"Profound judgement" required to understand gold and central banks

Central bank buying of gold is not a brand new phenomenon, with the official sector becoming a net buyer of gold back in 2009.  But there has been a bit more interest in this recently given the sell down in the most visible of investor holdings in ETFs, with it suggested that central bank activity is keeping the price higher than it otherwise would be (see this post at FTAlphaville).

Over the last few years, the increasing rate of central bank purchases has more than offset the slowdown in ETF flows.

In 1Q13 to date, we have seen 140tonnes of outflows from ETFs, with central banks so far raising holdings by 35t.

This maybe construed as supporting evidence of the statement above, but I would be very careful in linking quarterly movements in physical markets to what has happened with prices.   To be sure, it can be hard to make sense of the annual demand/supply balance for gold let alone on a quarterly basis.

Also the motivation of investors to continue to sell down is also questionable.  As I commented here, the sell-down on the back Fed minutes didn't seem to make much sense, while markets remained concern about any possible systemic financial risk in Europe, even from policy measures in Cyprus.

Much of the increase in official gold holdings is in countries like South Korea and Russia, with the Turkish banking system also accumulating gold given it is now accepted as collateral by the central bank.  The elephant in the room, however, is China, which has a huge amount of foreign exchange reserves and relatively little gold.

Last week the Vice Governor of the People's Bank of China (PBC) stated that a large increase is not on the cards for now, because "the gold market is too small" relative to the enormous US$3.3 trillion of reserves.  To be sure, managing liquidity risks is essential to reserve management, much more so than potential return.

So for the PBC "more gold always remains an option, but that requires profound judgement".  Of course, they could be saying one thing and doing another, given they know that confirmation of PBC buying would send prices higher.  But it seems to me that the apparent increase in Chinese bullion demand is more about private investors.

It is interesting that growth in Chinese forex reserves has stalled to close to zero over the past few years.  This has seen growth in global aggregates also slow quite markedly, suggesting global cross border liquidity has dropped quite a lot from the pre and couple of years post the financial crisis.

The original surge in global liquidity was also associated with the strong gains in the gold price.  So the more recent price weakness may not be just a function of investor apathy or concern about QE ending in the US, but also because global liquidity is meaningfully weaker than before.

The final point is that while there has been some interesting changes in the composition of physical market activity, its not entirely clear that had tipped the balance of being bullish or bearish on gold outside movements in currency.

As the chart left shows, gold is still sitting in the same band against the US Trade weight Index that it has for over a year now.  so still nothing meaningful happening to gold prices outside of the more recent cycle it has been in with the USD.