Central bank buying and the sudden fall in the gold price

We have seen new surprising and strong demand from global central banks in the last week.    This demand occurred over the last two months and had to compete with other strong demand from all sides of the gold market.   As we move into the quiet season for gold and have experienced a short sharp correction so far how will central banks react?   This week we received news that South America has now joined Asia, Russia, the Middle East and the Far East in buying gold for the national gold and foreign exchange reserves. Will the correction we are now seeing in the gold price affect central bank policies of buying gold?

Bolivia

Bolivia reported an increase of 7 tonnes of gold, taking its gold holdings to 35.3 tonnes, last week. While Bolivia has not made any public comment on this increase, it is very likely that the central bank has simply decided to restore its gold holdings relative to its growing foreign currency reserves, similar to other recent emerging market central bank purchases.

This is an encouraging development for the gold price, because other central banks may follow suit.  This will set a trend that will see price-insensitive demand grow from ‘Official” quarters.

Mexico

Mexico’s buying of gold in February and March amounted to 93.3 tonnes of gold, is one of the most rapid programs of accumulation on record.     With reserves now just over 100 tonnes in total, the market is holding its breath to see if it is an ongoing buyer.

Mexico’s vigorous purchase of gold over the last two months surprised the market by its speed and size.   For any central bank to buy 93 tonnes in this market is a clear statement that faith in the U.S. dollar is falling fast.   We do expect other emerging South American nations to follow suit over time, alongside many of the world’s emerging economies.

How Central Banks buy Gold

Buying programs by central banks usually follows a particular pattern.   Central banks buy to hold, not to trade or profit from.   They are a monetary asset held for the most extreme of national economic crises.   This affects the way they buy for their reserves.   The most preferred manner is to buy their own local production, as this is done away from the markets that really do make the gold price.   The only impact on the global gold market is to lower supply through the absence of that country’s production.

The price paid to local miners is related to the market price at the time of the purchase, irrespective of the volume.   The price paid by the central banks is not considered important but the volume acquired is.   Central banks will deal in a way that takes only the gold available on the market at any time.   This is done by ‘buying the dips’ or simply by notifying their bullion bank dealers that they are buyers of a minimum amount when it becomes available.   When prices run ahead as supplies diminish, central banks will not chase prices, simply take what’s offered to them.   This prevents the gold price from rising.

Will central bank buying end?

What is clear throughout the world is that central banks remain determined to keep their gold and foreign exchange reserves balanced with gold an integral part of those reserves.   The cessation of European central banks sales nearly two years ago confirmed this, as do the ongoing purchases by Russia and China.   Even in the Middle East oil producing nations are ensuring that they have gold in their reserves.   This is a practice that is unlikely to end in the future.   The days when the market feared central banks unloading all the gold they had are far gone.   It is clear that gold will remain a key part of the global monetary scene as instability and uncertainty become entrenched over the next few years.

We are watching global central bank behavior to see if the extremely worrying dollar health will accelerate gold purchases.   The South American central bank’s action has confirmed that this is the case.   We do expect more news on this front.

This week’s sell-off of Gold

This makes the sudden sell-offs we saw this week and the subsequent recovery so interesting.   We won’t be informed of whether it was central banks which picked up the gold coming onto the market, but we do expect them to be one of the buyers.

With newly mined gold production of around 5 tonnes a day reaching the physical markets a sudden additional amount of 5 or 10 tonnes will hammer the price.   Frantic calls to buying central banks would be made but perhaps the buy orders had to wait until London was open before it could be bought.   Meanwhile, in New York, the price would fall heavily.   The news that such volumes could be bought anonymously through London would reach the ears of all global buying central banks.   You can be sure that they would be linked to the London Fix by phone at the next Fix.

The net result would be what we saw this last week, a large fall and a quick recovery.   For some months now we have been forecasting that corrections will become short and sharp.   What usually took weeks or months now takes days.   This is because gold is not a commodity or a barbarous relic but a monetary metal.

Gold-positive global economy

With the developed world economic news pointing down to an anemic performance there is every incentive to avoid a drop in the value of developed world currencies by buying gold, as we have just seen in the last 18 months.   Remember too that gold, since the turn of the century, has been rising in boom times and bust.   Only in the latter half of 2007 did we see the gold price fall as investors in the developed world deleveraged their positions as the downturn made leveraged positions far more vulnerable.   Investors had to find liquidity to fill the holes all falling markets created.   Hence, their desire for liquidity became overwhelming.   Such over-leveraged positions are a thing of the past, but those that are still there disappear fast on such days as we saw this week.

The awareness of the vulnerability of investors positions has made them react more quickly, adding to market volatility.   But such volatility is short-term, as the cautious hunger for gold remains persistent and arrives ‘on the dips’.   Underlying, the precious metal markets is the insatiable demand from the Asian emerging markets, which, while it comes in jerks, is never-ending.

Again, like central bank demand, Asian demand is interested in acquiring volume.   Their price concerns are restricted to knowing they have not overpaid, but have bought at prices that will hold.   They will only sell if they believe the price has risen to far too fast and may fall soon.   Once the price has fallen they re-enter at lower levels, consistent with their objectives of holding gold long-term as financial security.   They see gold just the same as the developed world sees cash.

Where will the Gold price go now?

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