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Futures Fundamentals: Gold Glitters for Central Banks

August 25, 2015
Gold futures fundamentals

Many call gold the world's first currency. For thousands of years, gold has been recognized as a store of value. Gold coins were first created by King Croesus of Lydia around 550 B.C.E. and circulated in many economies before paper money was created. And in today’s markets? Gold is a unique commodity: it’s not widely used in industry, but has perceived investment value among investors.

For futures traders—and all broad-market investors—renewed gold volatility in recent months invites a fresh look at the global fundamentals that drive the yellow metal’s price, including demand from its perennial customer: central banks.

Commodities Retreat

This summer, gold is headlining a commodities sell-off triggered by a higher U.S. dollar and expectations that the gap between U.S. interest rate policy and policy elsewhere will keep the buck elevated relative to its rivals. COMEX-traded gold futures were near five-year lows in early August.

"Gold prices have been trending lower, largely on U.S. dollar strength and signs that the Fed will begin to normalize rates later this year. With our view for a liftoff in the Fed funds rate in September and continued strength in the U.S. dollar through the remainder of the year, more downside could be in store," said Dina Ignjatovic, economist at TD Bank. Gold is a non-interest-bearing investment, and higher interest rates are perceived as a negative factor for the yellow metal.

"Lack of physical and investment demand—particularly in China—combined with our forecast for a September rate hike and ongoing strength in the greenback, suggest further downside is in store for gold in the coming months," Ignjatovic added. "We expect prices to average US$1025/ounce in the final quarter of this year before heading back up to US$1200 by the end of 2016."

Who's Buying Gold?

Jewelry is the largest component of global gold demand, with Chinese and Indian consumers the largest buyers in the world, according to industry data. Investment ranks as the second largest category for gold demand; that includes bars, coins, futures contracts, and exchange-traded funds (ETFs).

Central banks, or so-called official purchases, are the third largest demand category for gold.

Emerging Market Demand

Central banks around the world have gobbled up gold in recent years to add to their reserve stockpiles. Central banks have been insatiable buyers of gold since 2009–10, switching in this decade to become net buyers of gold after being net sellers for almost 20 years, according to the World Gold Council. Official purchases have on average accounted for 10% of total gold demand over the past five years, according to Capital Economics research.

Central banks have purchased gold in part in recent years in a bid to diversify holdings away from fiat currencies including the dollar and the euro. Also, many older industrial nations see large gold holdings as a legacy of the gold standard years. Emerging market central banks weren't a part of that era, and subsequently have been underallocated to gold. Some of the recent emerging market central bank buying may come out of an attempt to diversify their reserves, say economists. 

World Official Gold Holdings

Tonnes% of Reserves*
1. United States8,133.574.2%
2. Germany3,383.468.0%
3. IMF2,814.0**
4. Italy2,451.867.0%
5. France2,435.466.2%
6. Russia1,250.913.4%
7. China1,054.11.1%
8. Switzerland1,040.06.6%
9. Japan765.22.4%
10. Netherlands612.557.7%
11. India557.76.0%
13. European Central Bank504.826.5%
14. Taiwan423.63.9%
15. Portugal382.574.3%
16. Venezuela361.068.3%
17. Saudi Arabia322.91.8%
18. United Kingdom310.39.7%
19. Lebanon286.821.1%
20. Spain281.619.5%

*The percentage share held in gold of total foreign reserves, as calculated by the World Gold Council in February 2015. The value of gold holdings is calculated using the end of month London PM fix gold price published daily by The London Gold Market Fixing Ltd.

**IMF balance sheets do not allow this percentage to be calculated

Drilling down into the data, in 2014, central banks bought a total of 477 tonnes, which represents a 17% jump from 2013 and the second highest year of central bank purchases in 50 years, according to the World Gold Council. Russia was the standout buyer in 2014, as the country added 173 tonnes to its reserves. Now, Russia holds over 1,200 tonnes of gold and is the sixth largest holder of gold in the world. The U.S. and Germany—the world's largest official gold holders—possess roughly 70% of their reserves in gold. In Q1 2015, central banks purchased another 120 tonnes of gold.

This fundamental underpinning is worth monitoring as gold markets—and all commodities—will likely remain volatile in a changing interest rate environment.

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