A golden year for gold: How real is the precious metal’s price rally?

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Gold is, once again, golden.

The metal that has a near-magical ability to arouse strong emotions, from loathing to love, is riding a fresh upswing that has taken markets by surprise. After four years in which it lost more than a third of its value, gold has suddenly reversed direction and surged about 22 per cent this year. Gold mining stocks have rocketed even higher, with shares of giant Barrick Gold Corp. more than doubling this year.

Skeptics, including Goldman Sachs and Citigroup, believe the recent boom is fated to end badly. They predict bullion's glow will fade in coming months as interest rates begin to rise, boosting payoffs from bonds and bank accounts. Higher rates may make gold, which offers no yield, look less attractive in comparison.

However, a growing number of other observers are declaring a new fondness for precious metals. Anita Soni and her team at Credit Suisse boosted their forecast for gold earlier this month, predicting that bullion will rise from its current level around $1,290 (U.S.) an ounce to $1,350 early next year. "We believe the gold rally has legs," agree the researchers at Pavilion Global Markets in Montreal. The folks at Capital Economics in London are just as enthusiastic. They say the metal will touch $1,400 an ounce in late 2017.

Behind this sudden outpouring of affection for a downtrodden commodity are some reasonable-sounding notions. The world's supply of newly mined gold may be on the decline. Meanwhile, demand for the metal could be growing as people look for a haven from negative interest rates. On top of all that, there is the prospect of new demand from India and China.

Do these arguments stand up to inspection? Let's take a closer look at some of the major pro-gold talking points.

Peak gold is here!

The simplest rationale for a higher gold price is the belief that the world is running out of new supply.

Ore reserves of the world's 10 major gold producers declined 15 per cent between 2013 and 2015, according to Goldcorp Inc., the Vancouver-based miner. Production from the bullion giants will fade 8 per cent between 2015 and 2018, the company says.

Some outside observers have come to similar conclusions. "We expect only a handful of new projects to enter production over the next five years due to a lack of viable new discoveries and a focus on balance sheet preservation and free cash flow," Ms. Soni of Credit Suisse wrote in a recent note.

The possibility that the world has hit peak gold certainly sounds as if it should send prices of the metal soaring, much as fears of peak oil drove big gains in petroleum prices a few years back. However, there's a crucial difference between the two concepts.

Unlike oil, gold isn't consumed. Rather than being burned as fuel, gold's job is simply to sit there and look pretty. It's extremely adept at doing just that. The metal has historically been valued as a store of wealth precisely because it refuses to rot, corrode or tarnish. As a result, all the gold that has ever been mined throughout history still exists.

Peak gold, if it is occurring, doesn't mean that the world is running out of the yellow stuff. It merely means that the total inventory of the world's gold is growing a bit more slowly than it did during boom times. To be sure, this slowdown is a good sign for gold prices, but it has to be viewed in context.

The Credit Suisse team estimates that annual supply from mines hit a high of 3,186 tonnes in 2015. They predict it will fade below 3,000 tonnes by 2018.

But here's the thing: Gold production, even at that reduced level, would still be running well ahead of levels before the great commodity boom. Prior to 2009, the world's mines were producing less than 2,500 tonnes a year, according to Credit Suisse estimates.

By historical standards, today's output looks quite reasonable. Fading mine supply may well help support the price of gold, but there are no looming shortages either.

Central bankers are losing their grip

One belief that unites many gold enthusiasts is a conviction that the global economy is on the verge of chaos.

"Central banks are printing money to buy time for governments to get their fiscal houses in order, which most have not done," Barrick executive chairman John Thornton told the company's annual general meeting this week. "The result: Today we have negative interest rates, while tomorrow we could well have inflation. Either way, if you hold cash, you lose money. In such a world, gold's function as a store and unit of value is obvious."

It's a fine-sounding argument, but one that lacks coherence. If central banks are recklessly printing money, as Mr. Thornton suggests, inflation should be running rampant through the global economy as the flood of new cash bids prices higher. Instead, the opposite is true – much of the world is locked in a deflationary vise, which is precisely why negative interest rates have become a feature in Europe and Japan.

The notion that gold is a reliable store of value also deserves to be challenged. Over the past five years, it has traded anywhere from $1,900 an ounce to $1,050 an ounce – not exactly a stable repository of buying power.

The doomsayers' argument for gold will always be there, but the metal's reputation as a rock-solid anchor of stability in an uncertain world is more a matter of faith than hard fact.

