Gold outpaces its long-term drivers

Gold continues its spectacular rally. Indications from the Bank of Japan that it would implement further quantitative easing are assisting gold’s ascendancy. However, gold is now outpacing its
long-term drivers.

For some time now, we have said that the long-term causal fundamental drivers for investment demand in gold is liquidity (not necessarily inflation) and long-term real interest rates. At the moment, both support a higher gold price into next year (see Commodities Insight dated 11 Aug 2010). The BoJ’s announcement yesterday spells a higher gold price. Gold’s relationship with liquidity is confirmed visually (see graph) as well as empirically. We measure global liquidity as the US Fed balance sheet plus global foreign reserves holdings excluding gold. YTD, our measure of global liquidity is up 10%. The gold price is up 18% YTD.

Following gold’s latest rally there is growing divergence between the gold price and global liquidity — the gold price has been rising much faster than liquidity. This is not inconsistent with past behaviour. There are many short-term drivers of gold (such as credit risk, equities and currency moves) which account for these short-term price movements. Furthermore, the difference between liquidity and the gold price is not at an extreme level yet, and we can therefore not conclude that gold is overbought. But we are certainly more cautious with gold at these levels. Speculative length is building, and scrap gold continues to come to the market.
As mentioned in we would not be surprised to see a pull-back in gold.

Looking into 2011, we believe that global liquidity will keep rising as emerging markets specifically further expand their foreign reserve holdings. However, we
expect it to slow in 2011 and 2012 — to only 8% and 5% respectively. This growth in liquidity should support gold.