The (Brief) Rise and (Inevitable) Fall of Gold

sad gold

Gold fell rather precipitously yesterday and it appears that many in the markets are scratching their heads. “Why,” they think, “is gold falling in price in the face of a looming government shutdown and a recent indication by the Fed that they are halting the QE taper?”

The best way to answer this is probably to lay out the events sequentially. Okay, so the Fed announced its intention to taper on June 19th of this year. As can be seen from the graph below gold, as we might expect, fell immediately afterwards. From that graph, however, it appears that the shiny metal was already in a downward trend prior to the announcement of the taper, leading one to suspect that it might not simply have been the announcement that led to the fall.

Gold Price

On July 18th Bernanke’s Humprhey-Hawkins speech was pre-released and analysts noted its dovish tone. Bernanke seemed to imply that should an economic recovery not be forthcoming the Fed might increase rather than decrease its bond purchases. The gold market failed to react meaningfully; it spiked for literally an hour or two and then fell to new lows.

Then came the announcement that the Fed might not taper after all which reached the collective ears of the market on September 18th. Once again, as can be seen from the chart below, gold failed to react. It continued on its downward trend.

Gold Price Taper Halt

All of this, of course, begs the question: if gold prices were not reacting to talk of a taper then why did they rise substantially from their bottom at the end of June to their peak at the end of August? It seems that the answer was rather simple: it was a dead cat bounce plain and simple. Gold prices had fallen so far by the end of June that they had to recover at least some of their losses.

The reason for this, it seems to me, is built into the structure of the gold market itself. As I have pointed out elsewhere before, the gold market has two distinct characteristics which, if properly understood, explain a great deal about its ups and downs.

The first of these is that there is what we might call a ‘hard core’ of gold investors and these account for the massive increase in ‘bar and coin investments’ since 2007. This hard core are, of course, the gold bugs and as I pointed out before their investments are purely driven by (lack of) confidence – i.e. fear of hyperinflation and the like. These are a somewhat problematic investment class because while, on the one hand, they remain loyal customers in that provided their fears are being stoked they will hold onto their gold, on the other hand, they are probably rather skittish.

This leads to the second defining characteristic, namely, that there is an extremely low price elasticity of demand for gold. This means that if even a small amount of gold is dumped onto the market the price must fall substantially before a buyer is found. This indicates that the above mentioned hard core are adopting a defensive posture; they are not really interested in more gold, but rather in defending their current gold hoardings.

Taken together these two defining characteristics suggest that the gold market is in an extremely fragile state. Any rush for the exit by investors means precipitous price declines. The dead cat bounce we saw from the end of June to the end of August was likely the result of gold bug investment managers convincing their wary clients to take advantage of the price declines. But this is likely subject to diminishing returns as those clients become ever more defensive moving into a future in which the likelihood of serious inflation seems less and less.

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About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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