Monday, October 10, 2016

Gold Demand Could Become a Self-Fulfilling Prophecy

Switzerland has been a net exporter of gold for the past four months. More gold is going out than is coming in. This means demand remains strong, but supplies are tight.

Switzerland does not produce its own gold. Some refiners may have inventories and there are gold vaults in Switzerland that are a potential source of supply. But the high-net worth individuals who keep their gold in Switzerland are long-term buy-and-hold investors and tend not to sell. On balance, these net outflows are unsustainable. If the outlfows persist, the price of gold is likely to go up because that’s the market’s solution to excess demand.

The “big five” destinations are China, Hong Kong, India, the U.K. and the United States. Those five destinations account for 91% of total Swiss gold exports.

Hong Kong demand is mostly for re-export to China. This is revealed through separate Hong Kong import/export figures, which are also considered reliable by international standards. Using Hong Kong as a conduit for Chinese gold is just one more way China tries to hide its true activities in the physical gold market.

Bear in mind that China is the largest gold producer in the world. There is an additional 450 tons per year of indigenous mining output available to satisfy China’s voracious demand for official gold, held by its central bank and sovereign wealth funds.

Chinese demand has been tempered by the recent strong dollar, which makes gold more expensive when purchased for yuan. That headwind may be about to dissipate if the Fed engineers a weaker dollar (which we expect) to deal with a slowing U.S. economy.

Switzerland has exported 102 tons to the U.K. and U.S., almost all to satisfy demand from ETF investors. Will this strong demand persist? ETF demand runs in a feedback loop relative to gold prices.

When gold is going up, ETF demand goes up also which puts more upward pressure on the price. This also works in reverse as we saw in 2013. When gold is going down, ETFs tend to disgorge gold, which puts further downward pressure on the gold price.

Either way, ETF demand tends to be pro-cyclical and to amplify whatever gold is doing based on other factors. If we have reason to believe that gold prices are going up on their own, ETF demand will tend to drive the price even higher and faster.

Supplies of gold in Switzerland are already tight (I heard this first-hand from my refinery and vault contacts there). If that shortage gets worse, as we expect it will, there’s only one way to adjust the Swiss gold trade imbalance — higher prices. Once the higher prices kick in, the ETF demand will send it into overdrive. From there, it’s just a matter of time before the whole paper gold pyramid comes crashing down.

Gold prices are set to skyrocket based on a combination of supply and demand fundamentals and the ETF pro-cyclical feedback loop. If gold goes up, the prices of gold mining stocks go up even faster. In effect, buying gold mining stocks is a leveraged bet on the price of gold itself.

- Source, Jim Rickards