Is the investor demand for gold exchange traded funds (ETFs) on the verge of collapse? Why is gold relatively strong, when ETF demand appears to have collapsed, asks a report from VM Group research for Fortis Bank Nederland - Metals Monthly March 2010.

"Our estimate of the supply/demand balance for 2010 posited a chunky surplus, even with 700t of ETF demand (up slightly from 576t in 2009)," says the report. Following is a fundamental study on gold and why gold ETF demand is on the wane.

Nevertheless, inflows as of mid March in 2009 have not just been light; there were in fact net outflows of around 15t across the 17 ETFs we track. By this time last year, there had been huge inflows, 105t in January 2009 and an enormous 221t in February 2009, while March 2009 also saw a large inflow.

Gold has been in a skittish mood recently, trading from 15 February to 17 March in a range of $1,094.50/oz to $1,136.50/oz (using the London PM fixes) with little sense of direction and rarely looking like breaking decisively higher or lower. It began March brightly, reaching $1,136.50/oz on 3 March, its highest since 14 January 2010, but it could not maintain its gains and slipped to $1,106.25/oz by 15 March, before rebounding strongly to $1,122.75/oz by 18 March.

Comparing prices in March to gold’s all-time high of $1,212.50/oz in early December 2009 suggests gold has been a disappointment, but this is to ignore the much stronger dollar now than back then. The US currency is currently 7% stronger than it was when the gold price peaked on its index (a broader measure of the dollar’s strength), and against the euro it has done even better, trading by 17 March 8% higher than it was when gold peaked. Indeed, earlier in March the dollar was even stronger, when gold was trading higher, meaning it set record highs when measured in many currencies – euros and sterling chief among them – on 5 March.

This suggests gold is not as weak compared with its December 2009 level as it might appear if we simply looked at the dollar price. The question is – what currency should we use? Naturally, the dollar price remains the most important, and it is not simply the case that in other currencies gold has been doing better than in dollars, as some currencies are still appreciating against the US currency. Notably this includes China, whose Yuan is semi-fixed to the dollar but slowly gaining – thus pushing gold prices slowly down there, relative to the US dollar price – and India, whose currency floats but which has been limpet-like attached to the dollar in recent months.

One method to get a broader sense of gold’s global strength is to look at its price in a basket of currencies. One such currency would be the IMF's SDR, a basket of dollars, euros, yen and sterling. We have created a broader basket of the top 20 major currencies, with their importance weighted by their country's share of global GDP.

If we compare this to the dollar price of gold by rebasing the two series to be the same at the start of 2009, we find that the current dollar price of $1,125/oz (as of 16 March 2010) is only slightly higher than our GDP-weighted price of $1,095/oz. This means the dollar’s movement has had little impact on the gold price over this period.

However, what is different is that the sharp rise in the dollar price of gold from about September 2009 is not so pronounced when using our basket – the dollar peak of $1,212.50/oz in December was only $1,151/oz on a GDP-weighted exchange rate basis. Because of this, gold’s decline from that peak to today’s levels has been smaller (5%) compared with 8% for the dollar gold price. This is perhaps a better guide to gold’s strength (or weakness).

This leaves a conundrum. Why is gold relatively strong, when ETF demand appears to have collapsed? Our estimate of the supply/demand balance for 2010 posited a chunky surplus, even with 700t of ETF demand (up slightly from 576t in 2009).

Nevertheless, inflows as of mid March in 2009 have not just been light; there were in fact net outflows of around 15t across the 17 ETFs we track. By this time last year, there had been huge inflows, 105t in January 2009 and an enormous 221t in February 2009, while March 2009 also saw a large inflow.

Unless investment in ETFs show significant increases soon, Q1 2010 will have seen an enormous shortfall of over 400t of gold. With fears over the euro still prevalent in financial markets, perhaps nervous European investors looking to preserve wealth might make some large ETF purchases; however, there is no evidence of this yet.

That the price is remaining relatively strong despite this shortfall in ETF demand suggests either supply is lower than expected or demand is higher. On the supply side, mine supply moves too slowly to be a major factor, and mining company hedging has been very limited for some time. Central bank sales have been zero this year when in Q1 09 hey were about 60t, which explains some of the difference. If we were to pin down a supply shortfall then scrap might be the explanation, but this too was huge in Q1 09 and is more limited this year.

On the demand, side there is some evidence that Jewellery demand is picking up. The Bombay Bullion Association puts Indian imports of gold in February at 35t, more than four times the level of February 2009. Industrial and electronic demand might be recovering faster than we expected. Dehedging in Q1 2010 is likely to be limited, now that Barrick have closed out their book, but it was also very slow in Q1 2009, so on a year-on-year basis this might be a positive factor.

Yet even if we take the most negative view on supply and the most positive on demand these views are still not able to account for the shortfall in ETF demand. Perhaps then there, is another major factor bringing the market into balance, even at these prices? Is there a central bank purchase we do not know about? Has investment moved from the easily visible exchange-traded products to less visible bars, or even to a classic under-the-mattress purchase of coins?

Short-term outlook on gold

The dollar started falling again on 16 March and gold gained, pushing through $1,130/oz. However, by 19 March it was back down to $1,108/oz.

This volatility is likely to continue but the range could get wider as investor’s sense a break higher or lower. Short-term London PM Fix: $1,075/oz-$1,140/oz.

Courtesy: VM Group research for Fortis Bank Nederland - Metals Monthly March 2010

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