Gold, Central Banks and The Force of Arms

Gold has been a disappointment of late. Perhaps too much was expected from the precious metal. It is up 11 consecutive years, averaging double-digit gains per year. Recent performance, however, has not been good. Gold touched $1,900 in the third quarter of 2011 and currently sells below $1600. reports that gold is up .3% at the close on July 12 from where it was exactly one year ago. It is possible that the calendar year results will not be up for 2012. That would represent the first down year in the last 12.

Gold Bubble

Is it OK for gold to go down? Those invested in gold would prefer it doesn’t, but a rational answer must be “Yes.” Trees don’t grow to the sky and few assets monotonically increase in value for lengthy periods. Gold is no different. It has had a remarkable 11-year run. But is this run over? Is gold just another bubble? We have seen several bubbles and will see more before this economic disaster fully plays out.

Human nature is spoiled by easy success in investing or other things in life. Success breeds confidence and higher expectations, often unwarranted. Men tend to believe that things in motion will continue in the same direction. No law, rule or guarantee exists to support such beliefs. That is not the way the world actually works, despite our brain’s tendency to see things that way.

Many gold investors are disappointed because their expectations have not been met recently. Latecomers to the commodity may have lost money. Many are wondering whether gold still a place to be. Is the 11 year feast that began with gold less than $300 over? Is it to be followed by 11 years of famine, perhaps returning to where it began?

These are valid questions and concerns. Everyone has an opinion, but no one can provide definitive answers to these questions. Neither life nor investing is linear. Nor are they always logical, at least in a manner in which we can comprehend.

One thing that is meaningful is the actions of central banks. They are behaving as if they believe in gold. According to Jeff Clark, they are purchasing it unlike any time in recent history:

  • Net central-bank purchases in 2011 exceeded 455 tonnes. This was only the second increase since 1988 (the first in 2010) and the largest since 1964.
  • Turkey has added over 123 tonnes since last October, buying 29.7 tonnes in April alone.
  • Mexico has purchased over 100 tonnes since February 2011.
  • The Philippines added 32 tonnes in March, its second-largest monthly purchase ever. Largely under the radar is the fact that it’s buying some of its local production.
  • Russia continues buying, adding 15.5 tonnes in May. Its total reserves now stand at 911.3 tonnes, the highest level since 1993.
  • Thailand has raised its holdings by more than 80% since mid-2010.
  • South Korea has bought 40 tonnes since May 2009, an increase of 180%.
  • The World Gold Council (WGC) reported that central-bank purchases totaled 80.8 tonnes in Q1 2012, about 7% of global demand.
  • Over the past 12 months, net purchases have averaged almost 20% of total annual supply.

These government financial types presumably know more than you or me. It they are moving toward gold rapidity, it suggests they believe in gold more so than holding reserves in fiat currencies. Mr. Clark’s analysis is one that should be looked at by those who are interested in gold. Recent central bank activity may be only the beginning of a trend:

In spite of the recent activity, world central-bank holdings are far below what theywere in 1980. Clearly, a few years of net buying does not a bubble make.

The difference is greater than you might realize. Consider that since 1980…

  • The global population has grown 55%
  • Worldwide gold supply has grown 120%
  • Foreign-exchange holdings have increased 650% since 1995, and now total $10.4 trillion.

It seems rather obvious that a lot more “catch-up” buying is needed before we start talking about a top for gold on this basis.

My interpretation of the central bank data is consistent with Mr. Clark’s, although I think the data supports more than a “catch-up.” Allow me to provide my view of the data:

Conspicuously missing from Clark’s list are three leading Central Banks — US, Europe and China. China does not regularly report its gold holdings, but there have been numerous reports that the Chinese Central Bank is diversifying out of fiat currencies (especially dollars) and into gold. We know they have encouraged their citizens to purchase gold.

Regarding the US and Europe, are they so preoccupied with mounting financial problems that they are unable to increase gold holdings? Or, perhaps they believe they have the two strongest currencies in the world (at least in terms of usage) and that there is no need for them to flee to gold. After all, don’t others flee to their currencies in times of local currency or economic strains?

