A report from Merrill Lynch on the unfolding gold bull market, and the 3 waves it will likely have. This via Jim Sinclair's JSMineset, here.
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The three stages of gold price appreciation to $1500/oz
As we first discussed in our October 13 2008 Metals Strategist, three variables alone can explain the fluctuations in the price of gold: risk, currency and commodity prices. Departing from this analytic framework, we argued back then that gold would move to $1500/oz in three steps over three years. The outburst of the credit crisis in August 2007 marked the start of the first stage, with gold rising from about $650/oz to about $950/oz. The second stage of gold price appreciation is primarily about USD weakness and lack of confidence in fiat currencies, and should drive gold above $1200/oz. The third and final stage will be driven, in our view, by a strong cyclical recovery in energy and commodity prices.
The 2nd stage of higher gold prices is about USD weakness
Decomposing gold spot returns into factors, we find that USD depreciation and currency risk have been the key contributors to higher gold prices in the last eight months. Our analysis also suggests that gold prices have also been leading indicators of 5Y breakeven inflation rates and the USD yield curve slope (10Y-2Y) since April. Moreover, we find that the correlation of gold returns to EURUSD is a lot higher on the upside than on the downside. In our opinion, the explanation for this is that the supply of money in all currency areas is increasing a lot faster than the supply gold. So the weak dollar is pushing gold prices higher in USD, and the increase in global money supply is driving gold prices up in every currency.
A 100t increase in gold demand = a $45/oz move in prices
Broad money in a number of key currencies expanded 7 to 10 times faster than gold supply in 2008. This trend is poised continue over the next 18 months. If EM CBs come to the conclusion that gold at the current prices is better value and offers lower political risk than government bonds denominated in EUR or USD, reserve diversification into gold will continue. We estimate that any given increase physical gold demand of 100t ($3.6bn) could push prices up by $45/oz. With EM FX reserves at nearly $6trn, it will not take much to send gold prices higher.
The point of fiat currencies is to debase them as needed
While some investors remain concerned that lax monetary policy could end up resulting in inflation sometime down the road, we would argue instead that the whole point of having a fiat currency is to be able to debase it when the economic conditions require it. Of course, as the combination of monetary and fiscal policy measures help create an upswing in economic activity over the next two years, cyclical pressures will come back into the system. Because we expect gold to maintain its long-run relationship with other commodities, we see a third stage of gold price appreciation in the next 18 months where prices push above $1500/oz on the back of higher oil and commodity price.
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Stephen J Carter | SF Novelist
