We had expected gold to experience “one last leg higher” during the second quarter before long liquidation and poor commodity fundamentals drove prices towards US$350 per oz. by the end of the year. However, events have fast-forwarded, with the second price peak of US$430.40 occurring on April 1, followed by a marked retracement during that month. Eventually, prices found physical and fund support during May towards US$380 per oz. and recovered back towards US$400 but had again slipped towards US$380 by mid-June.
The end of the “reflation trade” — where investors saw commodities benefiting from low interest rates, money supply growth, and a weak U.S. dollar — has greatly affected gold, where the dominance of speculators completely overshadowed weak commodity fundamentals. Indeed, gold prices would have fallen further in April had it not been for the ongoing level of geopolitical concern and the high price of oil. However, there has been a notable change in approach, with longs now looking to sell into price rallies.
Quite apart from the macro environment and the technical outlook, we see a number of negative developments within the gold market:
— Physical Demand — This remains soft, with price-sensitive markets (such as India) buying only on price retracements, while Western markets continue to suffer from the trend downturn in interest in yellow gold jewelry.
— Investor Demand — Still disappointing overall, with sentiment depending on improved activity in the London Stock Exchange-listed gold bullion product, with still no sign of SEC approval for a similar product in the U.S.
— Producer De-hedging — All the major surveys of quarterly de-hedging depict a slowing trend, with significant buy-backs now rare. We still expect de-hedging from the larger producers; however, there are already signs of hedging from smaller companies in an effort to finance a raft of new projects and expansions. Indeed, the reduced appetite for gold equities has increased the need for debt finance. Many of these new projects are in developing countries for which financiers will require risk management. And, finally, a future rise in interest rates plus the retracement in the gold price makes hedging more justifiable.
— Central Banks — It is clear now that France will join Germany as a major seller under the next European Central Bank Gold Agreement. We also see Italy as likely to join the other two large holders as sellers eventually, even if not under the second European Central Bank Gold Agreement. Uncertainty remains about how this gold will be sold and when, but the stance of large gold holders is clear — sell.
— Public Image — Already, gold jewelry is facing pressure in the U.S. from environmental lobby groups about mining practices, and in May there was an audio recording attributed to al-Qaeda leader Osama Bin Laden offering rewards in gold for the killing of foreign nationals in Iraq. This is unwelcome at any time, let alone with gold already under threat of liquidation.
We see the upside for gold prices capped at US$410 per oz. but with robust support at US$380 per oz. becoming increasingly vulnerable as the year continues in line with tighter monetary policy and a firmer U.S. dollar, at least against the euro. As a result, we expect to see gold trading down towards US$350 per oz. by year-end.
As we note regularly, standard commodity analysis for gold is fundamentally flawed as the massive inventory overhang (conservatively 300 weeks of demand) means that there is and can be no direct link between the physical supply/demand balance and the prevailing gold price. However, fundamental supply and demand issues can and do affect sentiment and trading strategy over time, and it is for this reason that they continue to deserve some attention.
However, we should point out that if we re-format the GFMS data into a more standard analysis, then 2003 marked the largest market surplus in three decades of supply/demand history. Worse still, 2004 appears likely to surpass even this!
The most distinguishing feature of the trading in gold since 2001 has been the paramount importance of the U.S. dollar, particularly against the euro. We again note that the physical justification for this increased demand and decreased supply is limited. However, the success of trading gold guided by the euro/dollar rate has become largely self-fulfilling.
During April, the gold-euro relationship did falter, as the market began to focus on broader weakness of the U.S. dollar, against Asian currencies, particularly the yen. Although this remains, in our view, an important determining factor going forward, it has been noticeable that during June, gold traders began to focus once again on the euro as the key price-determining variable for gold.
The sizable decline in equity markets from early 2000 until mid-2003 created a supportive environment for gold. The fact that this coincided with a volatile and uncertain performance across the major financial markets, bonds and currencies encouraged investors to consider all alternative assets, with property and commodities, including gold, benefiting in particular.
The recovery seen across most equity markets last year, and the good start to the year based on the back of stronger economic growth and higher corporate profits, were a threat to gold.
However, equities have faltered since March, with concerns about higher interest rates and rising input costs threatening profitability. Barclays Capital remains largely positive on equities and the economic outlook over the course of 2004, and so we expect positive financial market performance to dampen gold prices during the second half of the 2004.
