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Gold’s two markets-in-one can anger and confuse

Gold now viewed as the antithesis of the central bank – behavioural economist.

Any mention of the large bullion banks’ views on the gold market, especially if their view is that prices of the metal are going to go lower, provokes a very particular and, usually, pretty angry response.

A response that takes as a given the view that these banks, aided and abetted by central bankers, have colluded to suppress the price of gold; that any attempt to report their views is a sign of collusion on a part of the journalist concerned; that if physical demand for the metal were taken as the metric by which prices were set then they would be headed upwards at a rapid clip and, finally, that when the rest of the market finally realizes that paper money is nothing more than a fiction and that there isn’t really enough gold to go around, that the price of the metal will explode.

One can debate the various merits of the argument and Mineweb has done so on numerous occasions. But, increasingly, it makes sense to reject the entire premise upon which it is built – the notion of a single market for gold based on its role as a store of value.

As behavioural economist, Ben Hunt explained it to Mineweb recently, what is of great importance to the movements of markets is so-called common knowledge, something he defines not as what everyone knows but rather, what “everyone believes that everyone else believes.”

See also: The narrative of gold and the new common knowledge

“It’s an amazingly powerful force in human behaviour because as social animals we are really hard wired to pick up on these sorts of cues and to act in our behaviour – particularly our investment behaviour, our investment decisions – on what we think that everyone else thinks,” he adds.

For Hunt, the difference between the current market narrative for gold and that of previous periods of financial crisis is that, in previous eras regardless of what anyone believed, the assumption was that everyone else believed that gold was an independent and consistent store of value. These days, he says, this is no longer the case in Western markets.

Today, he says, gold is viewed as the antithesis of the central bank, the physical manifestation of lack of confidence in the current system.

Thus, when markets feel, like they currently do, that the Fed and its peers are actually making inroads into solving the crisis, they no longer need to hold gold.

Further, if gold is being considered as a hedge against Central Banker incompetence, rather than as an actual store of value, then holding physical metal becomes less important.

That is not to say that no one wants to own physical gold, indeed, physical gold ownership is on the rise a matter with which we will deal shortly, rather, what it points to is that, for the most part, these two markets are now almost completely removed from one another – conveniently, largely along geographical lines.

As a case in point, in Incrementum’s recent annual In Gold We Trust Report, it quoted a LBMA study from 2011 that said total trading volume in 2011 amounted to 50 billion ounces. A figure, Incrementum pointed out is 600 times annual production.

“According to the study,” it said, “10.9 billion ounces of gold worth a total of 15,200 billion dollars were traded in the first quarter of 2011. That equals 125 times annual production, or twice the entire amount of gold ever mined. 240 billion dollars in trading volume per day amounts to more turnover than in most currency pairs. Insofar, gold is one of the most liquid investment assets in the world.”

Put a slightly different way, assuming no one told the markets, all of the world’s gold mines could shut tomorrow and, for a fairly long time, very few people in the Western world would actually be any the wiser.

In this world then it makes complete sense that all eyes are focused on what the US Fed is likely to say at the end of its two day FOMC meeting that starts today, rather than the latest developments in the wage talks in South Africa’s gold sector, or the rather poor results being put out by the world’s top gold diggers.

As UBS writes in its latest daily commodities note, “In late June we noted that the macro environment was becoming increasingly difficult for gold. That trend looks set to continue amid improving outlooks on the US economy and growing bullishness on the dollar.”

Importantly, however, the bank goes onto note that while conversations with its Asian clients last week revealed a clear recognition of and little pushback against these developments from them, “appetite for physical gold is broadly expected to remain healthy this year”.

“Most of local market participants we spoke with in China,” the bank continues, “were of the impression that so long as gold prices are deemed attractive, physical demand will be strong. Although this is unlikely to provide enough firepower for a sustainable rally, it does hold the promise of a sturdy price floor.

For the majority of western gold traders, who are, in the main, of the institutional variety, Asian retail demand remains a happy relic of the old days when gold was viewed as a store of value. Long the bedrock of the sector, it has in recent years been far outstripped by investment buying in the West, ignited by the creation of the ETFs.

As UBS explains it, “Another key takeaway is the stark difference between how gold is viewed in different parts of the world. Discussions with institutional investors in the Western Hemisphere earlier this year revealed strong negative feelings towards gold. Most pointed to monetary policy expectations and positive views on the dollar, the diminished role of safe-haven assets in an improving global economy, and the desire to re-allocate wealth into growth assets like equities, and even PGMs. In contrast, retail investors in Asia – who account for the bulk of physical buying – have found good value in this year’s lower gold prices.”

There is no denying Asian demand for physical metal. India’s attempts to stem the buying of the metal by its citizens provides just one very good example of just how strong this demand is. But, expecting prices to jump to new records in the short term because of this demand is as flawed as expecting that prices cannot fall below the price of production in the short term.

Both expectations fails to properly take account of the role that the paper market has assumed within the life of the metal. The narrative of gold in the West as it stands is well entrenched and is only likely to change if the system breaks down totally. Caveat Emptor.


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