Despite the somewhat quieter trade in precious metals this week, there has been no shortage of gold related news and developments, with the Indian governments gold scheme getting off to a very slow start, with only 30 kilos of gold going into the “gold monetization scheme”.

We’ve also seen further evidence of China’s insatiable demand for precious metals, with currency devaluation, a plunging stock market, concerns around economic growth and their natural affinity for history’s greatest store of wealth all pushing gold demand higher in China.

Indeed, as per this article in Bloomberg, Chinese imports of gold from Hong Kong hit their highest in 19 months in September, whilst Haywood Cheung, permanent honorary chairman of the Chinese gold and silver exchange society in Hong Kong predicted that mainland gold consumption this year will exceed all records, including the 2013 Chinese gold binge that was sparked by the huge fall in the price that year.

At a company level, we can certainly vouch for increased buying from many of our Asian clients and gold jewellery shops that have had long standing relationships with ABC Bullion. As regular purchasers of metal, they’ve really stepped up their buying in the last week or two, happy to accumulate the metal with AUD spot closer to $1500 an ounce.

Back to Chinese demand specifically, and as you can see from the chart below, withdrawals from the Shanghai Gold Exchange are set to hit a record this year, with more than 2000 tonnes already moving through the exchange this year.

This is a clear continuation of the “weak to strong hands” trend that has developed in the gold market over the last four years.

In that time, we’ve seen gold ETP products shed some 40% of their tonnage, with Western investors giving up on the metal, preferring to join the central bank sponsored party in equities and other risk assets.

Buyers in the East tend to have different motivations and timelines for gold ownership. We’re quite certain they won’t be sellers any time soon.

When western investors rediscover some affinity for the precious metal complex, they may find they’ll have to offer much higher prices to get their hands on the metal.

Bring on a rate hike

Last week we shared a chart that suggested a US rate hike was already fully priced in by the market. We’ve seen further evidence of this in the past few trading days.

The release of the FOMC minutes, which took place earlier this week, was always going to be keenly watched by market players, who would be looking to gauge just how confident the Fed was in the current state of the US economy, and whether or not it could handle the first interest rate rise in the better part of a decade.

The minutes, which can be read in full here, were full of the typical wishy-washy wording we’ve come to expect from the Fed and other central banks in the last few years (we don’t say that too critically for they have to be careful with their wording), but the market certainly didn’t interpret them as being dovish, with the rate hike still looking likely.

Of late, you’d have expected that to lead to further USD strength, and a slide in precious metals, but that is not what has occurred. Indeed, after trading close to USD $1,060oz earlier in the week, gold has pared some of its losses, and is currently trading closer to USD $1,080oz.

This chart of the last three trading days for gold illustrates what has happened in the gold market.

How high will rates go?

We’ve commented in the past about why we don’t fear US rate hikes when it comes to their likely impact on the precious metal market. The reason for that is that has often performed very well during periods of US interest rate rises, including the following:

• Between March of 1971 and the end of 1974, interest rates had risen from just 3.71% all the way toward 13% at one point. The USD price of gold increased from $38.87oz all the way up to USD $183.85oz

• Between February of 1976 and the end of 1980, interest rates rose from 4.77% all the way up to 18.90%. The near 15% increase in interest rates did not send gold prices crashing, with the price of the yellow metal instead increasing from just over USD $100oz to USD $673oz by late 1980, a return of over 6 times invested capital

• Between December 2001 and July 2007, interest rates rose from 1.82% to 5.26%. Over this time period, the price of gold increased from USD $260oz to USD $665oz

But how high will interest rates really head in the coming years? Some commentators think the Fed will adopt a ‘one and done’ approach (i.e. one rate hike in December 2015 and then no more for a long time), whilst many see this as the beginning of “policy normalisation”, with rates heading back toward 3% over the next few years.

We do not think interest rates will get anywhere near 3%, as markets and the broader economy are simply too reliant on perpetually cheaper credit. As a result, we’d remind clients to be sceptical about any mainstream analysis regarding the future direction of interest rates, and how far they’ll move.

For further evidence of why scepticism is warranted, consider the following chart, which plots actual interest rates, as well as what “the market” has been thinking would happen since the GFC.

When we say “the market” we mean market consensus forecasts for where the Fed Funds rate will be heading.

As you can see, the market has been constantly wrong in terms of where interest rates are heading. We think they’ll be wrong this time too.

Note the above chart came from Deutsche Bank, and I came across it in Alan Kohler’s Saturday Eureka report.

The Golden Opportunity Set

Most bullish forecasts to do with precious metals tend to focus on skyrocketing debt levels, trillions of dollars in quantitative easing, zero interest rates or just the nature of FIAT money itself, and why gold is clearly a superior savings asset.

All of these arguments have merit, but for me personally, one of the reasons I remain so bullish on precious metals over the medium to long-term is a simple rebalancing of assets away from stocks and bonds and towards precious metals.

As it stands today, above ground gold represents barely 3% of total US financial assets. This is but a fraction of what this number has been historically, with gold comprising closer to 20% of total financial assets back in the 1930’s and the end of the 1970s.

You can picture that clearly in the chart below, which comes from Tocqueville Asset Management.

Were history to repeat, it implies a potential six to seven fold increase in the value of gold, though we have no doubt it wouldn’t happen in isolation, with higher gold prices likely to be associated with greater stock and bond market volatility.

As investors, we need to constantly assess the set of opportunities we have before us, and measure both the potential return and the potential risk of the investment opportunities we have before us.

Without delving into a huge level of detail in this missive, any balanced observer must come to the conclusion that:

• Equity markets the world over are trading at or near all time highs, with investors paying historically high multiples for company earnings (especially if measured over the cycle)

• Fixed income markets at a sovereign level have been in a 30 plus year bull market, and are now at their most expensive point in centuries, despite a significant deterioration in the credit quality of the issuers

• The correlation between asset classes, which have been in a secular uptrend for two decades, has only risen further in this post GFC, central bank focused (obsessed) era

• Cash, mathematically designed to fail, no longer compensates investors for existing inflation, let alone the ever present risk of higher inflation that trillions of dollars of global money creation inevitably poses

• Physical gold, a highly liquid, globally tradable asset with zero credit risk, infinite duration and peerless track record as a portfolio diversifier, remains completely unloved by the market and represents but only a tiny fraction of total financial assets today

This historical anomaly will almost certainly rectify itself in the coming years, and it will be enormously profitable for those of us who maintain or even increase our ownership of precious metals in anticipation of it.

Until next week,

Warm Regards,

Jordan Eliseo

Disclaimer

This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.