Interesting Macro Factors That Could Fuel Long-Term Physical Gold Demand

Investment Thesis

We are seeing a lot of pushback from U.S. sanctions and tariffs, which fuels the search for alternatives to the U.S. Dollar dependence. There are no signs of the sanctions and tariffs to ease in the short term.

We have also seen physical gold demand pick up by central banks and consumers in various countries with weak currencies.



China Oil Futures

The Shanghai International Energy Exchange launched oil futures settled in yuan about 6 months ago. Up until that point, Brent and WTI crude, both settled in U.S. Dollars, have been the only pricing benchmarks available. In 2017, China surpassed the United States to become the world’s largest oil importer, so it is a natural step. Other similar global attempts have not been successful in the past.

Global market participants are naturally hesitant to commit to a market when the settlement currency is not as liquid or freely traded as the U.S. Dollar. There are also concerns about government interference in the exchange. Despite these concerns and the relatively short amount of time the market has been operating, it was reported that in July, the Shanghai exchange claimed around 14% of the global front month volume. As a comparison, it took Brent two decades to reach that level.

We can still be far from global acceptance of the Shanghai oil futures. More liquidity across the futures curve is needed for example and market participants will likely commit gradually until they are more confident in the market. There have been some talks about leveraging gold (GLD)(IAU)(PHYS) for settlements or backing, but regardless if this happens or not. If the exchange continues to gain market share, the demand and likely the value of the U.S. Dollar could decrease. Annual trade value for oil is around $14T, which means the even smaller increases in the global market share has the potential to make a dent in U.S. Dollar demand.

Allies Urging for EU Payment System

Whether it was right or wrong for President Trump to leave the Iran deal is irrelevant in the discussion. The decision was not well received by European allies. The trade tariffs are certainly not helping the situation either. German Foreign Minister Haiko Maas spoke out about the need for a payment system independent of the U.S. This is certainly a thesis Russia has been asking for as well. Not that Europe is on the best of terms with Russia presently, but Europe and Germany specifically are dependent on Russia’s natural gas and seem to have a more pragmatic view.

Central Banks Continue to Buy Gold

Russia has been buying gold for an extended period, even during the period when the oil price was low and the economy was contracting. It was reported that the amount purchased accelerated in the month of July, giving Russia 2,170 tonnes of gold in reserve. Russia’s gold purchases are a strategic move for more independence.



Figure 1 – Source: tradingeconomics.com

We have also seen the Reserve Bank of India buying gold for the first time in 9 years. The Bank of Mongolia earlier in the week said that it had purchased 12.2 tons this year with the aim to reach 22 tons by the end of the year. Turkey is another country which has significantly increased the gold reserves over the last couple of years, even if it is very difficult to predict what will happen with those reserves with the lira depreciating massively now.



Figure 2 – Source: tradingeconomics.com

Consumer Demand

Turkey has also seen the gold futures volume doubling since the start of the currency crisis. Even though President Erdogan has most recently urged citizens to sell gold and purchase the lira, one could at least hope the citizens aren’t complying with that advice given the level of inflation in the country.

Another currency under threat is the Iranian rial, where we have seen the demand for bars and coins increase significantly in 2018 compared to prior years.



Figure 3 – Source: bloomberg.com

India is a country which has a historical affinity for gold. The Indian rupee has like many other emerging market currencies been declining against the U.S. Dollar during 2018. During the month of August, Reuters reported that imports increased by 116.5% year on year totaling 100 tonnes. Just to put that into perspective, Financial Times estimated global gold production for 2017 at around 3,300 tonnes. This puts Indian imports in August at 36% of global monthly production, if we assume production to be flat in 2018.



Figure 4 – Source: tradingeconomics.com

Conclusion

We know China, Russia and other countries are interested in alternatives to the U.S. Dollar. More recently even U.S. allies are asking for decreasing the dependence of the U.S. Dollar. All the above data points can naturally be dismissed as anecdotal evidence. However, I believe that that if the U.S. continues with sanctions and tariffs, it will accelerate the pace at which alienated countries search for alternatives, where I think gold will either have an explicit or implicit role to play. That is very likely to increase the value of gold.

The price of gold in the short term is still to a large degree determined by the paper market, so I don’t expect physical demand to overtake any tactical trades. It could have the potential to put some downside protection on the price of gold and it can also further fuel the acceleration if we see sentiment change in the futures market.

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Disclosure: I am/we are long GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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