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Contribution Details

Type Master's Thesis
Scope Discipline-based scholarship
Title The Evolution of Gold's Role in International Monetary Policy And Financial Markets
Organization Unit
Authors
  • Francesco Schaerer
Supervisors
  • Jacqueline Haverals
  • Michel Habib
Language
  • English
Institution University of Zurich
Faculty Faculty of Economics, Business Administration and Information Technology
Number of Pages 106
Date 2015
Abstract Text At a US Congressional Hearing on July 13th 2011, the question "Is Gold money?" has been asked to the, at that time, Federal Reserve Chairman Ben Bernanke. His answer was direct: "No it is a precious metal". However, the justification to this statement may not be straightforward. Does gold still retain a fundamental role for monetary policy makers in the 21st century? What is its impact on nowadays economy and financial markets? How did this influence change in the past century? Indeed, it has been only recently, on August 15th 1971 that the US dollar gold standard ceased to exist. The United States unilaterally terminated the convertibility of the US dollar to gold, bringing the Bretton Woods system to an end. Before that day gold was still a synonym of money. Today most countries still hold gold reserves even though, after the abandon of the gold parity, they seem to be considered nothing more than the legacy of the past. After the 1971 many countries reconsidered the amount of gold reserves to hold, and lately the lack of trust in foreign authorities led some countries to plan a gold repatriation. This legacy though, gave this precious metal a privileged role. We often hear about gold as safe haven, inflation hedge, currency hedge or its diversification properties in portfolio management. Hence, how should we consider it? Why is this commodity set apart from all other (precious) metals and commodities? Indeed, the aim of this research was investigate the changing role of gold in international monetary system. Particularly I examined the persistence of gold holdings from the breakdown of the Bretton Woods Agreement up to now, looking into the reasons for central banks to hold or sell gold, asking what presence this precious metal still retain nowadays. Moreover I proposed the concepts of gold as safe heaven during the economic crises, as hedging instrument or its use as collateral to sovereign bond. In order to answer those questions I started by explained what role gold played historically in the economies and how monetary policy makers were fond of it. In the third chapter I proposed an economical prospective on the topic, using the fundamental concepts of the Quantum Economic Theory to shed light on the macroeconomics inconsistency of the economic system. During this analysis I was able to reveal the perverse mechanism that were hiding behind the Gold Standard and why those reasons led this system to fail. After being sure that gold is no more related with monetary issue, I went a step forward, trying to understand how exactly gold is linked with the financial market. Interpretations are different, however at the close of this analysis, the answer to the questions raised at the beginning seems to be clear. The role of gold has changed in the last fifty years and today it has no longer any connection with the currency in the western world. Gold's role as money has faded over time while its image and status as a commodity has grown. “Gold’s quantity cannot increase at the same rate as you can print money, which will eventually weaken the US dollar” (Marc Faber on CNBC, March4, 2010). I chose to end by quoting this statement because it manages to gather in itself all the main characteristic of the topic I have studied: gold is a limited resource that cannot cover the requirements of a monetary policy, secondly gold is linked with other market forces and variables, from which it absorbs specific properties. 3 Reviewing in detail all the findings of this research would be redundant. Writing this work has given me a better understanding of how gold has been and still is regarded by investors, monetary policymakers, and governments. It has enabled me to gather a vast amount of information, studies and interpretations, sometimes conflicting, but in general with a common background. In the second chapter, we explored the evolution of the role of gold through the centuries, from bimetallism, to the gold standard, up to the present day. I started by proposing a historical point of view of the role of gold, pointing out that the gold-exchange standard was born in response to historical and social factors. However, the fragility of a system that had to face an increasing demand for reserves worldwide, in circumstances characterized by inelastic supply of gold and elastic supply of foreign exchange, along with the Great Depression and two World Wars, pushed the gold standard into a tight corner. Furthermore, policy mistakes were made. Confidence and credibility problems, not to say ‘crises’, made it difficult for central banks to balance liquidity supplies by gold price adjustments. As a result the system was doomed to certain death. We have seen, especially in Chapter two, that the economic system harbours some perverse mechanisms, and that some misconceptions have led to the failure of the gold standard. Based on the relevant tenets of the Quantum Theory we analysed concepts such as currency, income, capital, and time. We discovered the complications related to the lack of a vehicular international currency. At the same time, we found that the gold standard had failed to attribute intrinsic value to money through the monetary convertibility of gold. Having established the inaccuracy, or flaws, of the gold standard, in the last chapter we examined what role gold can still play nowadays. What we gathered from empirical studies has enabled us to highlight the fundamental characteristics of this metal, which today plays a dual