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Why is the Gold Price Rising So Fast and So Far?

What has happened to the gold price lately?

The gold price turned around at below the long-term trend line at $1,160 and rose in an almost straight line to $1,360 before building some support at $1,350. This was after almost 18 months of consolidation between $1,050 and $1,250. The long period of consolidation was while the markets believed that there was a good chance that the recovery would gain traction and all would be well. Then the news darkened and fear and uncertainty in large doses returned alongside worrying actions on the U.S. stimulation front and the world's foreign exchanges. But far more than that happened in the gold market. It was and is a combination of all these factors synthesizing that has driven the gold price to present levels.

Fundamental changes in gold supply /demand

With the consolidation in the gold price between $1,050 and $1,250 over such a long time came the belief in many quarters, including the jewelry sector and retail demand out of India that the gold price would retreat from record highs. Gradually, the high prices came to be accepted as prices failed to retreat. Jewelry demand has returned gradually. We expect it to remain as it is or improve at these high levels, unless there is a very large jump upwards in the gold price.

Accompanying the return of jewelry demand has been the waning of scrap sales as holders realized that prices were not going to fall but to rise. With newly mined gold now relatively price inelastic the only source of supplies of gold are from current holders of gold. This is a critical point to realize about the gold market. At current prices, demand must recede to match the drop in scrap sales for the gold price to fall or move sideways. Any rise in demand and the price has to rise sufficiently to incite new scrap sales.

With the various types of demand joining to place upward pressure on the gold price, some of it has to give way to others so that overall demand can be reduced to meet available supplies. The only way to do that is with higher prices.

Changing investment demand

Even now commentators on the gold market focus on whether the gold price will rise or fall. The reason is that developed world markets are focused on making money. Consequently, the technical picture of the gold price is critical to investors that aim to make profits from the market. But they are not the major force in the gold market any more.

From Turkey eastwards, the prime driving force behind gold ownership is that it represents true wealth and a source of financial security. Investors are concerned not with prices rising, but have a fear of prices falling. Buying is focused on not paying too much for gold, for fear it will drop just after they have bought. In India demand waited for the gold price to make the solid 'floor' it did between $1,050 and $1,250. Once convinced, buying began again.

Further east, for the first time in so many Asian people's lives, they now have a good amount of disposable income. As people who know the downside of life only too well they have a propensity to save, almost naturally. Up to 40% of the disposable income they have goes into bank deposits or into gold. As China grows, a larger and larger number of people enter the gold market for the first time. These buyers simply want to save in gold. Price is not such a consideration nor are profits. However, gold's performance is good so they become even more convinced that it is a good investment and buy more. The more they buy the more they push the gold price up. But even with such growing demand the gold price can be vulnerable to big corrections. What is there in the demand for gold that changes its nature?

Central Bank demand

What is new to the gold market and has tipped the scales to the future gold price has been the change in central bank selling to central bank holding or buying. A central bank by its nature only buys gold to hold for the long-term. They no longer have the concept of selling if the price goes too high. It is an important reserve asset and always will be.

Gold represents a reserve asset that comes into its own when life becomes difficult and the days extreme. When the "Washington Agreement" began in 1999 September 26, the belief that central banks were unrestrained sellers of gold stopped. A 'cap' was put on these sales. The 'cap' was sufficiently low as to allow the gold price to turn round from the $200 area and move up steadily over the years until 2009 when European gold sales virtually stopped. At the time the gold price had hit $1,250.

Central banks buying began in earnest almost as a legacy of the financial crisis that had consumed the world since August 2007. Now, new crises have blossomed which led to confidence falling in the currency system itself, a fear compounded by the unfinished Sovereign Debt crises and quantitative easing. Solutions to these problems have not appeared and there is every reason to believe that we will see further decay in the global monetary system, as each nation looks exclusively after its own interests.

In the years before 2009 central bank selling supplied between 400 and 500 tonnes of gold to the market. This supply has now gone. Instead these banks, and there is a growing number of them [Korea is contemplating buying gold right now] want more gold. The only 'Official' seller of gold in the last 18 months has been the I.M.F. that has a program to sell 403 tonnes. It only has around 75 tonnes left to sell. Once this has gone central banks have only two choices in buying gold. Either they buy local production [easily bought from locals by referring to the price in the 'open' market at the time of the purchase [that's if they have any local production of gold], or by going directly to the 'open' market to buy gold. Central banks are determined to buy gold and will be persistent buyers until they reach their target tonnages. Russia needs to more than double its gold holdings to reach its target and emerging nation's central banks would like to have between five and ten times the gold they have at present in their reserves. That is a huge amount, particularly when you consider that the world's known underground reserves are somewhere around 22,000 tonnes only.

In the 'open' market their usual method of buying is to place a 'limit' order to buy gold at or below a certain price then wait for sellers to offer them gold at those prices. This way they don't know how much they will buy per month, but they don't chase prices. Thus they drain the gold market 'on the dips' and ensure that new buyers have to raise prices to source gold. In this way they underpin the gold price. Profit orientated buyers are the ones that push the prices up when they rise. Limit buyers then follow them up. The retail Asian tide can be seen in overnight prices moving prices gently up all the time.

So where are supplies over and above newly mined gold to come from? Current holders are the only source of new supply. Only substantially higher prices are going to release sufficient supplies from these investors, but at what price?


The Gold Market is not a 'bull' market
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