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Physical Gold and Financial Markets: What the Divergence Tells Us

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Understanding the discrepancy can help us separate short-run speculations from long-run movements.

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Last week, my firm illustrated how gold should be treated as a special alternative to dollar-denominated paper assets. Yet, It is not only the "system-hedge" aspects that determine the value of gold, since supply factors also come into play. There has been a lot of talk about the divergence between the physical gold markets and the financial markets. There are those who spout conspiracy theories about how financial institutions (including central banks) are manipulating the gold market (and as someone observed, that should not come as a surprise since central banks manipulate bond markets and interest rates every day). How true these statements are is a separate issue, yet there is, in fact, some level of discrepancy between the financial market and the real market (which overall in the longer run should disappear). This discrepancy can help us separate short-run speculations from long-run movements.

After the last huge fall in the gold price, one could observe that the physical market was not that shaken. Actually, it was spurred. As Bloomberg reported, the Shanghai Gold Exchange supplied 1098 tons of gold in the first part of 2013 (1139 being the total for the whole 2012 year), which is around 40% of annual gold production (yes, you are reading correctly: during half of the year the Shanghai stock exchange saw trading of 40% of annual production). We see, therefore, some big gold volume being traded in the market. Although we have to admit there was a visible slowdown. In April, 236 tons were delivered, in May, 224 and in June, 180.

What does it tell us? The "fundamentals" do not look very frightening. A recent huge decline in gold was a result of investors backing out of financial investments (ETF funds, etc.). Either they had expected very high levels of inflation, or else were interested in the short run "financial" side of the market. Naturally they are big players; they do influence what is going on in the spot market, as we saw last month. Nevertheless there is still a real part of the gold market associated with physical trades. This is what separates gold from paper currencies. Even if gold loses its value, in the end there is a real cushion. Gold can go down, but in the end it does not go to zero, because it is a real commodity that has a certain value. As long as it is a scarce, useful resource that cannot be printed, there is demand for it. For paper currencies there is no such bottom: Once they start losing their value, the limit is the cost of producing paper.

In the case of gold, the cost of production is a big part of its value. The main reason for gold being valuable is that it cannot be easily produced. It takes time and resources to mine it. What are the current costs of mining gold? It depends on the producer, but overall the cost of producing one ounce of gold is over $1,000. Andrew Su, CEO at brokerage Compass Global Markets, said last month that costs vary between $1,000 and $1,200 but in reality they can even be higher.

Could gold go higher, or at least not stay at even lower prices for months? There are strong supply arguments for it. The supply argument tells us that there are cost cushions against further falls after which gold stays low for a prolonged period of time. Especially in the light of the fact that lots of physical gold is being traded in the market.

Matt Machaj, PhD, is an economist whose research is focused on the monetary policy, the gold standard, and alternative monetary regimes. Matt is a university professor, blogger, publicist, founder of the Polish Mises Institute branch, member of Property and Freedom Society, and laureate of Lawrence Fertig Award.

For the full version of this essay and more, visit Sunshine Profits' website.

Twitter: @SunshineProfits
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