The Dynamics of the Gold Market, Forecasting the Gold Price and the Risk that is Associated with Owning "Non-Physical" Gold

According to economic theory, the price of a good is a function of its supply and demand. Otherwise stated: to be able to accurately forecast price movements in the market for a named good, one would need to understand the dynamics that shape its supply and demand.

In this blog post, I will discuss the demand for gold and a reliable method for forecasting changes in the price of gold. I will go on to discuss "gold leasing" transactions that central banks enter into, and, the "black-swan" risk that these transactions create for owners of non-physical gold.

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Illustration 1, below, deconstructs the demand for gold into its core elements and it expositions the key driver of each core element:

Illustration 1 (click on illustration to zoom in)

According to Illustration 1, the world demand for gold can be deconstructed into the following core elements:

1. Jewellery / Jewelry (makes up ~ 50% of the demand for gold): This element is largely driven by the demand for jewellery in the most populous countries in the world, i.e. India and China, which account for a 63.2% share of this demand sub-category.
2. Industrial and Dental (makes up ~ 11% of the demand for gold): This element is largely driven by the use of gold in the manufacture of electronic goods, which account for a 63.64% share of this demand sub-category.
3. Investment (makes up ~ 39% of the demand for gold): This element is largely driven by the demand for gold by Exchange Traded Funds (ETFs), which account for a 46.15% share of this demand sub-category.

...Forecasting the gold price

Hence, to be able to forecast the price of gold, one simply has to understand; the demand for golden jewellery in China and India, the demand for electronic goods with golden components and the demand for gold by ETFs, as these entities and demand categories account for an aggregate 56.6 % share of the demand for gold. Right?

The answer to that question would be a qualified "Yes". Why? Because in India, the supply chains for jewellery tend to be multitudinous and informal, and, they tend to evolve constantly. This makes it difficult to accurately aggregate / forecast the transactions that occur in the said supply chains.

Thus, analysts generally prefer to use the size of central bank balance sheets to predict future movements in the price of gold. When analysts employ this methodology, they examine the growth of the balance sheets of the 5-6 largest central banks in the world, including; the US FED, the People's Bank of China, the Bank of Japan, the European Central Bank and the Bank of England, as is shown in Illustration 2 below:

Illustration 2 (click on illustration to zoom in) Adapted From: Sprach Analyst

They then make assumptions about the degree of looseness of monetary policy in each of the 5-6 largest economies. (The general rule of thumb can be abbreviated as follows: the greater the degree of monetary looseness the larger the size of a central bank's balance sheet and, ceteris paribus, the higher the gold price.)

By and large, the degree of looseness of monetary policy increases when:

• An economy is experiencing a cyclical downturn, and accommodative policies are put in place to bolster the economy.
• An economy has an onerous debt burden, which largely consists of debt that is denominated in its currency, and monetary authorities elect to inflate away the debt.

Once the projections of the change of each central bank's balance sheet have been mapped, the analysts go on to use regression analysis, as is shown in Illustration 2, to project the overall trend of the change of the balance sheets of the 5-6 largest central banks. They then infer the change in the gold price from this overall trend.

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This is one of the most accurate methods for forecasting changes in the gold price. However, it is far from perfect...


...Gold Leases

Gold is an inflation-hedged alternative to fiat currency. In every country, the central bank holds a certain amount of gold in its vaults as a reserve currency. If the central bank seeks to generate income streams from the gold in its vaults it could lease-out its reserves to bullion banks as is shown in Illustration 3 below:

Illustration 3 (click on illustration to zoom in)

Bullion banks are members of the London Bullion Market like; Barclays Bank PLC, ScotiaMocatta, Deutsche Bank AG, HSBC Bank, JPMorgan Chase Bank and UBS AG. They serve as intermediaries in gold market transactions.

As Illustration 3 shows, bullion banks go on to sell that leased gold, as futures contracts with varying durations, to multiple buyers. For instance, in Illustration 3, if a bullion bank borrows 600 kilogrammes of gold from the central bank, it will draw-up two futures contracts, i.e. Futures Contract 1 and Futures Contract 2, each for the same 600 kilogrammes (kgs) of gold. The counterparties in each of the futures transactions would be Buyer 1 and Buyer 2 respectively.


...Fleshing Illustration 3 with numbers

Gold lease transactions are best explained using numbers. I will draw those numbers from Illustration 4 below:

Illustration 4 (click on illustration to zoom in)

If the bullion bank leased 600 kgs of gold from the central bank for $90 (i.e. 2012 dollars) per ounce per year in 1980, for a period of 10 years (see point a in Illustration 4), and entered into a futures contract with:

• Buyer 1 to sell the 600 kgs of gold at the 1980 price ( ~ $2,300 per ounce in 2012 dollars) in mid 1982 (see point b in Illustration 4);
• Buyer 2 to sell the 600 kgs of gold at the 1980 price (~ $2,300 per ounce in 2012 dollars) in 1988 (see point c in Illustration 4);

The bullion bank would have to buy gold at the spot price on two occasions:

• In 1988 at  ~ $1,000 per ounce (in 2012 dollars) to meet its obligations to Buyer 2 (see point c in Illustration 4).
• In 1990 at ~ $750 per ounce (in 2012 dollars) to meet its obligations to return gold to the central bank.

...Profitability of the transactions

Using the figures that were drawn from Illustration 4, the profit that the bullion bank would earn, from the lease and futures transactions, can be computed as follows:

Table 1 (click on table to zoom in)

Table 1 shows that the transactions would earn the bullion bank close to $41 million (in 2012 dollars).


 ...The Black Swan risk that is created by gold leases

If there is ever a reason to doubt the stability of the bullion bank, the holders of gold futures contracts, i.e. Buyer 1 and Buyer 2 in Illustration 3, would each concurrently demand 600 kgs of physical gold from the bullion bank, or, they would both demand some form of "guarantee" / collateral.

In such a scenario, the bullion bank may fail to meet the new demands; which would trigger or magnify the "run on the bullion bank". This would reverberate across gold futures markets and cause them to seize up. Succinctly stated: the holders of gold futures would be left holding nothing but "paper assets".

While this has never happened in recent history, there is no guarantee that it would never happen in the future. And if this ever happens, most entities would be caught off-guard.