By Rhona O'Connell
Partner, Hoare & Company

Encouraging signs as membership of the '$400 Club' rises.

After over a year spent in the range $375 - $395/ounce, when gold appeared to be oblivious to developing currency chaos and the odd problem in the derivatives markets, even hardened adherents to gold's cause were beginning to question whether it would ever again reassert itself as the ultimate hedge against risk. This debate was, however, very much confined to "professional" market watchers. The hefty absorption of physical gold in Asia and the Far East particularly, has provided continuing evidence that several millions of individuals have unshakeable faith in gold's role as a safe haven! This sentiment is now growing in the professional sector, as confidence in international economic management is undermined. And the '$400 Club' expands day by day.

February is almost invariably one of the most difficult months for the gold price, as regional seasonal demand dries up.

It is entirely possible that daily physical demand for gold in February runs at roughly one half of that of the previous four months, and in these circumstances it was not surprising that the price this year tested support at $375.

As March developed, so the market's more normal equilibrium was regained and prices started to improve, without any help from the international money markets.

At one stage, with private Japanese purchasers in the vanguard in response both to the strength of the Yen and post-­Kobe distress, the physical position became so tight that refiners were working flat out, and parts of the Far East ran out of gold.

This, combined with a likely 200t+ shortfall in supply, is not a characteristic of a market in decline!

The producers; help or hindrance?

The strong physical market has so far been able to absorb accelerated producer sales.

Some commentators opine that producers are killing the goose that lays the golden egg by preventing prices from rising.

Of course, there is merit in this argument, but equally there is an opposing view.

It is also arguable that, in capping the price through forward sales, producers help the longer-term stability of the market:

(a) because they prevent a price-elastic reduction in physical demand and

(b) the eventual unwinding of hedges brings forward the end of a mine's life, since the metal's delivery is already discounted into the market price.

The charts opposite show long-term interest rates in Australia, Canada and South Africa; and the spot and estimated long-term local forward gold prices.

Forward indicators

The data are merely an indication, being an amalgam of the spot price and long-term interest rates rather than a quoted contango.

Interest rate moves suggest that long-dated contangos, certainly in Australia, are due to narrow.

Combining this with the trend in local forward prices would back up indications that Australian producers have recently been active in the gold market, endeavouring to maximise forward prices.

(Forward selling only is under consideration here, not options.)

The pattern is less clear cut for the North Americans, although there are suggestions that interest rates are topping out in Canada also.

Although South African producers were generally unwinding hedges during 1994, there have been comments from management that, where appropriate, prices would be locked in for two years forward or more and the general expectation in South Africa is for another interest rate hike; therefore it may be that future sales will he held off until the outlook for South African interest rates and the Rand has cleared.

Gold and interest rates in sync?

In this sense it is arguable that the relationship between gold and interest rates is circular. High interest rates theoretically lead to forward selling which helps to cap gold's price, implying that, pari passu, flattening gold implies a topping out in interest rates.

In fact this relationship has held good for a long time - since well before forward selling developed. Gold and interest rates move in the same direction, with gold in the lead - reflecting anticipation of inflationary trends.

This relationship still holds good even though gold is barely an inflation hedge in the first world now, being rather a hedge against risk.

With the market in a shortfall, burgeoning demand will have to be met by the release of metal.

This will be prompted either by markedly higher prices - or markedly lower ones! The background factors all point to a further, gradual rise in price.

A rapid spike would be de-stabilising, and help no-one except the speculators.

Rhona O'Connell is a partner at mining stockbrokers Hoare & Company in London. She has specialised in precious metals analysis since joining the Consolidated Goldfields head office in 1981, subsequently working for Rudolf Wolff and Shearson Lehman Brothers.