Does the recent rebound in prices signal a long-term turnaround for the precious metal? Here's why it just might.
Certainly, gold has picked itself off the mat. Prices have rebounded, up 9% from the low, as the dollar has weakened, the Fed has softened its message about tightening the money supply, and a surge in crude oil prices has revived inflation concerns.
All those factors favor higher gold prices, because a strong dollar and a softer money supply feed inflation, and the yellow metal is the traditional inflation hedge.
Other factors favor a turn, too, including simple inevitability. Gold is now going for around $1,290 an ounce, down from its all-time high near $1,900, and no trend lasts forever.
So while it's likely too early to jump in just yet, a careful look at what's happened to gold and what might happen next tells me to get ready. Here's why the rebound should continue.
First, consider the combination of factors that has crushed gold (and silver) prices since October.
Inflation, and fear of inflation, waned. Energy prices dropped. Interest rates increased. And above all, the Federal Reserve indicated -- hinting shyly at first before hammering the message home -- that it was preparing to scale back its cheap-money economic stimulus efforts. Specifically, it was looking at "tapering" its $85 billion-a-month bond-buying program.
Anthony Mirhaydari
This stimulus is what gold fans in particular deride as "money printing." It keeps them up at night worrying about the dollar's collapse.
That new Fed direction strengthened the dollar, which gained 8% from its low in September to its high earlier this month. And that pummeled the price of gold, which is valued as an alternative to the greenback that will keep its value. The yellow metal lost 34% in the period, falling from nearly $1,800 an ounce to just $1,179.
Investors bailed, pulling money out of gold exchange-traded funds such as the SPDR Gold Trust (GLD) ETF. And small speculators in the futures market expanded their bets against the metal to a net short position -- meaning that in the aggregate they were betting that prices would continue to fall -- for the first time since at least the early 1990s.
But in the past few weeks, this picture has changed. The Fed blinked. Crude oil prices tested $107 a barrel for the first time since early 2012. And gold bounced.
Can that bounce continue?
The first thing to consider is that the price decline has taken gold below the all-in cash cost of production for many mining companies, which are struggling with higher operating expenses, increased political risk (witness the platinum strikes in South Africa) and that fact that new gold discoveries are happening almost exclusively in unfriendly parts of the world.
In short, the problem is that high production levels no longer pay at today's prices -- which means production cuts.
On Monday, in fact, AngloGold Ashanti (AU) cut its 2013 gold production forecast by upward of 10%, to four million ounces, in an effort to remove "unprofitable ounces from our production profile."
Researchers at Barclays Capital estimates that the industry's marginal cost -- that is, the cost to produce an additional ounce of gold at 90% capacity -- is around $1,300 an ounce. The average cost of production -- the cost at 50% capacity -- is around $1,100.
So it's no surprise that supply is being pulled from the marketplace. Already, according to Bank of America Merrill Lynch analysts, one-third of the industry is "underwater" in that prices aren't covering the cash production costs.
The other side of the equation is demand. And in particular, demand from investors.
Yes, there is a small industrial component to demand for gold. About 10% of annual gold production is used in electronics, where it's valued as a high-quality conductor. According to Societe Generale, this number isn't expected to change much in the foreseeable future.
There's also demand for gold production for use in jewelry, particularly in the emerging Asian economies -- especially India, where gold plays an important cultural and religious role. A strong monsoon season is expected to bolster crop yields, which in turn should bolster gold demand later in the year as farmers traditionally snap up a few gold pieces when their harvests are sold. Overall, jewelry demand expanded 12.3% in the first quarter of 2013 compared with the same period in 2012, to 551 metric tons.
The big swing factor is investor demand. And that is expected to rebound later this year, according to Standard Chartered analysts, who are looking for prices to rally above $1,400 an ounce by year's end -- an 8% move from current levels.
The chart below shows just how severe the pullback in investor demand has been. Assets in the SPDR Gold Trust ETF, which are backed by physical gold, have fallen 50%, returning to early 2009 levels.
For gold to keep going, this picture would need to turn around, a trend that tends to be somewhat self-fulfilling. As gold prices rise, so does demand from investors, which in turn would push prices higher. A good dose of inflation worry would help as well.
The good news for gold investors is that it looks like all that might just happen.
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