Which way for gold?

On Friday I was at a gold conference at Bloomberg’s glitzy London office at Finsbury Square when news came through of the fine imposed by Uk regulators on a senior trader at Barclays for manipulating the price of gold and on Barclays for lack of internal controls: “What, Barclays again?”, said one participant, referring to the number of scandals the bank has been involved in (the market manipulation took place on June 28, 2012, the day after Barclays had paid £290 million to settle allegations of attempts to fix the LIBOR rate).

The news broke just as participants were discussing the future of the spot market. The uneasy feeling among the experts was that the London gold “fix” (ha, ha) has had its day. But a spirited defence was put up by Ross Norman, CEO of bullion brokers Sharps Pixley and a veteran of the gold market, who took the opportunity to lambast reports that elevated a “rumour” to the status of fact. He insisted that it was “almost impossible” to front-run the fix. Others however said that client confidence had been damaged, and pointed out that several banks had withdrawn from commodities trading – partly because of higher capital requirements but mainly for fear of “reputational damage” if further scandals were to emerge.

There was support for the argument made by Harriet Hunnable of the CME group that London should be more transparent – e.g. volumes traded at fixes should be disclosed.  Self-regulation was “untenable”. Indeed, she reported that market participants now prefer a regulated environment.

Agreed, it would be very difficult to replace the fix – and the fact that many trades were concentrated around the time of the fix was “quite natural” – if you have a big deal to manage, of course you will do it when when the market is most active and “everybody is awake”. Central banks, for example, which deal in large sums, naturally buy in the afternoon.

Certainly the “fix” is due for a rebranding – whether it will be anything more than that will only emerge as a result of regulatory scrutiny now being conducted.

“Armageddon fatigue”

Some argued that the bull run in gold would resume after the present “lull”. These bulls pointed to continued unaffordable sovereign debt levels, the difficulty that economies (East and West) would have in growing out of the debt burden, and the prospect for falling supply as low margins cut mining investment.  “Black swans are everywhere” said one delegate – referring to unexpected bad news that could increase fear and flight from other assets to gold. A collapse of property bubbles in China or indeed other centres could also divert money into gold. “Fractional reserve banking system is in trouble” , said another, while China goes its merry way creating new money on a vast scale (M2). Weakness in the US could yet persuade te Fed to reverse its tentative reduction in stimulus. All of these  trends have inflationary potential.

Others pointed to negative factors.   The market is suffering from “Armageddon fatigue” . People realise that several catastrophe scenarios that were sustaining the decade-long bull market have NOT materialised and may NEVER materialise in future – e.g hyperinflation in the US, the collapse of the eurozone, war in East Asia. The geo-political tensions over Ukraine should have unleashed a bigger surge in demand for gold as a safe haven. China’s growth rate is declining, while fears surounding Fed policy are already priced into the market. Moreover, the  probable rise in interest rates over the next two to three years will raise the opportunity cost of holding gold.

“Why are we talking of a bull market?” asked one industry insider. “It is bizarre”, he said, given that the price has fallen by nearly a third since its peak of $1921 an ounce in September 2011.Ross Norman said it reminded him of the market in the late 1990s – it is an “old-fashioned” market driven by fundamentals, and most investors were “pretty negative” on gold.

Well, I am not so sure. Remember the big differences between now and the late 1990s. Then, some big central banks like the Swiss were selling (remember Gordon Brown?); now central banks are buying (net) on a substantial scale; they have been net buyers for 13 consecutive quarters (122 tonnes in the latest quarter). They have recently renewed their gold agreement, which removed the main threat of large-scale sales, while leaving potential on the upside. For central banks, there are not many ways effectively of diversifying reserve assets – a key requirement at a time when all currencies tend to lose value at about the same rate (so diversifying from dollars into, for example, euros does not really help you retain purchasing power). The move of some central banks into equities, albeit still on a limited scale, demonstrates their anxiety to find alternatives.

Also, gold as a classic official assets retains huge advantages. There remains great nervousness about the weakness of US monetary policy. China is clearly on a long-term drive to build its gold holdings, both by public and private sectors. Jewellery demand in Asia remains strong – this year has seen the strongest start to the year for jewellery since 2005.

The fundamentals of the market seem to me much healthier than they were in the 1990s. If the central banks succeed in managing the transition to a more normal monetary policy and balance sheet smoothly, the gold bears might outwit the bulls. But any surprises are likely to be on the upside.