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Central banks are buying gold, says HSBC. That mean that the metal’s stratospheric rise may not be over yet. And with Goldman Sachs spelling doom for the dollar, gold fundamentals look strong
“Gold gets dug out of the ground… we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head,” said Warren Buffett, the legendary chief of Berkshire Hathaway in 1998. He still has not changed his position on gold, but he may find himself these days in the minority, given the yellow metal’s stellar rise.

The price of gold is normally determined by a combination of global real interest rates, the value of the U.S. dollar and risk aversion (so-called ‘safe haven’ demand) plus net supply from new production and changes in stocks held by central banks.

Calculate them and you get a two-year chart of gold which looks like this:

While retail demand from China and India are strong drivers of gold prices, HSBC believes that the arrival of central banks into the fray will mark a new chapter for growth in gold prices.

“The change in central bank demand is an important structural difference in net supply and demand conditions relative to the past and it seems set to continue. Central banks in the emerging world remain keen to diversify away from the US dollar and the attraction of precious metals, including gold is unlikely to fade anytime soon.”

“Changes in central bank stocks of gold can make a bigger difference to net supply than changes in production because of the huge size of stocks relative to annual production. Central banks are the holders of the largest stock piles of gold. For many years they were net sellers of gold. They preferred to own assets that generated a running yield because the focus was on improving the rate of return on their assets,” says HSBC.

Concern about dollar weakness and debasement from ultra loose monetary policy has turned central banks into a source of net demand for gold not net supply. Central banks in India, China, Russia and Mexico have recently been buyers of gold in an effort to diversify their foreign exchange reserves away from excessive dependence on US treasuries and other US dollar-denominated assets.

The figures from World Gold Council confirm that trend.

“Significant purchases by central banks across a number of regions in the first quarter reinforced gold’s vital role as a reserve asset. Purchases by central banks jumped to 129.0 tonnes (US$5.7-billion), more than the total for 2010 as a whole,” says WGC, which believes 2011 will see more central banks turn to gold purchasing programmes as a means of diversifying their reserves.

Central banks of emerging economies remain under weight in their gold hoardings and WGC expects the rebalancing to continue.

The growth will be largely driven by the People’s Bank of China (PBOC), the country’s central bank, which is already the sixth largest official holder of gold. Still, gold is a mere 1.6% of its overall reserves and the statements coming out of the PBOC suggest that it views gold as a strong investment alternative to offset rising inflation and global instability.

Apart from central banks, investors are also piling in. Despite the high prices, demand for gold in the first quarter rose by 100tonnes, to reach 981.3 tonnes, worth $43.7-billion.

“Much of the 100-tonne increase in demand was due to strong growth in the investment sector. We believe that suitable conditions remain in place to ensure that investment demand will maintain its solid growth in the coming quarters.”

GOLD VS DOLLAR
Gold’s strong inverse co-relation to the U.S. dollar has been a key driver of high gold prices. Goldman Sachs thinks the U.S. greenback is about to go down further.

Here are Goldman Sachs’ two reasons why the dollar will sink again:

U.S. trade and investment balances with the rest of the world remain negative. “The U.S. trade deficit is still widening and we expect it to continue to widen,” Goldman analysts said in its note. “Ultimately, it is difficult to envisage a dollar-bullish scenario without a notably stronger U.S tradable goods sector.”

The bank says continued deterioration in the trade balance will pass through into a continued deterioration of the U.S. current account deficit. For the dollar to strengthen in this scenario, foreign appetite for U.S. assets need to pick up substantially to have the deficit financed through foreign direct investment and portfolio inflows, Goldman says. But data shows that is not happening.

The Fed will be the last among major economies to raise interest rates, and the U.S. Federal Reserve will leave interest rates on hold this year and next.

The bank now sees EUR/USD at 1.45, 1.50 and 1.55 in three, six and 12 months vs 1.40, 1.45 and 1.50 previously. It projects $/JPY at 82, 82 and 86 over three, six and 12 months from 86, 86 and 90, previously.

With such structural forces driving gold, the fundamentals for the yellow metal look solid. But fundamentals don’t always drive markets.

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