How Gold ETF Demand Could Lift The Gold Price Dramatically Higher

Market sentiment towards gold and silver remains negative. The latest daily Sentimentrader report makes this clear. Even with higher lows in the gold price since its lowest point early July and a $100 gold rally in the latest two weeks, the sentiment data remain in negative territory.

gold_sentiment_25_october_2013

This sentiment is also reflected in the physical gold holdings of the GLD, the largest Western gold investment vehicle. As we noted earlier, in the first week of January 2013 the GLD was backed by 43,149,400.96 ounces of physical gold. Today, its holdings stand at 28,036,311.27 ounces, a decrease of 35% year-to-date. The following chart shows the correlation between the gold price and GLD gold holdings until this summer (courtesy of Zeal Research).

gold_gld_holdings_august_2013

We noted earlier that the gold exodus in GLD is closely related to the massive gold inflows in China (but also the East in general). We also described how gold is moving in massive quantities through Switzerland where it is refined before sending it to China.

Coincidentally, these trends tend to occur with negative gold forward lease rates (GOFO, gold forward rates). A negative GOFO rate implies that gold investors pay a higher gold price over the next three months than in the future. This “backwardation” is not common in precious metals. Although we had stated before that there is no gold (significant) backwardation based on the difference between gold spot and futures prices, it appears it is occuring now specifically in 400 oz good delivery London bullion bars.

A recent FT.com article provides an interesting insight in the dynamics of the 400 oz bars market :

The negative gofo is just a shortage of kilo bars. It is, technically, a backwardation, but I call it the convenience yield of having gold immediately available for physical delivery. Look at the huge premiums in the Shanghai exchange and in India. You think maybe the market will normalise and the premium will disappear soon. So you pay up for immediate delivery.

The 400 oz bars, though, are the only acceptable form of backing for gold ETFs, not to mention the London market. There is a shrinking supply, which have been gradually flown from London to Switzerland, where they are further refined, cast into kilos, and sent on to China, India, the Middle East and elsewhere.

Say, what if there is a rise in the world gold price that leads to an increase in demand for gold ETFs and exchange traded futures? Could the gold flow back from those kilo bars to recasting as good delivery 400 oz bars?

“Much of that has been converted to jewellery. It would be a lengthy process. Those are pretty sticky hands. This could turn into a very violent wake-up for (screen-traded gold). People talk about ‘fiat currencies’, but we also have fiat gold.”

Most commentators focus on the gold exodus in GLD. Although that observation is correct, it is only half of the story. The missing part is that the gold is not gone; it merely moves from West to East. THAT is the key reason why a resumption of the gold bull market could result in violent price reactions to the upside. The physical gold could be gone once the Western demand returns. That will possibly become the inflection point where the physical market will take over control of the gold price. Physical gold owners will be the best positioned investors. Negative GOFO rates could be early signs of this process.

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