Gold: Euro, China and Goldman Sachs

By Dian L. Chu    Apr 20 2010 10:53AM dianchu.blogspot.com

Gold fell the most in two months as the SEC’s action against Goldman Sachs (GS) spurred investors rushing out of riskier commodities and into perceived safer assets such as the U.S. dollar. Futures for June delivery slid 2% in one day to $1,136.90 an ounce.

Paulson Linked to Goldman’s Case

Goldman Sachs, the largest U.S. commodity broker, is charged with defrauding investors with a financial product tied to subprime mortgages by the Security Exchange Commission (SEC). In addition, hedge fund Paulson & Co. is also mentioned by the SEC, but not charged, in connection with the Goldman Sachs matter.

Paulson & Co. is the largest institutional holder of the SPDR Gold Trust (GLD) with about 8.4% stake, whereas Goldman Sachs also holds the 11th largest stake at 0.6% in the fund, according to Bloomberg data. SPDR is world’s biggest exchange- traded fund backed by physical bullion with a record gold holding of 1,141.041 tons as of April 15.

Goldman & Paulson Massive Gold Positions

Paulson's high-profile bets have partly help drive gold to record-high prices above $1,200 an ounce. Although no charges were brought against the hedge fund, the double whammy news weighed on gold, and prompted some concern in the commodity markets, since Goldman Sachs is a major player with massive positions in all commodities including gold, silver and crude oil.

An Overdue Technical Correction

Typically, when market confidence is shaken by events such as the SEC Goldman suit, it should spell bullish for gold -- an independent store of value. However, even before the Goldman news, gold, which rallied to a four-month high of $1,170.70 on April 12, was poised for a technical correction. So, the Goldman news most likely just triggered an exit opportunity for short-term traders to lock in profits from recent gains.

Gold-Euro Affair by PIIGS

Gold futures have been in an uptrend recently and rallied more than 11% from a multi-month low in February. The metal remains near record highs in euro and pound more on account of the currency weakness, and not due to the performance of the metal itself

Both the euro and sterling pound had declined around 6% against the dollar in the first quarter of 2010, as the U.K.'s and PIIGS countries fiscal deficit crossed the 12% mark of respective GDPs, much higher than the EU's prescribed limit of 3%.

With investors rotating out of the euro and into alternative assets like gold and the U.S. dollar on concerns of the Greece debt crisis, the historically negative correlation between gold prices and the dollar index has been broken since last December.

Instead, gold is now trending more positively with the dollar and inversely with the euro. (Fig. 1)

Watch EUR/USD

Over the near term, gold will keep looking to the dollar/euro relationship for direction with the euro dictating gold’s price.

The ongoing Greek debt saga has been a key driver of investors risk appetite. The EU already indicated Portugal may need to enact additional measures if it’s to cut its budget deficit.

Concerns of further fiscal crisis contagion into other members in the European Monetary Union could seal the euro’s fate of a continuous downward spiral against the dollar in the near term.

However, given the mountainous US deficits, it looks likely gold could reach record (nominal) highs in dollars as well in the medium term.

Technical Indicators

The U.S. Commodities Futures Trading Commission (CFTC) report indicated speculative financial investors seem to have become increasingly reserved and have been trimming their net-long positions in recent weeks. Commercial participants, who accounted for 51.3% of open interest, held net short positions at the end of March.

A further increase in the net short position, coupled with the negative sentiment stemming from Goldman/Paulson could put the gold price under pressure and test the psychologically important $1,100 mark.

For the time being, a dip below the $1,100 should provide investors with a buying opportunity and a rise above $1,150 would serve as a profit-taking signal. (Fig. 2)

Technicals aside, gold’s long term outlook is further solidified by a couple of new “China factors.”

China Gold Demand to Double

Gold demand in China has steadily increased since 1992 accounting for 11% of global gold demand in 2009. The World Gold Council forecasts demand doubling in the next 10 years from $14 billion to $29 billion on rising jewelry and investment demand.

Currently China's per capita gold consumption level lags most other major gold buying countries. Although China is the world’s largest gold producer, rising domestic demand for gold outstripped domestic supply by 109 metric tons last year. This shortfall creates a "snowball" effect as China's gold industry has to rely on imports, the World Gold Council said. (Fig. 3)

Boosted By A Stronger Yuan?

Meanwhile, some analysts also think a stronger yuan could be a catalyst to spur China’s gold demand. China might revalue its currency--the yuan or renminbi--after a recent meeting between U.S. Treasury Secretary Timothy Geithner and Chinese vice Premier Wang Qishan. Some analysts argue that the yuan is undervalued by as much as 40%.

A stronger yuan could support higher gold prices as the precious metal becomes cheaper to buy. Beijing has been encouraging citizens to buy gold and silver, a rise in yuan would certainly facilitate more buying.

According to the Associated Press, China let the yuan appreciate almost 20% between 2005 and 2008 during which gold prices touched $1,000 an ounce for the first time.

Underpinned By Fear & Uncertainty

Although it would seem that the Goldman-linked SEC case single-handedly killed the price of gold last week, as discussed here, it was only a catalyst to a technical correction that was overdue.

The fact remains that in times of uncertainty, investors historically turn to gold as a hedge against inflation and unforeseen crisis since gold is one of the very few asset classes that is not someone else's liability.

Many experts argue that gold is not an effective hedge against inflation since the then-record $873 an ounce established in 1980 should appreciate to $2,287 in terms of today’s dollar.

However, fear of any sort usually does translate into higher gold prices. One hypothesis is that the seemingly slow and steady inflation is not explicitly overt enough to cause an overwhelming fear of inflation yet. Nevertheless, the record government debt levels and monetary printing machines will most certainly heighten investor’s inflation concerns and push gold prices much higher over the long term. (Fig. 4)

Dian L. Chu, M.B.A.,
C.P.M. and Chartered Economist