply only makes up a fraction of available supply, the question is at which price will enough “old” supply come back into the market to balance the incremental demand. The skyrocketing gold price tells us that we are not quite there yet.
What is the market telling us about expectations for the gold price?
We can read a lot of valuable information from the pricing and positioning in the gold options markets. Implied volatilities in the price of gold options, a measure of the market’s expectation of future price fluctuations, have more than doubled since July 1. Markets were not at all prepared for the sharp rise in gold prices (see Chart 5). Implied expectations for gold’s trading range in one year’s time have increased from an interval of 1,000-2,200 USD/oz on July 1 to 1,100-3.200 USD/oz. currently (see Chart 6). Option prices also indicate that the risk to prices is not skewed particularly to the downside as one might expect after such a strong rally, but remains fairly symmetrical. The number of outstanding contracts (open interest) in options to sell gold at 1,600 USD/oz. in December have increased 13 times since July 1 as prices have gone from 1,500 to 1,900 USD/oz. (see chart 7). Options to buy gold at 2,200 USD/oz. in December increased in August but have since fallen back. The market seems to be most worried about the short term downside in gold prices.
Conclusions
Gold prices are not yet at extreme historical levels in real terms or in terms of relative valuation. Compared to average levels around previous price spikes, current prices are much closer to extremes. In the current dire and uncertain economic environment, however, it’s difficult to see what could stop the “gold rush” in the short term. All the conditions for strong investment demand are still present and the starting point of normalising Western interest rates is likely still 1-2 years away.
Should the world suffer a severe recession, however, gold prices will also fall as gold would eventually be sold to cover losses and cash needs elsewhere. During the previous 5 US recessions since 1980 gold prices fell on average 35% from peak to trough.
Forecasting gold prices in the current environment is extremely difficult. Our base case is that gold is not yet at extreme levels, but would be so around 2,200 USD/oz. We do not rule out a short-term correction after the recent price rally. Prices will likely trend higher until (i) the market believes in a normalisation of Western monetary policy is approaching, or (ii) until the world enters a new recession or (iii) until prices spike and crash in the meantime.
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