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Gold Bubble Set To Burst In 2010
February 18, 2010

In this article, we will analyse the main reason of the recent gold rally and why the gold price is overvalued based on the fundamentals.

Author : iFAST Research Team

Untitled Document
Chart 1: The Performance of Gold Prices Denominated In Different Currencies In 2009
Chart 2: Net Position in Gold Future Market
Chart 3: Annual ETFs Demand
Chart 4: The Breakdown of Gold Demand
Chart 5: Gold Forward Price Have Continued to Drop

Key Points

  • The sharp increase of gold price in 2009 was primarily driven by dollar depreciation and speculation.
  • Basic demand on gold recorded a substantial decline in the first three quarters of 2009.
  • Central banks’ buying is by no mean justify the high gold price because there were only few central banks to participate into the market and the volume of the buying was insignificant.
  • 1-year gold forward price implies the gold price would move horizontally over a period of time.
  • The gold price would then experience a nasty correction should the Federal Reserve starts to raise interest rates. Therefore, we recommend investors to sell the gold fund which mainly invests in futures.

The international gold price once surpassed US$1200 per ounce in December 2009, hitting a historical high without factoring in inflation. The gold finished 2009 up by 24.4%, its ninth consecutive annual gain. Gold price was propelled by the depreciation of the US dollar and the worries on potential inflation. The continuous uptrend in gold price reinforced the bullish sentiment and provided more incentives for investors to speculate on gold.

Table 1: 2009 Precious Metals’ Performance
Precious Metals 2009 Performance


















Source: Bloomberg and iFAST Compilation

However, we find that contrary to popular perception, gold was actually the laggard in the precious metals universe for 2009. In fact, gold was not only the worst-performing precious metal (see table 1) and was also far beaten by the performance of the equity markets under our coverage (except US and Japan) in 2009 (see our article “Top Markets of 2009”). Besides, the gold’s annual return last year was not spectacular as compared to the returns in previous years like 2002, 2004 and 2005. Thus, the gold fever could be barely based on the expectations of rampant monetary inflation and the greenback’s loss of status as the world’s reserve currency. The fundamentals, however, do not support the rally of gold price.

In this article, we will analysis the main reason of the recent gold rally and why the gold price is overvalued based on the fundamentals. 

Dollar Depreciation and Speculation Pushed Up the Gold Price In 2009

The sharp increase of gold price in 2009 was primarily driven by dollar depreciation and speculation. The gold spot price and the US dollar were negatively correlated in most of the time in history. It is because the international gold price is denominated by the US dollar and gold is an alternative for the dollar as the world’s reserve currency.

Chart 1 shows the performance of gold prices denominated in different currencies in 2009. Since 9 March 2009 when the US dollar index hit the year’s peak till end of October 2009, dollar-denominated gold price climbed 13.4%, which was comparable to the 14.3% decrease of the dollar index in the same period. On the other hand, gold price in euro and pound sterling dropped 2.7% and 4.7% respectively. It proved that the rally in gold price in that period was mainly driven by the dollar depreciation.

In November 2009, speculation became the dominant force to spur the gold price. The rise in dollar-denominated gold price (16.3%) far outpaced the decrease in the dollar index (2.5%) in the month. Gold price denominated in euro and sterling also surged sharply by 13.9% and 14.8%, which broke away from their sluggish performance in the past 6 months. Double-digit increase in gold price for a single month is quite unusual. It implied that the speculation on gold was very rampant.

Speculation Has Become The Dominant Force For Gold Rally

US Commodity Futures Trading Commission (CFTC) data shows that the long position on gold futures contracts was dominated by the speculative demand in last year. Table 1 explains four different users in the gold future contract namely Merchant, Swap Dealer, Money Managers and Others.

