Why Gold's Recent Rally Was No Surprise

The recent rally in gold prices should not come as a surprise. After all, the gold market has been in backwardation for months, the three-month lease rate, reflecting the cost of borrowing gold, reached a four-year high on August 7, demand for the physical metal has been exceptionally strong amid an outflow of funds from exchange traded funds and of course the continuing deliberation by the US Fed towards tapering its asset buying program has made it difficult for investors to decide when and if this is going to happen.

Engineered Fall
But in addition, it was well known in the market that the fall in prices in April was engineered by bullion banks and had absolutely nothing to do with the supply and demand fundamentals. And, major investment banks were sending reports to the clients advising them to sell the metal. But, one of the key timing indicators for this turn around in gold prices was the news that some gold miners have started to hedge their production. While most of the major miners have yet to hedge any of their production, around the beginning of this month there was news that small and medium-sized gold companies had begun to hedge in recent months after gold prices had fallen by around 30%.

This was the final indicator that prices were close to a reversal in trend. Gold mining executives are notorious for miss-timing the market. It cost AngloGold Ashanti and Barrick billions of dollars to unwind their hedges. It seems that they use a philosophy of hedge when prices are low, and unwind when prices are high! It is quite unbelievable how bad their timing is.

The highest profile hedging activity has come from Petropavlovsk, the London-listed gold miner, which has hedged about half its gold production -- although bankers say several other deals have not yet been made public. Peter Hambro, Petropavlovsk chairman, said the "timely" move had "helped to secure our cash flows."

The majority of the recent hedging deals have come from miners in Africa and Asia, bankers said. Unlike the bumper deals of the 1990s when miners sold forward several years production, now producers are largely hedging their production for just the next year or so.

And, true to their form, as soon as they locked in their production at the lower prices, the price of gold has rallied. Obviously they do not follow the developments in the gold market. But whatever the case is, the fact remains that the plan of the bullion banks to suppress the price and scare investors out of the gold market has backfired. The lower prices only spurred demand for the physical metal around the world. And, one of the major players in this market, namely China rushed in to buy large quantities. Chinese demand for gold is on the verge of eclipsing that of India, currently the world’s largest consumer.

Global Demand
In its latest report, Gold Demand Trends, published by the World Gold Council (WGC) global gold demand was 856.3 metric tons in the second quarter, down 12% from the same period a year ago mainly due to a wave of outflows from exchange-traded funds. However, this was largely offset by record demand for gold bars and coins while demand for jewellery grew significantly to reach multi-year highs.

According to the WGC the consumer market for gold was once again dominated by global leaders India and China, which together accounted for almost 60% of the global jewellery sector and around half of total bar and coin demand. On a year-to-date basis, total consumer demand (for jewellery, bars and coins) in each country is almost 50% ahead of the same period in 2012.

Recently, the China Gold Association reported that domestic purchases of gold jumped 54% to 706.4 metric tons in the first half of 2013, compared to the 460 tons that was purchased in the same period a year ago. Buying of gold bullion bars surged 87% and jewellery demand increased by 44%.

Last year, the total demand for physical gold was reported at 832.18 tons. China's gold demand could hit a record 1,000 tons this year and will overtake India, the World Gold Council recently stated.

ETF Holdings
“The gold that has come out of (ETFs) has gone into strong hands, because it’s obviously gone East into mainly jewellery, bar and coin demand in India and China,” said Marcus Grubb, managing director for investment with the WGC.

Holdings of gold by exchange-traded funds fell by 402.2 tons during the second quarter. Perhaps three-quarters of these redemptions were in North America, Grubb said. The majority was in Western markets, where all of the major ETFs are based.

When asked if all the tonnage leaving ETFs was absorbed Grubb said. “Well, it was absorbed in a 71% rise in total demand for India in Q2 and an 85% rise in total demand in China in Q2…You’re seeing that ETF gold being absorbed and going eastwards.”

