Is it time to shift to gold?

Its time for the Gold bugs to come crawling out of the woodwork. Bond yields have corrected, equities are falling, commodity markets are not exciting either, dollar has corrected after showing strength at the start of the year. Oil too has stopped moving higher. Uncertainty on account of Greece and overall global growth is increasing. These are ideal breeding grounds for the gold bugs to prosper. 

But is the gold rally here to stay or is it a temporary phenomenon. The recent movement in gold prices has a lot to do with the events in the bond market. The Wall Street Journal has quoted Ole Hansen, head of commodity strategy at Saxo Bank saying that gold and silver have both benefited from the unusual volatility in debt markets, which dented bonds’ status as a safe haven.

Gold moved towards $1,200 as investors moved their money out of the debt market and into gold. Prices of Japanese, European and U.S. government bonds pulled lower as investors who had piled into debt markets in recent weeks were forced to unwind those bets as prices fell. “The current bond upheaval has not been seen for many years. Too many large long positions were established in the belief that bond yields would remain low for long due to the quantitative easing intervention from the European Central Bank. Instead, they are currently being sold into a market where risk appetite is generally weak” Hansen said.

While one might argue that the current move and fundamentals behind it are short term in character, there is a strong undercurrent which will be supporting gold prices going forward. In an interview to Business Standard, Bob Alderman, head of wealth management at Gold Bullion International says that gold is a good long term investment bet based on supply, demand, current price relative to mining costs; geo-political uncertainty; and currency struggles around the world.

Demand for gold is strong, which will only increase as uncertainty increases. But there are supply side issues. Alderman says that current prices are prohibitive for new mines to start production. Gold production peaks every 20 years. Last time it did so in 1995 and in 2014 touched a production level of 3,100 tonnes which is the highest in the last 20 years. Not only new mine discoveries are down dramatically but supply from recycled gold is also down considerably. 

But in the medium term, gold prices can continue to remain subdued. An interesting relationship between gold, crude oil and dollar was explained by Alderman in his interview. 

There seems to be a strong correlation between crude oil and gold, but this is because we are comparing both the commodities in dollars, says Alderman. Since 1990, every time an ounce of gold is able to buy 20 barrels of crude oil there was some form of ‘crisis’. As oil prices came crashing down last year, the ratio stayed above 20 for most part of 2014. The ratio presently is below 20. Crude prices are expected to remain subdued on account of fracking, increased output by OPEC countries and lower demand which would keep oil prices low. In such a scenario, price of gold will depend on the strength of the dollar if the ratio of 20 is to be maintained.

In conclusion, two of the three trends are favouring a strong gold rally, but one would need to wait for medium term trend to fall in line to take advantage of the tailwinds.