There Is Not Enough Physical Gold To Serve Growing Central Bank Demand

2016  is truly different. This year’s gold rally is not a simple rally, there are many factors ‘under the hood’ that account for that.

First, the US Fed has proven that their said recovery is as weak as it can be. It only took a month, after a first mini-increase of rates in December, that markets came down, almost collapsing, before the “oracles of the Fed” came out and started talking about negative interest rates.

Earlier this week, the otherwise rather gold-unfriendly World Gold Council warned global investors and central banks, saying: “Looking forward, government bonds are likely to have limited upside, due to their low-to-negative yields and, in our view, would be less effective than gold in mitigating risk, ensuring portfolio diversification, and helping investors achieve their long-term investment objectives. Portfolio analysis suggests that gold allocations in a low rate environment should be more than twice their long term average. We believe that, over the long run, negative interest rate policy may result in structurally higher demand for gold from central banks and investors alike.”

Second, debt levels have increased to a level that the marginal effect of debt is close to 0.

Third, even central banks are back again buying gold in masses. Here it becomes interesting. The fact of the matter is that central banks can push gold to a tipping point. How so? Their physical gold demand could surpasses supply. This week, the team at USAgold.com wrote this excellent piece which makes that point, we feel free to quote part of their work.

From USAgold.com:

The fact of the matter is that there is not enough gold in size available to accommodate a doubling of already strong central bank demand. At current prices, the availability of metal comes nowhere near matching the availability of capital. China, for example, is hoping against hope that it will have enough time to beef up its holdings sufficiently before the eventuality of a full-blown currency crisis. Barring a miracle on the supply side of the fundamentals ledger, the likelihood is that they will come up short.

This is a case where, for once, the private investor has the advantage. Individuals can still buy gold and silver in sufficient quantity to achieve their portfolio goals (and quickly if so required). What we do not know is how long under the circumstances that advantage will remain on the table.

New physical demand will come on top of already elevated base

Any new gold and silver physical demand entering the market relative to the interest rate environment will come on top of an already elevated base. That base was built in the period after the Lehman Brothers collapse and the big numbers never receded. Here for quick reference is an overview of the sources of that demand, its importance to the overall market, and the differences imposed on the market since the earlier breakdown. Worth noting: Insofar as their demand is for the actual physical metal, these three sectors will be in direct competition with each other.

• First, as pointed out in the previous issue of this letter, central banks, led by China and Russia, are already aggressive net buyers of gold. In 2008, they were still net sellers. “Central banks,” says the World Gold Council, “have been accelerating the use of gold to diversify their reserves since the 2008-2009 financial crisis. In the second half of 2015 alone, central banks bought more than 336 tonnes of gold – the largest semi-annual total on record. The acceleration of such purchases, across a diverse range of countries, highlights the fact that diversification of foreign reserves remains a top priority for central banks. As foreign reserve managers all over the world continue to grapple with the challenges of negative nominal interest rates, we expect to see record amounts of central bank gold purchases in 2016 (and beyond).”

• Second, private investor volumes globally are considerably higher now than they were in 2008. In the years following the initial phase of the crisis, volumes for gold bullion coins went multiples pre-crisis levels and stayed there indicating the public concern about central banks ability to deal with the crisis and any further escalation. Investors need to take into account the potential for intermittent bottlenecks, outright shortages and escalating premiums on gold and silver coins and bars.

• Third, institutional investors, as covered in detail above, have returned to the gold market, and as a result volumes at gold ETFs are running at a record pace.” Even though the ETFs for all intents and purposes are a paper position as far as most holders are concerned, these institutions must actually go out and procure the metal represented by sales of shares. I would not be surprised to learn of record volumes at both gold and silver ETFs now and as we move deeper into 2016.

2016 is setting up to become an extremely interesting year for gold.

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