Friday, December 18, 2009

The Gold Market: Update on Central Bank Activity and More

People get excited about central banks because they have lots of money (called inflation) and they tend to make big moves. The central banks do not move as a group. Some may be buying while others are selling. You also have to factor in the IMF, which has a lot of gold and is selling to support its activities. When the IMF sells and some central bank is buying, they tend to set the transaction between them, so there is no impact on the gold market. The IMF has been selling around 400 metric tons a year. There is an agreement among the major central banks called the Central Bank Gold Agreement in which they voluntarily limit the amount of gold they sell a year, currently 400 metric tons. That doesn’t mean that they are selling that amount, just that they won’t as a group sell more than that. It is suggested that they aren’t selling at all. Who can know? We won’t know for some time. There is reason to think that some central banks, small countries, are buying, probably from the IMF.

One writer suggested that central banks do not pay attention to price, once they decide that they want to buy. On the other hand, a spokesman for the Chinese Central Bank said that they would not buy when the price was “high”. I think that belittling the bankers is reasonable when writing about them, but when devising a gold purchase strategy, it is risky. Overestimating the reasoning power of other market players is a better approach to risk management, keeping in mind their motivations and perspectives.

An article I came across recently reminded me that over the last two decades the central bankers have been selling gold. Even last year, on balance, they sold. I think that period has ended. It ended primarily because of the realization of the weakness of the dollar and, more importantly, the U.S. financial system and economy. They might have the wrong idea as to why the U.S. financial system is weak, blaming the banks rather than the Fed, but they do understand that the recent worldwide recession began in the U.S. financial system. What has happened since has done nothing to reassure anyone.

From a wider perspective, the relation between gold and inflation is not direct. The effect, the ability of gold to keep pace with the drop in value of the dollar is in the long term, over years, sometimes decades. This is the result of the activities of the different elements of the market. The big drop had to do with the waining of the U.S. price inflation and gold selling by the central banks. The movement of gold upward now is due to fears and uncertainty, not a response to specific changes in the purchasing power of the dollar or other currencies, but expectations of deteriorating conditions. If conditions do not deteriorate within a certain time, the attention in gold will be reduced and the price will flatten, at best, maybe drop.

With the certainty that the Fed will be expanding the money supply by expanding credit as forcefully as it can, as it has been doing for the last year, we will see something happen. It could be another asset bubble, it could be a huge increase in our trade deficit, a significant drop in the value of the dollar, or, because of Obama’s spending, it could be real price inflation. We do not know where all that money will pop up, maybe many places at once. Just keep your eyes open.

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