the next leg of price rally could be triggered by worldwide currency

While the precious metal has largely withstood an overall plunge in asset prices so far, the next leg of price rally could be triggered by worldwide currency debasement. Devangi Joshi explores

    In January '09, Indiana state senator Greg Walker introduced a bill: "The Indiana Honest Money Act" which proposed to allow citizens the options of making monetary exchanges based on physical gold or silver or equivalent electronic receipts as an alternative to the Federal Reserve notes for all transactions conducted with the state of Indiana.
    Such a single instance in one of the American states does not mean that the entire fiat money system is on the verge of a collapse. However, it does indicate that the paper currencies are losing their vigour due to the developments in financial markets since late 2007, and in turn bringing back gold as the measure of monetary value. This week, ET Intelligence Group brings you an analysis of the situation in the gold market and what it means for the investors.
    2008 was an exceptional year that showed unprecedented price movements for most of the asset classes, with historic highs, as well as lows, being made in the same year. Gold, however, stood out amidst the chaos because while prices rose to their all time highs in March, they managed to show a significant resilience against a fall in prices of other asset. Average international spot prices stood at $872 an ounce in 2008, up 25% from their average in 2007. In the third week of February 2009, the precious metal has continued its momentum with prices making new highs in most currencies, but US dollar.
    The reason for this deviation or outperformance is the value the yellow metal enjoys as a safe haven. This view is substantiated by shifts in correlation gold generally holds with currencies like Euro and British Pound as well as crude oil. As gold is a US dollar denominated asset, it holds a negative correlation with the greenback and hence a positive correlation with major currencies that compete with the US dollar, mainly Euro and to some extent pound. However, since late 2007 this positive correlation is waning with both the latter currencies feeling the heat of the mounting economic troubles in respective regions.
    With crude oil, the yellow metal holds a strong positive correlation because rising crude oil prices cause higher inflation and gold is perceived to be an inflation hedge. However since, mid-2008 this correlation has also started somewhat fading.
    The current global economic scenario is a complete turnaround since mid-2008, with the concerns of inflation being replaced by fears of deflation. The question that comes to one's mind is why the gold prices continue to do well while the inflation is heading down.
    The answer to this question is in the current financial instability that could prevail for long. While the credit is drying, most of the countries across the world have seen a significant rise in their debt obligations. As on January '09, national debt of developed economies like the US and the UK stand at 75% and 48% of their Gross Domestic Product (GDP), respectively. According to market estimates, global bond issuance in 2009 will reach an all time high of more than US$3 trillion—a three-fold rise from 2008. With more frequent announcement of government stimulus packages, the debt to GDP ratios of leading economies are expected to blow up further.
    Adding to this, if the global Central Banks run out of the interest rate adjustment options (as possible in case of the US and the UK), then they would be left with the choice of quantitative easing—an exercise of printing money to buy a variety of securities (mortgage backed securities in this case) with an objective to pour the financial markets with liquidity.
    However, the current spates of reducing key interest rates have already strained the currencies worldwide. Historically, financial crisis have always caused debasement of the currencies. Currency debasement is the term used to indicate the revaluation of the currency due to a decline in its purchasing power.
    As the paper currencies lose their purchasing power, gold prices could rise further as gold is looked as a financial constant that can gauge the real value of currencies. A deteriorating faith of investors in the paper currencies would further brace up gold's status as a refuge in uncertain times.
    The lead chart (see The Golden Egg) compares the performance of major currencies against gold since 1999 with prices indexed to 100. The yellow metal has clearly shown a gain in its purchasing power, while leading currencies like dollar, euro and pound have fallen.
    Looking at the gold total demand in last few years, there has been a clear shift in demand distribution. While fabrication demand is on a decline there has been a significant rise in investment demand. Fabrication demand includes consumption of the metal in jewellery and industrial usage. Investment demand comprises of retail purchase of bars and coins of the bullion and more recently the ETFs (Exchange Traded Funds) and similar products. The Shining Armour
CONSUMPTION in jewellery, which traditionally constituted more than 70% of total demand, has seen a continuous decline since 2005, since gold prices breached the $500 an ounce mark.According to data available from World Gold Council (WGC), in last five years (2003-2008), the jewellery demand has declined by a compounded annual growth (CAGR) of 3%. This decline has been more than offset by the investment demand, which grew at a CAGR of 26% during this period. Bar and coin retail holding, in 2008, has shown a massive growth of nearly 43%, to 637 tonnes, while ETF demand rose by 27%.
    Developments in supply side also indicate that higher prices followed by global financial turmoil have caused a swing in traditional trends. In last five years official sector sale, which include sales from central bank and monetary authorities like IMF, has experienced a decline at a CAGR of 15%. Conversely, due to higher prices, the scrap supply has increased at a CAGR of 4%. Last year, the official sector sale of gold came down by 44% whereas the scrap supply increased by 18%.
    There are also mounting expectations of a rise in central bank buying of gold as the monetary authorities try to regain the lost confidence and add some strength to their balance sheets.
    This could explain why gold prices shot up to $1000 an ounce in third week of February 2009 when the Central bank of Russia announced an addition of $1 billion in gold's share to its total reserves.
    In conclusion, fundamental developments indicate a brighter outlook for gold prices in coming months. Even as gold prices have seen wider swings due to fast changing dynamics and profit booking in last few months, the underlying uptrend seems intact. Considering the firm stance of US dollar, which is backed by cash requirement rather than strong economic conditions, is one hindrance that can restrict the rise of gold prices. There could be instances of a significant retracement towards $910-870 an ounce levels before international prices swiftly breach through a strong resistance range of $990-1030.
    devangi.joshi@timesgroup.com