Table 2: Users of the Gold Futures Market
Users Description
Basic Demand For Gold Futures


Predominantly engaging in the production, processing, packing or handling of a physical commodity and uses the futures markets to manage or hedge risks associated with those activities

Swap Dealer

Dealing primarily in swaps for a commodity and using the futures markets to manage or hedge the risk associated with those swaps transactions
Speculation In Gold Futures

Money Managers

Managing and conducting futures trading on behalf of clients


Other reportable trader that is not placed into the above three categories
Source: US Commodity Futures Trading Commission and iFAST compilations

As shown Chart 2, in 2009, Money Managers were net long (means net purchase, long position minus short position) by 195825 contracts, a sharp increase of 113% from a year earlier. The total speculative demand were net long by 230490 contracts, which rose 83% year-on-year in last year.

Apart from the futures market, according to the data from World Gold Council, a massive amount of speculative capital has entered into the gold exchange-traded fund (ETF) markets. In the first three quarters of 2009, the demand for gold ETFs surged drastically 154% year-on-year (Chart 3 demonstrates gold ETF demand in the first three quarter of 2009 far outpaced the annual ETF demand in the past). This makes the speculative demand to be a major component of the total gold demand. Besides, the gold holdings of the world’s largest gold-backed ETF, the SPDR Gold Trust, increased significantly by 350 tonnes or 45% to a record high of 1133 tonnes in 2009. However, the trust’s gold holdings have continued to dip from its peak since 2010, implying the potential upside on gold is limited.

Gold Fundamentals Are Still Weak

There are four main categories for gold demand namely jewellery, industrial, retail investment and ETF. Over the past ten years, the average annual total demand for gold was in the vicinity of 3500 to 4000 tonnes. Jewellery, consistently accounts for over 60% of the total gold demand, is a key component for underpinning the overall demand for gold. On the contrary, ETF constitutes only a small portion of the total demand (less than 10% of the global total demand). Therefore, the demand of jewellery is probably the most crucial factor that influences gold price.

High unemployment, negative income growth and climbing family debt in developed countries suppressed the consumer demand on gold. Three out of four categories in gold demand (jewellery, industrial and retail investment) recorded a decline in the first three quarters of 2009, with ETF being the only component to register an increase (see Chart 4). The decline in the gold demand was almost universal (except in China).

Table 3: Demand in Major Jewllery Consuming Countries In Q3 2009 (Value, $US Million)
Country Jewellery ( Q3 2009) Jewellery ( Y-o-Y change in Q3 2009) Total Demand ( Y-o-Y change in Q3 2009)


9831 -21% -32%


9971 12% 16%

Middle East

7254 -19% -17%


2443 -50% -50%


1959 -26% -26%


1157 -20% -20%


4553 -24% 3%

World Total

50576 -18% -5%
Source: World Gold Council and iFAST compilations

In value terms, US is the largest market for gold jewellery while in volume terms, India is the largest consumer. In the third quarter of 2009, jewellery demand in India dropped 42% year-on-year while net retail investment demand recorded a decline of 67% over the same period. A downtrend in jewellery demand was also seen in other major consumer including US and Italy which dropped 24% and 20% from a year earlier respectively (see table 3).

Economic growth is a leading indicator of jewellery demand. Historically, it gives a picture of where the jewellery demand is heading to in next 2 to 3 quarters. As the global economy just started to recover, it may take more time to see demand for real physical gold to pick up.

Gold Buying By Central Banks Will Not Last

Investors believe that central banks’ buying to diversify the foreign reserves could help to push up the gold price. Reserve Bank of India purchased 200 tonnes from International Monetary Fund from 19 October to 30 October 2009. It was the biggest single central bank purchase for at least 30 years in such a short-period. Investors expect more of central banks’ buying to come.

