Making sense of gold’s place in the financial world

Gold is an important investment topic because fiat currencies are being challenged and China clearly wants to end the U.S. dollar’s reign as the world’s sole reserve currency.

Short term retail investors want to know whether gold will soon have a meaningful move; long term retail investors ponder whether gold’s ultimate zenith will be $3,000 to $5,000 an ounce — numbers often bandied about by gold bugs.

Quite possibly, the central banks, which have foreign reserve surpluses (and particularly China), will have the greatest impact on gold prices in years to come. So far, in 2012, these dollar-surplus countries have been buyers.

Gold hit a high in September 2011 at $1,921 an ounce and has been contracting for more than eight months in a narrowing triangle formation. The triangle’s bottom remains in the low $1,500s as that price shows big buying interest. Upside resistance is somewhere around $1,700. Often this pattern coils price so tightly that at the triangle’s apex, there is a break out establishing a new trend, either up or down.

What is behind this back and forth price action? Why hasn’t gold continued its several-year upward trajectory? Here are some ideas.

Gold’s role in central banks’ coffers might br be morphing. Gold has been a form of currency in past centuries. It once backed the

Usi U.S. currency (e.g., gold standard and, as such, a form of currency); and, by the 1970s, it became an inflation protection asset.

But what is it now? Sure, it is scarce… but sscarcity without value would not command a market move from $250 an ounce in 2002 to $1,921 in 2012.

Although Fed Chairman Ben Bernanke protests that gold is not a currency and Warren Buffet’s partner, Charlie Munger, takes media center stage to pronounce that gold is not worthy of investment purchase, some well-capitalized and smart central banks have recently made large purchases of gold. So could it be that at some fundamental level, these central bankers perceive gold as having value tangential to currency? Otherwise why would they keep buying it?

Central banks self-report their gold holdings. A country is deemed to have “a lot” of gold based on the ratio of its central bank’s gold size relative to GDP size. Based on this measure, the U.S. has “a lot” of gold, but Congressional requests for gold audits are consistently declined by the Federal Reserve. The mystery as to “who has how much gold and where” extends across the Pacific to China. The Bank of China has not shown its cards since since 2009 when gold holdings were last reported to be 1,054 tonnes (or 1.6 percent of its foreign exchange reserves)… assuming a then accurate number.

What we do know is that China was a heavy buyer of gold in the first quarter of 2012: “Imports from Hong Kong were 135,529 kilograms… between January and March, (up) from 19,729 kilograms in the year-earlier period,” per Hong Kong’s Census and Statistics Department. That is a jaw-dropping increase! (Bloomberg, May 8, “China’s Gold Imports Jump as Country May Become Biggest User”.)

China is not alone in its purchases, according to Gold Core’s May 25 online report: “The IMF central bank gold demand figures for April were very bullish and suggest that (global) central bank demand in 2012 may be even higher than the 456.4 tons added last year — which was the most in almost five decades.” Even the “Bank of Russia plans to keep buying gold on the domestic market in order to diversify their foreign exchange reserves.” So two out of four BRIC countries are meaningful gold buyers.

But the big news is the recent moves by China as part of its long term plan to become a major force in physical gold trading. China recently made a hefty bid (and then tabled it) for the London Metals Exchange, which controls 80 percent of all global metals futures trades and is big in industrial metals, too. This comes on the heels of China’s creation in 2011 of PAGE (Pan Asian Global Exchange) where physical spot gold is sold in RMB to global participants. PAGE is in addition to the Beijing Gold Exchange, which has 60 retail outlets across China.

You don’t need to be a Wall Street whiz to see the picture created by these puzzle pieces: countries that are not broke and that have foreign exchange reserves are buying gold at current levels and are making bigger and longer term plans.

Seems as if the story with gold “ain’t over until it’s over.” And China may be saying, “We’ve only just begun.” ¦

— There is a substantial risk of loss in trading futures and options on futures contracts. Past performance is not indicative of future results. This article is provided for informational purposes only. No statement in this article should be construed as a recommendation to buy/ sell a futures/ options contract or to provide investment advice.

— Jeannette Showalter, CFA is a commodities broker with Worldwide Futures Systems, 571- 8896. For mid- week commentaries, write to showalter@wwfsystems.com.