The key to understanding the gold market is understanding the role central banks play in prices.
This article originally appeared in the April/May 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Central bank purchases, particularly from the official sector in emerging economies, have been the largest single driver of higher gold prices during the past five years. This development is particularly notable because central banks have historically been net sellers of bullion since the 1980s. Central banks from emerging economies have been buying gold to diversify their foreign exchange reserves, while developed Western countries with large legacy bullion holdings now see gold as a strategic reserve asset and have accordingly halted their gold sales programs. Gold holds particular appeal for countries with large U.S. dollar holdings such as China and OPEC member nations, given gold’s historically negative correlation versus the greenback. However, central bank buying cannot maintain its current pace over the long haul, which supports Morningstar’s lower long-term gold price forecast of $1,200 per ounce. That being said, there are a number of potential scenarios regarding official sector gold demand over the next several years, some of which include accelerated central bank purchases, that could be very bullish for gold prices in the near to intermediate term.
Before 2010, central banks around the world were major suppliers of gold on a net basis, selling on average more than 400 tons of gold per year between 2000 and 2009. 2010 marked the first year in which central banks were net purchasers of gold, buying 87 tons that year, and the trend accelerated in 2011. To put this in context, global gold demand has increased from 3,800 tons in 2000 to 4,108 tons in 2010.1
The increase in gold demand that resulted from central banks switching from selling to buying bullion has been the largest component of gold demand growth over the past five years. During that period, it has outpaced demand growth from the inception of bullion-backed ETFs, which many analysts like to cite as being the primary culprit behind the recent bull market in gold. Increased central bank buying has also more than offset declining global jewelry demand.
Why Are Central Banks Buying Gold?
While countries might have different reasons for buying gold, Morningstar’s analysts believe that central banks have been purchasing bullion primarily to diversify their foreign exchange reserves. Gold holds particular appeal for countries attempting to diversify their reserves away from the U.S. dollar.
Currently, the U.S. dollar comprises the majority of global foreign exchange reserves, thanks to the United States’ dominant economic position and the dollar’s role as the currency of choice for international trade. At the end of September 2011, U.S. dollars comprised about 61.7% of total allocated central bank foreign exchange, or FX, reserves, which is by far the largest percentage for any asset or currency.2 In contrast, total official gold holdings amounted to only half as much, equal to 31.3% of global allocated FX reserves, assuming a gold price of $1,722 per ounce.
As one might expect from any money manager whose portfolio is overly tied to a single asset, central banks have been looking to diversify away from the dollar. (Why they have only realized this recently is another question, and it’s very hard to get concrete reasons for why central banks do what they do.) As a result, the greenback has been declining as a percentage of global FX reserves during the past 10 years, while other currencies, most notably the euro, have gained share. However, the euro’s share of global FX reserves has also started to decay after reaching its peak in 2009 as the ongoing European debt crisis has undermined confidence in the currency. Central banks are increasingly looking to gold rather than the euro in diversifying their FX reserves away from the U.S. dollar.
Gold is also appealing to countries with large U.S. dollar holdings because of the negative historical correlation between these asset classes. Since 1986, the correlation of returns between gold and the U.S. dollar has been negative 0.10.3 Only real estate and select baskets of commodities have featured a lower correlation with the U.S. dollar than gold among the major asset classes during this time period, and gold is a more appealing asset for central banks to hold in reserves than real estate or commodities. Compared with real estate, the gold market offers greater liquidity and the option to purchase discreetly, given the bullion market’s anonymity. In addition, gold is easier to store compared with other commodities such as petroleum, agricultural goods, or base metals.