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​Why Do Central Banks Buy Gold?

08 February 2019

Gold price chart

Gold pulled back slightly this week to USD$1,314 with silver dipping back below USD$16.00 per ounce to USD$15.71.
 
In local currency terms, we can see the AUD/USD tumbling over 2.3% this week to USD$0.707, seeing gold for local investors a whisker off all time highs at AUD$1,853, with silver trading close to AUD$22.40.
 
Silver seems the better value of the two with the ratio trading at 84.66.
 
Those waiting on a pullback to top up their precious metals holdings may have been forced to wait a little longer or get in higher, as the RBA finally came to the table with the inevitable, which was to say the next move in the cash rate is ‘evenly balanced’ between higher or lower. One could read this as ‘likely lower’ given the RBA’s usually upbeat outlook on the Australian economy.
 
“In the event of a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point”- Philip Lowe
 
The AUD/USD was crushed in one of its worst trading days in two years on the back of the RBA governor’s statements. Financial markets quickly priced in a full 25 basis point cut by February next year, with a small risk it may be two.
 
AUD/USD
It is amazing how late to the party the RBA is at forecasting, despite the number of economic analysts that must be working there. For over a year, our commentary has been consistent that the next move in the cash rate from 1.5% is more likely to be lower and that the housing bubble bursting will see prices move a lot lower in Sydney and Melbourne markets.
 
If the severity of the housing downturn caught any economists by surprise, they should hand in their badge and take up a new profession.
 
Only after prices started falling do we see the RBA come to the table with the amazing insight that Sydney property prices should fall further. With eyes firmly focused on the rear view mirror, they steer the Australian economy toward an oncoming crisis.
 
Even though we see the next move in the cash rate to be lower, we do not expect this to rekindle a move higher in property prices, as the momentum and psychology of investors in this market has completely shifted compared to a few years earlier. Often it is the direction of prices versus the actual price itself, which sparks speculators’ interest, and the complete drop off in auction clearance rates is an example of the mania phase being over and the new trend being undoubtedly lower.
 
This week saw the results of the Royal Commission and I think the market’s reaction on the day sums it up best:
 
CBA + 4.69%
ANZ + 6.5%
WBC + 6.36%
NAB + 3.91%
AMP + 9.95%
 
Mortgage brokers were the ones to take one for the team as Mortgage Choice was down more than 25% and Australian Finance Group losing 29%.
 
So it’ll likely be business as usual for the major banks, but what the Royal Commission did uncover (and very similar to the US housing crisis) was that the standard of lending to Australians during the bubble phase was reckless to say the least, so the level of risk to the overall economy – should house prices continue falling – is great indeed.
 

Gold ETF Inflow Data

 
The most recent data of ETF inflows for the month of January is out, and as per our expected trend, we are seeing large inflows into gold ETFs from European & US investors.
 
Almost 71 tons of gold (2.31 million FTozs) was bought by ETF investors in January, in addition to the 72 ton increase in December. Likewise, open interest in gold futures in New York increased by about 8.75 million FTozs between mid-December to the 28th of January.
 
We continue to see a major driver of gold prices moving forward to be the increased appetite of US Investors, as uncertainty around Fed policy builds in 2019 and stock market volatility sparks safe haven demand.
 
 

Why Do Central Banks Buy Gold?

 
Central Banks 
It’s not only western investors that are upping their gold allocations of late, as Central Banks bought more gold in 2018 than any year since 1967, or since the US dollar left the gold standard 48 years ago.
 
According to the World Gold Council’s full year Gold Demand Trends, central banks collectively added net 651.5 tonnes to their holdings, which was some 74% more than in 2017 and the second highest annual total on record. The countries adding to their reserves included China, Poland, Russia, Turkey and Kazakhstan.
 
We will cover a bit on what makes gold a unique monetary asset and why Central Banks hold it in the first place.
 
 

Stock-to-Flow

 
All gold investors should have a strong understanding of the importance of gold’s high ‘stock to flow’ ratio. Failing to understand this concept can be one of the main reasons why many people don’t ‘get’ gold as an investment class.
 