Table 4: Major changes in reported central bank gold reserves (tonnes) in the second half of 2009
Country Comments Jul Aug


Purchases and swaps +0.1 +1.4 +6.0 - - -


The purchase of 200 tonnes from the IMF took place in October - - - +200.0 - -


The purchase of 2 tonnes from the IMF took place in November - - - - +2.0 -


Purchases of gold mainly in the domestic market +18.3 +9.6 +13.0 +16.6 - -

Sri Lanka

The purchase of 10 tonnes from the IMF took place in November - - - - +10.0 -
Source: World Gold Council and iFAST Compilations

In fact, central banks’ buying cannot by any means justify the high gold price because there were only few central banks to participate into the market and the volume of the buying was insignificant.

Relative to the average annual total demand of gold over the past ten years (about 3500 to 4,000 tonnes), 200 tonnes of gold is indeed negligible. Moreover, the planned sale of 403 tonnes of IMF gold is still lack of buyers. After the purchase from India and Sri Lanka, there are still 200 tonnes of gold unsalable. Table 4 listed the major changes in central banks’ gold reserves in the second half of 2009. It shows that the numbers of central banks to buy gold and the amount of gold they bought were very pitiful.

Moreover, dollar depreciation does not mean that central banks will buy gold for diversification. Lee Eung Baek, head of the Korean central bank’s reserves management department, said that the gold price is too expensive. He believed holding gold as part of reserves would make sense in meeting diversification purposes. However, there will not be many central banks want to balloon their holdings with the current high gold price. He also saw an illusion in gold, implying that other central banks would not buy any assets that had little value with no cash return. The statement demystified the rumour that banks would continue to buy gold.

The Actual Average Annual Gold Purchase from China Could Be Much Smaller Than Expected

Besides, it is widely believed that Chinese central bank is eager to buy gold to diversify its foreign reserves. Many investors also believe China has surreptitiously building its gold reserves without reporting the build-up as the central bank do not want to have a negative effect on the gold market. In April 2009, Chinese central bank officially revealed that the country’s gold reserves rose from 600 tonnes in 2003 to 1054 tonnes, making China the largest buyer of gold in 2009. It was the first public announcement on its gold holdings in the past six years.

However, investors should note that the purchase was not commenced in 2009. According to World Gold Council, China announced the gold reserves had increased by 454 tonnes since 2003. We thus believe the purchase was taken place over a six-year period from 2003 to 2009 rather than mainly in 2008 and 2009 as the market expected. It was a slow process through domestic secondary markets since Shanghai Gold Exchange was established in October 2002. Therefore, the actual average annual gold purchase from China could be much smaller than the market expected.

Hu Xiaolian, a vice governor at the People’s Bank of China, also warned that the gold bubble is forming. Diversification of foreign reserves is a long-term progress. Central banks need to consider the long-term benefits when deciding what to use as reserves. Thus, it is unrealistic to expect that central banks to keep buying gold for diversification especially when the gold price has been too high without the fundamentals’ support.

Downward Risk Is High For Gold Price

Apart from the expensive price, there are some other negative factors on gold. In fact, we don’t see any threat of hyperinflation. The breakeven rate for 10-year US Treasury, which is an indicator of inflation expectation, was at moderate level of 2.3% as of 31 January 2010. In addition, global economy has just started to recover and investors have regained their risk appetite. Hence, the demand for riskier assets has increased. Coupled with the weak demand for gold, gold price is likely to correct down.

Chart 5 shows that the gold-forward prices have continued to drop since December 2009. It implies that the market expects the gold price to drop in the future and thereby investors have been selling forward contracts. The decrease in gold forward rate may also reflect that investors have started to reconsider the gold’s fundamentals and the negative factors such as the rate hike in US which would probably drag down the gold price. As at 29 January 2010, 1-year gold forward price was US$ 1088, indicating that gold price will remain vulnerable for 2010.

Besides, investors should note that gold does not provide interest income. If the Federal Reserve starts to raise interest rates, investors will re-embrace the US dollar and re-price on gold. The gold price would then experience a nasty correction.

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

© 2010 iFAST Financial India Private Limited All Rights Reserved.

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