Central Banks Back to Buying Gold

The gold market is about to go through big changes, according to the author of this article, and the new environment will favor long-term investors who buy and hold the metal over speculators who trade on day-to-day gyrations. This is mostly due to central banks getting back into buying gold who have been increasing their holdings over the past twelve months.

By Simon Constable
June 11, 2012, 9:54 AM
Wall Street Journal Blogs

Big changes are afoot in the gold market. The short take: The new environment will favor long-term investors who buy and hold for years over speculators who try to trade day-to-day gyrations.

For one thing, central bankers are back buying gold. Think it’s no big deal? The last time we saw the so-called official sector as such a consistent and major buyer was in 1965.

Central banks increased their gold hoards by 400 metric tons — each equal to almost 2,205 pounds — in the 12 months through March 31, up from 156 tons during the prior year, according to recent World Gold Council data.

The council “is now confident that central banks will continue to buy gold and has added official-sector purchases as a new element of gold demand,” writes Austin Kiddle in a report for London-based bullion dealer Sharps Pixley.

The recent data cement the fact that central-bank buying is here to stay. This stands in stark contrast to large-scale selling from 1966 through 2007. The majority of those years saw massive dumping of the metal by central bankers, punctuated by a few years of modest buying.

After the end of World War II, central banks had to hoard gold because it was the center of the global financial system. But as the Bretton Woods system, which relied on gold, collapsed in the late 1960s, the bankers no longer needed so much bullion. The system died in 1971.

Central banks started to warm to gold again during the 2008 financial crisis. The U.S. Federal Reserve began a campaign of money printing known as quantitative easing in 2008 to boost economic activity. In order to diversify away from greenbacks and other paper currency, central banks of emerging-market economies like Mexico started snapping up bullion. Central banks “will probably be continuous buyers of small volumes of gold for the foreseeable future,” says Jeff Christian, founder of New York–based commodities consulting firm CPM Group. By small volumes, he means 311 to 374 metric tons a year, or about 10% of the global supply.

So will that drive prices higher? Maybe, maybe not, says Christian.

He says that central bankers will avoid buying any quantity that dramatically affects the price. They know that the market is tiny, compared with the $4 trillion-a-day foreign-exchange market. Still, consistent buying of 10% of annual supply can’t but help keep the price elevated.

But that’s only one big change. The second: Short-term speculators have fled the market. Open interest of managed futures funds, considered a good proxy for all speculators, has dropped a staggering 28% since the beginning of September, to approximately 203,224 contracts as of June 5.

“I think we’ll see more volatility in gold because of the absence of speculators,” says George Gero, a precious-metals strategist at RBC Capital Markets in New York. Speculators often damp volatility because they add liquidity to markets.

The price of the metal, which closed up 0.2% Friday at $1,590.10 a troy ounce, could make major moves in very short periods, says Gero. In simple terms, the moves will be too big and too rapid for many short-term speculators to deal with.

“The best way to play gold is as a long-term investor as a hedge against loss of purchasing power of paper money,” says Gero.

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