By Olav Dirkmaat
In order to understand where gold prices are heading, we first have to learn about price formation. Also, let’s debunk some myths surrounding the Chinese demand for gold, and how it affects your gold investments.
Myth: the Chinese Government Will Back the Yuan with Gold
“People should invest in gold, given that the Chinese government wants to back the yuan with gold;” is an argument that we frequently hear in the gold market. Many argue that the reintroduction of the gold standard will lead to much higher prices.
Unfortunately, that is largely an illusion.
First, note that no single government or central bank has any interest in reintroducing the gold standard. A gold standard restricts the ability of central banks and governments to obtain funds that are not raised in the capital markets, or collected from tax payers.
A criminal will not turn himself in.
For example, earlier this year, the Chinese central bank (People’s Bank of China) made a commitment to provide ‘additional credit’ to the China Development Bank. The PBoC finances infrastructure investments. Would the PBoC be able to do this if the yuan were to be backed by gold, or if it was linked to a gold reserve? They would not. Also, nothing indicates that the PBoC will suddenly change its course so radically.
The gold standard has only existed in times when populations at large across the world had a strong belief that they should limit the power of central banks and governments. The gold standard was the result of the prevailing public opinion, not the result of a central bank wanting to limit its own power.
The gold standard will only be reintroduced if the larger public forces governments and central banks to do so. They may do so through politics, or by revoking their trust in their own currency.
The Transfer of Gold from the West to East Is Irrelevant
Yes, China is buying gold. We know that Chinese private investors are buying gold. We’re also willing to bet that the Chinese central bank is buying gold. But that doesn’t tell us anything about the future gold price.
After all, there is always a seller for every buyer. The fact that, right now, the sellers are largely situated in the West, and the buyers in the East, doesn’t mean there is an increased demand for gold, nor does it say something about the gold price.
An analyst who says that the ‘gold price is declining despite strong demand’ lacks a solid understanding of the financial markets. That there are transactions between two parties doesn’t tell us anything about the demand for gold, let alone the gold price. That there is a transfer of gold from one group to another does not imply anything about the future gold price.
The same applies to the stock market; the trading volume doesn’t tell us anything about the “demand for stocks”.
It is strange how much time is spent in describing the geographical movements of gold. These changes are then presented as ‘evidence’ for an enormous gold demand, and therefore, proof that the gold price will rise in the future.
Let’s go back to the basics to see what is important for the future gold price. We will take a look at the theory of price formation. What determines the price of gold?
Economics 101: Price Formation
The best explanation of how price formation works comes from the Austrian economist Eugen von Böhm-Bawerk (1851 – 1914). He unambiguously demonstrated how price formation works in different situations. From a situation with one potential buyer and one potential seller, to a more frequently occurring situation in which there are multiple buyers and sellers.
We will now take a look at how a ‘market’ and price formation works.
We assume that there are 10 potential buyers, and 8 potential sellers. Thereby, we simplify reality but the same principles apply in situations with thousands of buyers and sellers who are competing among each other.
|10 POTENTIAL BUYERS||VALUATION||8 POTENTIAL SELLERS||VALUATION|
|Af||210 OUT||Bf||215 OUT|
|Ag||200 OUT||Bg||250 OUT|
|Ah||180 OUT||Bh||260 OUT|
What does the table above show?
The left column shows the potential buyers. Take Aa. Aa values 1 troy pound of gold at 300 monetary units. He is therefore prepared to buy for any price less than 300.
On the right you see the potential sellers. Take Bh. Bh values 1 troy pound of gold at 260 monetary units, and is therefore prepared to sell for any price above 260. The price that people are prepared to pay for gold is below their valuation. The price for which people are prepared to sell their gold is above their valuation.
With this information we can analyze the list. Aa and Ba can make a trade, given that Aa is prepared to buy for any price below 300, and Ba is prepared to sell for any price above 100. Ab is prepared to buy for any price below 280, and Bb is prepared to sell for any price above than 110, etc.
The gold price will then be somewhere between the ‘marginal’ pair:
- The first successful buyer and the first ‘unsuccessful’ seller, Ae and Bf.
- The first successful seller and the first ‘unsuccessful’ buyer, Af and Be.
In this case, the market price of gold would be between 210 and 215 monetary units. The valuation of other potential buyers and sellers imply that they will not be able to trade. They are priced out of the market (‘OUT’).
So, what’s important for the gold price is not so much which group holds the gold, but the intensity and desire of potential buyers to buy gold, and the reluctance of potential sellers to sell.
Implications for the Gold Price
What can we derive from this?
There are many good reasons to invest in gold, but the fact that gold is being transferred from West to East is not among them. Of course, there will always be the eternally optimistic investors (‘permabulls’ in market jargon) who will use anything to justify their optimism, even fallacies. But you shouldn’t be fooled by them.
The desire to hold gold will increase when the returns on the capital markets are low, or even negative (anticipating on a market crash). But also when the final settlement of the debt crisis is forthcoming, when gold is again considered as a hedge or ‘fire insurance’ and when the trust in central banks collapses.
Considering this, past Friday’s publication of the second estimate of U.S. GDP growth over the first quarter was interesting.
What turned out to have happened?
The U.S. economy hasn’t grown by 0.2% in the first quarter (as indicated by the first estimation), but has shrank with 0.75%. But the sentiment for gold is so bearish, that even the disclosure of this mistake had no impact on the gold price. I anticipated the (disappointing) second estimate and had expected that the gold price would shortly rise above $1,200/oz.
As long as the Fed keeps responding indifferently to the disappointing economic data, the gold price will continue to be under pressure and could potentially even decline to $1,100/oz. A potential cause for a decline could, for example, be a financial agreement between Greece and Europe for more state aid.
It is hard to imagine a better time to buy gold.
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