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Gold: A Prescription for 1970’s Inflation?

After three decades being out of favor, the gold market is showing signs of shifting back into vogue. Ultimately we think the world will be presented with a 1970’s style inflationary wave, but in the near term a number of forces like historical investment flows, central bank buying, declining South African production, a falling dollar and a world gold deficit are likely to drive gold to new all-time highs, but in measured steps.

World gold demand - ETF & Similar products

In the past, the gold market has had a tendency to violently top out after inflation fears have dominated the headlines. At this point inflation is viewed as highly unlikely (some think impossible) based on the idea that the US Federal Reserve knows how to keep it under control, but also because of global economic headwinds flowing from the coronavirus catastrophe. However, a second wave of US infections could result in yet another round of US and foreign stimulus efforts, and we think that would eventually ignite inflationary fires. Central bankers would have to get “caught” providing too much help for too long to spark inflationary price moves, and this could occur with a successful vaccine that results in a shallower and shorter than expected slowdown.

While it might be questionable to expect that the historic pattern of investment inflows into gold derivative instruments that has occurred in the first six months of 2020 will be replicated in the second half of the year, it is worth pointing out that inflows so far this year have surpassed the previous record for a full year that was posted back in 2009. Gold ETFs added 734 tonnes for the first six months of the year, representing 45% of global production for that time. At this pace 2020 investment demand would reach 1,468 tonnes. To put this in perspective, the record for annual central bank buying is roughly 700 tonnes. In 2018 India bought just below 800 tonnes, China bought roughly 1,000 tonnes, and total world jewelry demand totaled 2,241 tonnes.

Gold commitments of traders - net position

We would also suggest that surging gold prices in the second half of 2020 could ramp-up investment demand to a level that would nearly match the combined usage of the world’s two largest consuming nations. At the current time stellar gains in equities are probably holding back some flows into gold, but with the Fed promising to hold rates down until they are convinced the recovery is self-sustaining, we can’t rule out a massive rotation from interest bearing items into gold upon the official announcement of a successful vaccine.

It is unclear what central banks net purchases will be for 2020, despite their having posted 10 straight years of purchases and two consecutive annual records in 2018 and 2019. One could argue that central bankers have had their hands full in 2020 and that they might shift their focus from building gold reserves into providing as much market liquidity as possible. On the other hand, China’s current gold reserves are estimated to be about a third of the US. To meet their goal of being the being most capable central bank in the world, China would need significant backup in the form of gold holdings.

India vs Greater China Gold demand

Another supportive factor is the Indian government’s attempt to legitimize their populous’ desire to own gold with the development of interest-bearing gold instruments and other methods that would bring gold investing into a safe, modern system. This could serve to boost gold investment overall.

The gold rally that started in March 2019 has seen a much bigger increase in open interest and trading volume than in the sub-prime rally, which suggests buying interest is very broad. Gold volume over the last 12 months was easily the largest in history, but futures spec and fund net long as of June 30 was still 100,000 contracts below the record from earlier this year. Current bull market conditions appear to be strong enough to justify new records in the spec net long position and new highs for prices.

Riding a second wave. Monthly gold futures

Elliott-wave analysis suggests that the bull market was confirmed by an increase in trading volume on the second wave, but it also suggests that the second wave should be larger than the first wave. This creates a target of at least $2,200 on the monthly chart, which merely equal to the first wave. A closer-in target using the width of the April through June consolidation as a measuring tool (from the breakout above $1,789) comes in at $1,915.

Originally Published on July 10, 2020

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