Weak Gold or Strong Dollar?

Gold ended 1999 on a relatively high note after the announcement from the European central banks that they would limit sales and lending. However, subsequently, the new millennium has been rather disappointing for gold, so far at least. Sentiment, as reflected by the gold price, peaked in February with the announcement from a number of producers that they would limit their hedging activities this year. Since then, however, the gold price has slid lower and has failed to get above US$280/oz since late July. Gold's uninspiring US dollar performance is shown in Fig 1.

This performance seems counter­intuitive based on the supply/ demand balance in the gold market. The key elements are summarised below;

Supply has been constrained by the following factors

• Mine production growth is low and constrained by the low spot price
• We estimate that the producer hedge book contracted in H 1-00
• The European central banks have remained within their 400 tonnes sales quota. Other central bank sales have taken place but there has been no obvious flood of central bank selling.

Demand has been lower than forecast, but there is still positive growth

• Jewellery demand growth is up marginally on H 1-99, according to the WGC
• India's 2000 Monsoon has been 'mostly normal', but official gold imports are down substantially on 1999.
• Coin demand has fallen sharply in the US compared to theY2K demand last year
• Bids for used coins are at a discount to spot gold in the United States.

Overall, we expect that identifiable supply should exceed identifiable demand by some 400 tonnes this year. Why then has the gold price not rallied? The answer is that it has, but not in US dollars. Fig 2 at right, shows the price of gold in a number of major currencies, since the beginning of the year and indexed to 100.

Gold's performance in the currencies shown above has been better than the dollar gold price performance. Since the beginning of 1999, the gold price has increased in all of the currencies shown above with the exception of tJ1e US dollar and the yen.

Is the performance of gold in these currencies important? Conventional wisdom indicates that it is, as US dollar strength is often used as the reason that gold has come under pressure in a market commentary. Although the US economy is by far the largest economy in the world, it is neither the most important producer nor consumer of gold. Fig 3 below shows the proportion of gold production and consumption in US dollars and in other currencies. This calculation includes not only the USA but also countries that have pegged or maintain a tight trading range between their currencies and the USD.

Approximately 20% of both production and consumption are either in US dollars or in currencies that are for now, closely linked to the dollar. The balance of the supply and demand is spread between many diverse currencies. The conclusion from this is that although the interbank gold market trades gold in USD, the price in other currencies is an important driver of the gold price.

We see moves in the foreign exchange market impacting on the gold price in a number of ways. Some of these issues are discussed below :

A strong US dollar impacts on supply and demand in the following manner:

• Supply of privately hoarded gold (coins and bars) increases sharply when the European currency price of gold is high. There have been material sales of privately held gold on each wave of Euro weakness.
• Physical demand is sensitive to the local price of gold. Although the professionals are naturally aware of the U price of gold, terminal demand is at least partially influenced by local currency. This has certainly been a factor in Europe this year with the very weak euro, and Swiss franc and high rupee prices have contributed to disappointing Indian demand, although the drought earlier in the year hardly helped.
• Weak producing country currencies tend to accelerate producer selling. Although we estimate that the global hedge book declined in the first hair of this year, there is evidence that there has been some new net hedging over the past few months. GFMS forecast that the global hedge book will begin to grow again in the second half or 2000. Although we are less certain of this, certainly there have been indications of AUDXAU-related selling at times over the past few months.

Another way of looking at the gold price in other currencies is to look at the volatility of gold in different currencies. The correlation between gold and the currency is inversely related to the volatility between gold and the currency have plotted the actual three - month volatility of gold in four currencies over the past five years. This is shown above in Fig 4.