The relationship between inflation and gold is an enduring one. Intuitively, it is appealing as gold is a genuinely tradable hard asset and so should hold its value against paper assets as inflation rises. Inflation is becoming an increasingly common topic, with loose monetary policy and rising commodity prices having raised the spectre of rising inflation in the future.
However, first, underlying rates of inflation are very low. Second, gold has arguably already factored in more expectations/fear of inflation than bond markets. Lastly, there is now a wide range of inflation-protected paper assets on offer to the potential consumer that offer greater liquidity and lower risks than gold. Hence, inflation — at this stage — is a supportive rather than a driving theme for gold.
The renewal of the European Central Bank Gold Agreement was largely within market expectations. The increase in annual sales from 400 to 500 tonnes was towards the top end of expectations but not by such a degree as to have a negative impact on sentiment. The U.K. did not sign the agreement but seemingly only for political reasons. There are market doubts about whether there are sufficient sellers to reach 2,500 tonnes over five years — but the figure came from somewhere!
There were no positive surprises either. The lack of new central banks joining the agreement (such as the new E.U. entrants or South American central banks) disappointed some in the market. Similarly, the wording on leasing and use of futures and options were also slightly more open than some had hoped.
Silver
We have reduced our 2004 price forecast since our last report, after the market suffered long liquidation earlier than we had forecast.
Silver surged to a 16-year peak of US$8.09 per oz. on April 2, although it would have been more appropriate to have peaked a day earlier! Arguably more than any other commodity, the move in silver signified the impact of the sheer weight of speculative interest. Fund buying has been sufficient to drive silver through successive buy-stops, with the next targets being the October 1987 high of US$8.50 per oz. and then the April 1987 high of US$9.80.
The surge had been based on silver’s traditional role as an investment alternative to gold, with investors seeing silver as better relative value. The speculative appetite for silver was ravenous, with Comex long positions surging to record levels eq
uivalent to half of annual mine supply. During the rally, we noted consistently that the move could not be attributed to any significant improvement in silver’s physical commodity fundamentals, which remained challenging, and warned of silver’s history of even sharper corrections.
However, even given our bearish view towards silver, we were surprised by how quickly and how sharply the retracement in silver prices took effect. From 16-year peaks of over US$8 per oz. in early April, silver collapsed back to test support below US$5.50 by mid-May. Prices have stabilized since then and we would expect both industrial and jewelry demand to support prices at these levels and, in line with our view on the base metals, we look for silver prices to firm into 2005 but without the speculative excess seen earlier this year.
The surge in silver prices was fuelled almost entirely by speculative buying, triggering further buy-stops. Investors looking for attractive risk-reward propositions used the gold/silver ratio as an excuse to take a long position in silver.
However, it is notable that a large speculative position in Comex still remains. Part of this position may well reflect commodity basket buying, but we still believe this long position is a threat to short-term prices.
In addition to speculators looking at silver as an alternative to gold, or from a technical perspective, investors have also increasingly looked to trade silver in line with the base metals, particularly copper. Since 2001, silver has tended to have a higher correlation with copper than with gold.
Short-term rallies (spikes, normally) are the hallmark of the silver market. Such rallies are usually associated with a similarly dramatic increase in silver lease rates, but notably this is not the case this time. Indeed, lending by investors into the front end of the curve is pushing short-dated lease rates to zero.
There had been a modest increase in silver lease rates, more at the back end of the curve, but even this has now fallen back on increased lending across the curve.
The low level of lease rates is really a crushing blow to silver bulls that base their super-positive silver view on the basis of a market in deficit and an imminent shortage of the metal. The market is palpably telling you that this is a market in physical surplus and with more than ample inventories.
Previously, we noted that although demand from the photographic industry had been damaged structurally by the rapid emergence of digital cameras, growth in the retail processing of digital photographs was offsetting some of this.
However, we noted recently that the latest data show that traditional film sales are declining at an even faster rate, down by around 18% for the year to May. This figure is much larger than the Photo Marketing Association’s forecast of 6% and Kodak’s 10-12%. The prospects for traditional film could improve over the summer holiday period. but industry consultants report that consumers are increasingly trusting those “moments” to digital cameras.
— Kevin Norrish is responsible for energy and metals research at Barclays. Kamal Naqvi is responsible for precious metals research. The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and kamal.naqvi@barcap.com
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