Europe and the US cannot protect themselves from their own currency collapses. Their fiscal problems are too great and it appears as though they will continue to attempt to paper these over at the expense of their currencies. Any attempt for them to load up on gold would likely hasten the demise of their fiat currencies, as the effort would drive the price of gold through the skyward, revealing their overextended issuance of fiat currency. Furthermore, such a strategy could not be pursued without printing even more money than they are doing today.

If the world’s fiat currency regime is going to blow up, the amount of dollars and Euros outstanding is too great to back/hedge with gold (without driving the price of gold multiples higher than where it is today). Countries can protect themselves against the dollar and euro by holding gold in lieu of dollar reserves. The beginning of such a transition may be what is reflected in the data presented by Clark. That is, fear of currency collapses may be driving smaller countries to gold as a protection against such an event.

If disruptions are anticipated in currencies, gold seems to be a way to immunize against these disruptions.

What happens if the dollar and/or the euro collapse? For smaller countries, the simple answer is that reserves held in dollars become worth less if not zero. But what happens to the US and Europe? Great pain will be inflicted upon their economies. Debt burdens, considered impossible to maintain today, become much worse in the event of a devaluation. Default on government obligations is virtually assured.

Won’t the US be considered a financial pariah in the event of debt default? Yes! But the penalties usually exacted for such behavior will likely not apply. Default will occur without the usual consequences. Normal sanctions imposed on bankrupt sovereigns will not apply. The debt default will be accepted by the rest of the world.

Why do I say this? Quite simply, the US will demand debt forgiveness. The biggest military the world has ever seen will dictate the terms of bankruptcy and these terms will not be favorable to lenders. Default will be on whatever terms the US decides. Perhaps now US military might exceeding that of the next largest twenty-five countries combined will make some sense. The biggest sovereign bankruptcy in the world will occur and the deadbeat will receive the most favorable terms ever!

Should (when?) this happens, anyone holding dollars will likely be wiped out or see the value of such holding drastically devalued. In my opinion, that is why smaller central banks are fleeing to gold. They are seeking protection against the likelihood of the failure of the world’s reserve currency. Small states, like individuals, must protect themselves against this event. They must hedge against or get out dollars and dollar exposure.

For many individuals in the world, it is easy to stay away from dollars (and euros). The bulk of the world’s population is outside of the US and Europe. In ordinary circumstances they have little exposure to these currencies.

For US (and European) citizens, it is impossible to avoid the dollar (Euro). For them, gold is the only way to hedge against the failure of their own currency. That is why I intend to stay with a percentage of my portfolio in gold. It is insurance that I hope to never have to use, but fully expect to.

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1 Comment

  1. Several thoughts on gold performance. First, one of the things that came to light during the Libor manipulation scandal is the degree to which central banks have manipulated gold and silver prices. I read an article yesterday which stated that this may be the single greatest financial scandal in history. Second, I have read in this past week alone three articles from different sources predicting substantial increases in gold prices, one author stating it will be “parabolic”. Third, this is historically the time of year when gold prices are very low and usually rally very strong at the end of the year.

    All the basic reasons to hold gold are still in place. Perhaps even more than we realize. There is an article out today stating that if it was not for the Federal reserve, the Dow would be down FIFTY PERCENT !!! Think of that! That means that not only are stock prices WAY off, they are double their value and being propped up by printed money. That’s a double edged sword because they had to devalue the dollar to artificially prop up the Dow. Those two will collapse simultaneously and gold prices will go parabolic at that point.

    Regarding the major reserve banks. I read yesterday that in the past 5 months alone, China has acquired more gold than all of England has in reserve. Seeing as how they stand to lose the most from the economic collapse of the US, I think we can see what they believe will retain value. Furthermore, China and Iran now purchase oil in yuan, not US dollars, a MAJOR sign the US dollar will lose its status as the International reserve currency. Some speculate that China will try to form a new international currency backed by a gold standard. Were this to happen, gold prices would hit $50,000-$100,000 an ounce.

    IMO, only fools would think of selling off gold. Now is a good time to acquire more.

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