The Gold Crash

The price of gold took an elevator ride all the way down to the basement last week when it crashed nearly 4%…in just a few seconds.

The reason: China.

Apparently everyone in the People’s Republic was looking for the same exit door. In those few seconds, the amount of gold that was sold was equal to what is sold in one-fifth of a whole day’s trading. Close to 5 tonnes of gold were sold – about the size of two adult blue whale tongues – in a market where 25 tonnes a day is the norm for an entire day.

gold

Wild. But who could sell that much gold in such a short time? To dump that much you’d have to be a major player. The CEO of London gold broker Sharps Pixley contends that it was likely a large fund or investor looking to bet against the gold price by trading short. That is, the investor borrows money to buy gold, betting that the price will fall, then dumps gold they already own in an attempt to drive the price down. You make money when the price falls and then you buy back the gold you sold at a lower price. Easy game.

Gold prices have been coming down since 2011 but in just a few seconds, last Monday, the price dropped to $1087 an ounce. At its height in 2011, gold was worth a whopping $1923!

Having hit its lowest level since March 2010, gold has since rallied slightly above the $1100 mark but the trend is clear. Gold is being sold off.

A number of trends and related factors have also coalesced perfectly to create the conditions for a massive sell-off of gold. One MarketWatch chief strategist Colin Cieszynski at CMC markets describes 4 of those factors:

1) Reduced demand for defensive havens

The world is a better place now. We’ve safely navigated the treacherous waters of the Greek crisis (seemingly), and with the new U.S.-Iran nuclear deal global tensions are fairly low.

Gold is usually seen as one of those assets to which you’d want to hold on when the end of the world is near. If there was a zombie apocalypse in the near future you can bet that traders would be trying to buy up gold rather than sharpening their melee weapon skills.

 

2) Reduced need for inflation hedges

A hedge is an investment used to balance out another, usually, losing investment. For example let’s say you own shares of Tesla. You know that whenever the price of Tesla goes down, Apple shares rise. Well then it would make sense for you to buy shares of Apple to act as a hedge: the gain from Apple shares rising offsetting any loss on those Tesla shares.

A lot of people believe that gold is an excellent hedge against inflation, a general rise in the price level of the goods and services we buy. If inflation rises, then our money buys less and less over time.

The first thing to understand is that gold actually isn’t a good hedge against inflation. The data just doesn’t show it.

gold

The chart above shows that generally higher inflation leads to lower returns on holding gold. That’s not exactly what you want to see from an inflation hedging instrument.

But, there are many that BELIEVE gold to be an excellent hedge and belief alone is more than sufficient to move markets.

So, the point is that we are in a low-inflationary environment and central bank shenanigans have contributed to this. The price of oil has also remained low, (around $50 a barrel) which all serves to keep inflation down. That means the gold bugs will look to sell.

3) U.S. interest rate lift-off and dollar rally

About those previously mentioned central bank shenanigans…Well, the U.S. Fed is going to end their Quantitative Easing experiment. When they do, the expectation is that interest rates are going to rise. They almost certainly will. That means it’s going to cost more to lend out money and the traditional view is that as interest rates rise, gold prices decline as investors chase higher returns outside of the shiny yellow metal.

 

Combine that with the fact that the dollar has been incredibly strong for a long time now and you get a perfect storm. When the dollar is strong it puts pressure on commodities – especially oil and gold. When the dollar rises, the price of gold generally falls. It’s not that simple, the U.S. dollar is by no means the sole determinant of gold prices – but it does seem to influence it.

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4) China

China is one of the largest buyers of gold in the world, often swapping the top spot with India. In 2013 China bought 1066 metric tons of the stuff with India a close second.

When the largest buyer of anything starts selling it tends to generate concern in the markets.

According to official numbers released by China, they have about 1700 metric tons of gold in their reserves, up 57% from 2009. Despite that increase, the percentage of Chinese gold as a total of China’s foreign exchange reserves is still less than it was in 2009. In 2009, gold accounted for 1.8% of total FX reserves but only 1.65% today. Something’s a little fishy.

Looking ahead, it looks like gold may fall further. There are some analysts calling for gold to fall to $800 an ounce. It kind of doesn’t look good for any commodity right now. Many other commodities have been dragged down along with gold. Platinum and palladium have both declined in value.

There might be a reprieve coming though. Market participants are reporting that gold is at or near its all-in production value. This means that if gold prices continue to stay low, then producers will scale back. After all, if you are selling gold and you are a mining company that can’t make enough money to continue operations, then you are going to slow down. This pressure may tighten supply and force prices to go up.

For the moment, gold miners across the world are going to have to tighten their collective belts.

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