Are you baffled by Gold's fall? - Outside View by Chirag Mehta

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Are you baffled by Gold's fall?
Dec 30, 2011

The markets this year could be described as a battleground as commodities continued to collapse, the Euro zone crisis remained in the woods as yield soared at accelerated levels and the Euro plummeted, along with unease among the people. Historically, gold tends to thrive in such uncertain times. To the contrary, we saw a sharp fall in gold prices.

Investors have all kinds of questions surrounding this unexpected decline in gold prices. Many are so perplexed that they are agreeing to the "gold bubble" story.

Gold analysts have created their own versions of the reasons surrounding this sharp decline. On that note, let us state that gold investors are currently seeing a decline of close to 19% from its peak in September, of $1920.

A number of reasons such as the increase in Dollar, liquidation to fund losses in other assets / meet redemptions and severe slow down in physical demand are being ascribed to this fall in gold.

We believe that the liquidity argument is contributing to the decline in gold prices since at present; liquidity is the focus of the market. The region's sovereign debt crisis has undermined the Euro, while the Swiss Franc and Yen have fallen as their governments have drawn their tolerance limits. There is no substitute to the Dollar that can absorb huge flows on account of liquidity issues. Also, the demand for Treasury securities that mature in under a year have increased as financial institutions boost holdings of the highest-quality assets to meet new regulations set by the Bank for International Settlements in Basel, Switzerland. Bank holdings of Treasuries and government-related debt totaled a record $1.69 trillion at the end of October 2011, up from less than $1.1 trillion in 2008. With the heightened emphasis on stronger liquidity positions for financial institutions around the world, we've seen an increase in the regulatory demand for liquid assets, but we're not necessarily seeing an increase in the supply of liquid assets. They are meeting that need by holding Fed balances.

In addition, people are hoarding cash because they see that the U.S. Dollar is having trouble funding the market as banks shed Euro-denominated assets. Other traditional havens in times of market stress, the Swiss Franc and Yen, reached record highs against the Euro and Dollar respectively, this year before their central banks acted in September and October to drive them from their peaks. The U.S. Dollar has become the beneficiary on account of lack of available options; particularly for large reserve portfolios that require exceptionally liquid markets, only the U.S. market can accommodate them.

Commercial banks are hoarding too...

There were increased talks that the Commercial banks were meeting their Dollar liquidity requirements by leasing gold to facilitate these loans at lower interest rates. After the massive swap arrangements made between the U.S. Fed and the E.C.B., many felt that they had overcome the problems of Dollar liquidity. However, by the extensive leasing of gold, this does not appear true. Although there is no factual data available, the negative lease rates does provide some support to the argument.

Yes, all these reasons do help us infer gold's recent decline, if not completely.

Gold lease rates have moved into negative territory
Source: Bloomberg

We believe that the recent fall in gold is probably more due to lack of catalysts that could have helped push it to record highs. In simple words, it is a move towards a more rational behavior despite the ongoing crisis. We've been used to seeing monetary interventions by central banks through monetary infusions to resolve the underlying issues and attempts to promote growth in such uncertain times. But this time, the market forces have pressured central banks to not bow down to such ill conceived notions.

The reluctance of central banks (although forced) to avoid further easing measures have in the short term removed the catalysts for gold prices to increase further. Markets were expecting an announcement of QE3 (Quantitative Easing) soon, which did not materialize even after the recent FOMC (Federal Open Market Committee) meeting. In the light of intensification of the Euro zone crisis, there was a view that the ECB (European Central Bank) would start printing to paper over the debt problems, but that has not taken place as yet. This reluctance has triggered a fall in gold prices.

So does this mark the change in the policymaking attitude? We do not think so.

Central banks continue to run into deficits, as there is no plan around cutting public spending which is a worrying issue. It's likely that these market forces can only sustain until the deflationary forces remain subdued or the crisis doesn't further intensify. On any of these signs, the trigger to print money at full capacity would be immediately in force.

Watch patiently until these criticalities in the eyes of policy makers wear off.

Reasons for Gold's decline

Some are even worried about gold's recent tendency to move along with risk assets. Yes, it has been moving along, but the interpretations are different. Risk assets are selling off on account of worries over low growth that would ensue as debt deleveraging plays on and until the central banks do not get over their reluctance to intervene and promote growth by way of monetary infusions. Gold has been declining on account of recent hesitation by policy makers to jump start their printing press as envisaged by many. Technical sell offs, liquidity issues and Dollar strength are only exacerbating the decline.

Earlier in this article, we had mentioned about market forces demanding a more rational decision-making at the center. The Fed's earlier attempts at rounds of Quantitative Easing or money printing were highly criticized, as they have not aided the problem at hand. Therefore, they require justifications in order to carry out further QE rounds.

We reiterate that it is highly likely that policy makers would switch on their monetary infusion engines at the first signs of growing deflationary threat, liquidity tightness or it may be a contagion triggered by European debt woes. The decline in gold prices presents an opportunity even if in the interim, to increase allocation to gold. It is also possible that gold prices fall further and hence investors can use such opportunities to reach their desired allocation levels.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.


The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.

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