The sharp drop in gold prices during the second quarter spurred a jump in jewellery demand, according to the report. Jewellery demand surged 37% to 575.5 tons from 420.8 tons in the same quarter a year ago.

Of the roughly 155-ton increase, 120 came just from India and China.

“Although jewellery demand is influenced by a wide set of factors, including economic growth, consumer sentiment and disposable income, to name a few, all were eclipsed by the effect of the drop in the gold price,” the WGC said. “The resultant buying frenzy caused a huge rise in regional premiums on gold, as supply chain bottlenecks caused delays in meeting demand.

“The upward trend was almost universal, with the most notable year-on-year improvements occurring in India, China, the Middle East and smaller Asian countries.”

While India's consumption this year is expected to be lower than last year's 860 tons as the government continues its ridiculous policies to curb imports, the smuggling of gold into the country has escalated substantially. It is therefore impossible to access the true situation regarding the inflows of gold into India.

Total investment demand for gold bullion coins and bars jumped 78% to 507.6 tons from 285.9 in the same quarter a year ago, with Asian and Middle Eastern markets. According to the WGC bar and coin demand hit 913.2 tons, already almost three-quarters of the total for all of 2012.

The WGC report stated that while ETF holdings may continue to contract, the pace is likely to slow. “We do think that we have seen the worst of the redemptions…and that a lot of those investors who were in on fear of the financial system have gone out,” Grubb said.

However, the WGC report also said, bar and coin demand may struggle to retain the “exceptional levels” of the last quarter, although it still has “solid underpinnings,” especially in Asian markets.

The premiums of gold bullion soared during the second quarter in a number of markets as dealers struggled to obtain supplies as refiners, even working at full capacity, struggled to convert larger gold bars (London Good Delivery bars and 100-oz bars) into smaller bars fast enough to meet the needs of Asian consumers.

Combined demand for physical gold from the smaller markets of Thailand, Vietnam and Indonesia increased by 46%. And, at times, the premiums on gold sold by Vietnam’s central bank exceeded US$200/oz.

EU Demand
The rise in investment demand for gold bullion across the European region was dominated by Germany and other German-speaking countries. Demand was heavily concentrated in bars rather than coins. The 250 gram bars were reported as being the most popular.

U.S. Demand
In the US while US investors added bars and coins to their holdings, the American eagle coins were in such demand sales of the one-tenth ounce coins were briefly halted.

Investment in Turkey hit new quarterly records for both volume (37.9t) and Lira value (TL3.2bn).

The WGC also reported that Central banks have remained net buyers of the yellow metal, although purchases have slowed somewhat. Central banks collectively bought 71.1 tons of gold in the second quarter, down from 164.5 in the same period a year ago. “Overall, it was still a good quarter when you compare it to the last 15 to 20 years,” Grubb said. “We expect central banks to remain net buyers of gold, although there may be a slight drop-off in annual demand to between 300-350t,” the WGC said. “This is still roughly in line with the average for the last three years.”

The WGC previously anticipated higher 2013 central-bank demand of around 400 to 450 tons, Grubb said. Emerging-market nations, in particular, are likely to remain buyers. “Those countries have not changed their targets for the proportion of gold in their reserves,” Grubb said.

After struggling to break above the important resistance level of $1,300 an ounce for several weeks, last week, the gold price finally made its move to the upside pushing through this level as well as the $1350 an ounce level to a seven-week high on safe-haven demand and a growing Chinese appetite for the precious metal.

If you understand that gold is an alternative for the fiat currencies around the world, then you should act now and add physical gold to your holdings. And, let me reiterate, physical gold is gold bullion bars and coins, not limited edition medallions or exchange traded products.

Target
Gold prices are now up by 17% since their recent lows of June. Last week, the price of the yellow metal broke above the 50 day Moving Average as well as a key psychological resistance level of $1350 (R) an ounce. The next near-term target is $1400 an ounce.