London, 19 August 2010

The current rally in gold could well be unsustainable, with the bubble set to burst at the first sign of weakness, warns DailyFX, the leading online trading news and information service.

With real supply and demand conditions for gold pressuring prices lower, continued interest in investing in the metal is the only way for prices to continue to advance – but the truth is that the rally has become self-fulfilling with its appeal to investors dependent almost entirely upon its continued gains.

Ilya Spivak, Currency Strategist at DailyFX, said the current situation “leaves the door open for a sharp reversal at the first hint of a meaninful setback, an outcome that [will be] all the more dramatic because of the proliferation of exchange traded funds as a vehicle for gold investment, which makes gold positions much easier to liquidate.”

Where might such a setback come from? Well, there are a number of factors that are likely to impact negatively on gold’s appeal as an inflation hedge. The story begins with inflation expectations.

Throughout 2009, the price of gold intimately tracked US breakeven rates– the spread between yields on regular and inflation-indexed 10-year US Treasuries that is used as a gauge of investor price growth expectations – amid concerns that quantitative easing would debauch paper currency. At a time when many feared that a period of runaway inflation would soon result from central banks effectively “printing” money, gold proved attractive as a standby store of value.

However, this inflationary fear appears to be unfounded. Looking at the US as an example, the amount of money actually created by the Federal Reserve’s liquidity injections is a function of the money multiplier, a ratio measuring the total impact of a deposit into the banking system after it expands through lending and borrowing while cycling through the banking system. Data compiled by the Fed’s St. Louis branch reveals that currently the money multiplier is hovering near 0.8, the lowest level in more than 25 years. This means that for every dollar created via quantitative easing, only 80 cents actually makes it into circulation. Furthermore, a Fed measure of the velocity of money - the speed with which it changes hands - has also fallen to a multi-decade low.

But while some of the current inflation picture can be attributed to sluggish economic activity, that doesn’t tell the entire story. The unprecedented scale of the 2008 credit crunch has prompted a major shift in consumer behaviour with personal saving among previously spendthrift US households sharply outstripping borrowing. Put simply, Americans – like most consumers across the world - have become keener to save than borrow. Against this backdrop, the current state of affairs is hardly surprising: in order for the banking system to multiply deposits, people must be willing to take out loans. On balance, this means that despite the Fed’s artificial creation of liquidity, a catastrophic period of inflation is unlikely because the mechanisms of monetary policy transmission are not operating as they should. “The result,” says Ilya Spivak, “is that gold is increasingly likely to lose its appeal as a hedge against inflation.”

More recently, gold has traded as a safe-haven asset, with spot prices showing a strong inverse correlation with the S&P 500 benchmark stock index. While this may boost prices amid risk aversion as traders become increasingly worried about the continuity of the global recovery, it seems only a matter of time before expectations of a slowdown are priced into the market and lose their ability to meaningfully shock investors.

Ilya Spivak explained: “The overall picture is that gold may move higher in the near term but these gains seem inherently limited, offering another likely stumbling block that threatens to undermine the rally.”

DailyFX says the trends in real gold demand also look decidedly lacklustre, with use of the metal for the manufacture of jewellery as well as for industrial and dental purposes clearly tracking lower.

Meanwhile, supply seems to be picking up. Mine production has snapped a multi-year downtrend with output rising for the first time in close to seven years. Further, gold scrap such as jewellery melted down for its metal content is on the rise as well.

The rapidly growing use of exchange-traded funds (ETFs) increases the chances of a sudden burst in the bubble. ETFs, which have become an attractive vehicle for gold exposure given their ease of use compared to physically buying bullion, with this kind of “soft” investment now on track to overtake its counterpart for the first time.

Ilya Spivak said: “The problem with ETFs is that while they make buying gold comparatively easy, they equally make liquidating the investment easy as well, prompting a far more violent downturn than would otherwise be the case should trader sentiment reverse.

“More worrying still, it appears gold’s appreciation has become the impetus for demand, the precise opposite of how an asset is normally expected to behave. Indeed, linear regression studies suggest that a whopping 89 percent of the variance in the spot gold price is explained by variance in the holdings of the SPDR Goldshares ETF (GLD), the leading exchange-traded fund tracking the metal.”

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