It's all about China – and India

If greater demand is needed to spur gold higher, much of the buying pressure will have to come from Asia. The World Gold Council, the marketing arm of the gold industry, says China became the No. 1 market for the precious metal in 2013. Together, China and India account for about 45 per cent of global demand.

Some observers believe Chinese buyers could swarm to gold if the economy slows, especially if policy makers in Beijing indicate they are willing to depreciate the country's currency to stimulate growth.

"There is a legitimate question as to whether Chinese savers will remain comfortable leaving their nest eggs in renminbi …," the researchers at Pavilion Global Markets wrote in a note this week. "While it is not a yielding asset, gold can represent protection from a gradually depreciating currency."

However, there is no sign yet of any sustained surge in consumer buying. The most recent report from the World Gold Council shows that China's consumer demand in the fourth quarter of last year was right in line with its five-year average, while India's was slightly below.

The lack of any apparent direction in recent consumer demand suggests that Asian buying has not been the driving force behind gold's recent gains. But Pavilion's point is well taken. If China's economic jitters grow, it's easy to envisage a scenario where millions of savers suddenly look to gold as a store of value.

A less muscular greenback bodes well

Gold's ascent began in mid-December, as weaker economic data cast doubt on expectations that the U.S. Federal Reserve Board would raise rates vigorously throughout 2016.

The prospect of lower-for-longer U.S. interest rates put a damper on the U.S. dollar, because lower rates mean foreign investors have less reason to rush into the greenback.

In years past, a weaker outlook for the U.S. dollar has typically spelled good news for gold, because a cheaper currency makes the precious metal – which is priced in U.S. dollars – more affordable for non-U.S. investors.

A weaker greenback also helps gold because it means that international investors who want to preserve their wealth can no longer scurry to the safe harbour of the U.S. currency.

The haven factor may loom especially large in today's market because so many countries are attempting to drive down the value of their currencies in attempts to make their exports more attractive.

"There's a competitive devaluation going on to preserve export markets," David Garofalo, chief executive officer of Goldcorp, noted in an interview this week. "In that context, gold is the one currency that can't be printed. It's quite finite in quantity and, as a result, there's more confidence in it as a store of value."

Negative interest rates drive demand

Negative interest rates in Europe and Japan are also putting a spring in the step of gold enthusiasts.

Historically, there is a strong relationship between gold prices and "real" interest rates (that is, rates after inflation has been subtracted from the nominal rate quoted in the newspaper).

Over the past several decades, when real rates have sunk – either because of rising inflation or falling nominal rates – gold has tended to climb.

This makes sense: Investors who may be tempted to take a flyer on gold have to look at the returns they can generate on competing investments. If alternatives such as bonds and bank accounts are producing no real return, then the fact that gold produces no dividend or yield becomes less of a deterrent.

"What's mostly driving the market right now are interest rates that are in negative territory, both on a nominal and real basis," Mr. Garofalo of Goldcorp says. "There's no longer an opportunity cost to holding gold."

Real rates may continue to be negative for a considerable time. Forecasters such as Capital Economics believe that U.S. inflation will continue to climb this year but the Fed will be slow to clamp down for fears of derailing an already sluggish recovery. The result will be a period of very low real rates even if nominal rates tick slightly higher.

"Lower real interest rates are positive for gold," Ms. Soni of Credit Suisse concurs. "The Fed's 2004-06 rate-hike cycle under [former Fed chief Alan] Greenspan showed that gold prices can rise during a rate-hike cycle."

But beware emotion …

No metal excites passion to the same degree as gold. At the moment, it's riding a powerful wave of positive emotions.

"Sentiment has clearly turned in gold's favour," Sean Boyd, CEO of Agnico Eagle Mines Ltd. said this week. "I think the stage is set for gold to set new all-time highs over the next three to five years.",

However, investors should keep in mind the fickle nature of commodity markets. The strongest reason's for gold's recent gains appear to lie in a weakening U.S. dollar and lower-for-longer real interest rates. Both may change quickly.

For now, skeptics point out that much of the recent surge appears to have been driven by speculators in exchange-traded funds, with only relatively weak physical demand for the metal.

"Despite the investor-led rally in gold prices … the lack of physical follow-through is a fundamental reason for why we think sustained gold bulls will be disappointed by year-end," Helima Croft and her team at RBC Dominion Securities wrote in a note this week.

"Absent a large and unforeseen [flight to safety] move driving gold higher, we think that prices likely have already peaked this year."