One of the reasons we (and likely Central Banks) feel so comfortable holding gold over the long term is due to this ratio. Unlike all other commodities, most of the gold ever mined is still available for use today. The ‘stock to flow ratio’ compares the above ground stockpiles (stock) of a commodity to the newly mined supply (flow).
 
Gold is unique in this regard as the amount of newly mined supply each year (flow) only adds to the above ground ‘stock’ by around 1.5%. So if you think of inflation as per the old measure, which is an increase in the money supply, gold would have a natural inflation rate of a very low 1.5% if it were strictly a currency.
 
If you think of gold as money, even if global gold production doubled in a given year, due to some very unlikely and unforseen discovery, this would be the equivalent of the money supply expanding by a mere 3%. Fiat currencies on the other hand can be created at an infinite rate, and central banks (seen recently with the BOJ) can adopt a policy to double the entire money supply in just a few years, if they wanted to.
 
So if you think of supply and demand fundamentals, there is a reason why grains of sand on the beach are less valuable than diamonds, it partly comes down to their seemingly infinite supply. The same is true for currencies. It is the very restricted supply and high stock-to-flow ratio that makes gold a uniquely stable means of storing value and is one of the reasons why gold remained to be seen as the ultimate form of money for 6,000 years.
 
Despite the fact that Central Banks know this, they seldom talk about it, as they have a vested interest in maintaining the faith in the perceived value of the fiat currencies they help to create. Too often Central Banks will describe gold as a pet rock or barbarous relic that serves no purpose, despite the fact that most hold a very large amount as a percentage of their reserves.
 
Allan Greenspan is a great example, as when outside his role as chair of the Federal Reserve between 1987-2006 his rhetoric on gold was vastly different to when he was chair. Some quotes below and the first being quite powerful:
 
1966: “The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. Deficit spending is simply a scheme for the hidden confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.”
 
2014: “Gold is a currency. It is still, by all evidence, a premier currency, where no fiat currency, including the dollar, can match it.”
 
Reserve Bank of Zimbabwe 

Without the faith in fiat currencies, their intrinsic worth is ultimately the paper or plastic they are printed on. Central Banks no doubt understand this, which is why most hold a significant gold position in the first place, and when they increase their gold reserves, it may be a sign that they expect gold to maintain value better than the alternatives moving forward.
 
When faith diminishes in a fiat currency, we can eventually see runaway inflation lead to hyperinflation, as seen most recently in Zimbabwe and Venezuela. The chart below is the Venezuelan Bolivar to USD, showing just how fast this can happen as the purchasing power of the Bolivar evaporated in 2018 as the country was gripped in crisis. As for the money supply itself, it increased by 30% in a single week ending January 25th.
 
Venezuelan Bolivar to USD 

With regard to Central Banks, it may be a case of ‘do as I do, not as I say’ as their actions would likely give a better indication of what they are thinking, as opposed to what they say in a public forum.
 
The chart below shows current ‘barbarous relic’ holdings as at January 2019 and as a percentage of foreign exchange reserves.


Current gold holdings

The Periodic Table of Endangered Elements

 
As for silver, although it does not have as high a stock to flow ratio of gold, its price too should benefit from scarcity moving forward as a larger percentage of the metal is used up in industrial demand.
 
An interesting chart from the American Chemical Society shows that Australia is also home to some endangered species of the element variety. The Periodic Table of Endangered Elements looks at all the chemical elements that are most at risk of having supply issues or becoming extinct.
 
All four precious metals are listed as having a future risk of supply, with silver taking the prize as one out of only nine elements listed as having a serious threat in the next 100 years.
The Periodic Table of Endangered Elements 
We have seen recently what can happen when supply dries up with palladium’s performance over the past few years. Although silver has essentially drifted sideways for a few years at the frustration of investors, it will certainly be one to watch long term.
 
 
Until next time,
 
John Feeney
ABC Bullion
 
 
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