Picture: REUTERS
Picture: REUTERS

LAST week the gold price fell $200 an ounce in two trading days, almost reaching the $1,300/oz level (though it recovered by $150/oz this week).

The previous time gold was under such concentrated selling pressure was in the eye of the 2008 global financial crisis. Liquidation for cash was the immediate priority.

However, the rebound from its $680/oz low in the wake of that selling was a spectacular rally that peaked at just above $1,900/oz in September 2011.

Since then, gold drifted gently downwards until the sudden sell-off just over a week ago. Calling an intermediate bottom now is as dangerous as trying to catch a falling knife.

However, the composure of the gold market starts to change when the metal suddenly becomes cheap.

The main price-setting centres of gold are in London and New York. The main centres of demand are in China and India.

Indian demand has a strong tendency to rise substantially on price pullbacks —  as is already evident with this decline.

Chinese demand has accelerated over the past few years and is expected soon to exceed that of India.

Furthermore, official selling by western central banks (mainly in Europe) has dried up and has been replaced by central bank buying mainly by emerging countries. Net central bank purchases in 2012 stood at the highest level since 1964.

Of major interest is the state of the physical market. Over the past six months, gold has been subjected to relentless selling and has frequently been “bombed” —  where a large number of contracts are dumped on the New York Commodities Exchange (Comex) over a very short period.

On April 12, the market was bombed with more than 500 tons of gold in a manner that caused great downward price pressure and panicked the market into selling.

The bombing of the gold market has been a frequent trading feature over the last two quarters. But the persistence of concentrated selling over the past two quarters has been unusual.

At the same time, interesting data regarding physical stocks has emerged.

The Comex physical inventory has been drained substantially over the past two quarters, a reversal of the trend over recent years. At the same time, Chinese gold imports through Hong Kong have soared.

US trade data also reflects a level of gold exports way beyond any domestic production. This means it is probable the supply comes from leasing, where gold has been borrowed and sold into the market.

The drop in Comex inventories, US gold trade data and Hong Kong trade data suggest the mobilisation of physical gold has resulted in a large transfer from western to eastern vaults.

Demand is soaring for gold at retail level in the form of sales of coins and gold bars at the US and Perth mints, among others. Indian jewelry demand also showed a strong pick-up in recent weeks and has risen further following the take-down in the gold price.

The consequence is that there appears to be a battle between the price-setting centres of London and New York and the demand centres of India and China. Against the backdrop of strong physical demand, the underlying fiscal conditions and complementary monetary policy remain highly supportive of the gold price.

In terms of quantitative easing (QE), or money-printing, the Japanese are virtually matching the scale of what the US Federal Reserve is doing but in an economy only one-third the size.

Central banks, including the The Bank of England, the European Central Bank, the Swiss National Bank and the Bank of China, are almost in a competition to debase their currencies.

One consequence of QE is the escalation of debt levels, which is creating some systemic stress. Already monetary policy has exhausted its interest-rate tool. Languishing economies and rising debt levels mean countries are trapped in their low interest-rate environment.

The bottom line is that over-indebtedness will ultimately result in higher inflation or deflation. These are systemic problems where gold provides one of the better chances of protection.

However, a rapidly rising gold price is undesirable as an indicator that reflects systemic distress. So, over the short term, the price will be suppressed, there will be more bull and bear phases, but the overall investment strategy remains to buy the dips. While another low in the short term is possible, the gold price is now in a good buying area.

 Hart is the chief strategist for Investment Solutions

 • This article was first published in Sunday Times: Business Times