role: gold is as much a commodity as a financial asset. It is a commodity that is used in diverse ways within the industry: it is extracted, stored and sold on the market where supply and demand decide its price. Similarly, the price of gold reflects features that go beyond the simple balance between supply and demand. Gold still has roots and memories from the past; it has physical characteristics that make it a prime commodity, and is of particular interest to people to find safety and security. We know that the market is made of men and directed by emotional men who react as much with their hearts and sensibilities as with their heads. It therefore becomes difficult to explain quantitatively the behaviour of an asset which is particularly prone to the irrational and emotional reactions of man. Empirical studies however seem to regard gold as a means of hedging but there is a flaw in this. The flight to safety has raised interest in gold as a form of financial asset other than simple commodity. The analyses proposed suggest that gold also has important properties for risk diversification when applied within a welldiversified portfolio, and is thus useful to investors, portfolio managers and reserve managers. But what are our expectations in terms of future evolution? As Bordo and Eichengreen recognize, gold holding persisted because of three main reasons: network externalities, statutory restrictions, habits. However the effectiveness of these reasons weakened after Bretton Woods, and will keep on decreasing in the future, leading central banks to divert from holding gold reserves. Nowadays, improved technology, international mobility of goods, people and capital and inter-connectivity of capital markets, enable agents to access liquidity and other forms of borrowed or unborrowed reserves. Along with flexible exchange rates, all these factors contributed to reducing the need for gold reserves 4 and gold demand. Finally, “network externalities, in conjunction with central bankers’ collective sense of responsibility for the stability of the price of what remains an important reserve asset, suggest that the same factors which have long held in place the practice of holding gold reserves, when they come unstuck, may become unstuck all at once” (Bordo and Eichengreen, 1998, p. 43). However the last financial crisis bears witness to the fact that gold still has not lost its peculiar characteristics. In fact, its prices soared to record highs. The new trend sees the price of gold dramatically dropping. Is that because the interest for it has faded? If so, is that going to turn how the way Bordo and Eichengreen forecasted? Will the role of gold as financial asset become less and less important? According to what I was able to find in the literature, I would tend to conclude that gold is following its natural path, and the drop in price that it is facing now, perfectly mirrors what has happened at other times in the past. Looking at the US we notice that the market has been bullish since 2010: the S&P reached a record high on May 21, 2015 closing above 2130 points, the Dow Jones Industrial Average had its historical highest peak on February 1, 2015 above 18132 points. The US unemployment rate touched the 5.3% in July 2015, a record low after April 2008, a number that is in line with the period previous financial crisis (during which unemployment rates hit a the record high of 10% in October 2010)3. The US economy is growing, as borne out by the strong likelihood of an interest rate rise in the next months. Roache and Rossi (2010) confirm that announcements which reflect unexpected market improvements have a negative impact on gold. When the equity market conditions are favourable, the attention of investors moves from assets that are known to provide risk protection to the stock market. On the prospects of an interest rate increase by the Fed in September 2015, gold tumbled to a five-year low on July 27, reaching 1073.70 US$. Higher rates mean less interest for the bullion as it does not provide returns or interests. Looking back over the past decades, the 2011 price spike looks very similar to the 1980 spike. However, at the end of the 1980s price volatility decreased and kept a relatively calm pace until the last financial crisis. If the same type of behaviour reoccurs, the gold price might settle for a period of subdued price movements for the next 20 years. According to Bloomberg banks like Goldman Sachs are predicting a further decrease in the gold price until 2018, below US$1,000. Investors are losing interest in the metal, George Gero said4: “Gold is becoming more and more distasteful as an asset for people to own (…) Better U.S. growth is going to reaffirm an interest rate hike in September, and that’s what is damaging gold.” At the same time, the Dollar Spot Index reached the highest levels in the last fourth months, confirming how gold and the US dollar are negatively correlated. High rates weaken the appeal of gold, which normally gives return under the form of price gains and analyst Robert P. Ryan (Bank Credit Analyst of Montreal) reported: “We believe gold has lost its safe haven bid. It has instead become primarily a source of cash in hard time (…) gold price is much more responsive to expectations for the Federal Reserve’s interest – rate lift-off, and the broad trade-weighted USD”5. The market sentiment is that gold is becoming less and less attractive, and that volumes of gold trading are getting ever lower. In August, volumes dropped by 8% compared to 2014 and 40% below the 100-day average and the expected tighter monetary policy will bring those numbers even lower. Forecasting gold price movements is extremely difficult: “Gold prices going down is not 3 Source: Bureau of Labour Statistic, http://data.bls.gov/timeseries/LNS14000000 4 Bloomberg. Joe Deaux and Tatiana Darie. Gold Bears Returns as Traders Look to September for Rate Increase, August 5, 2015 5 Source: Tom Keene. July 21, 2015. Gold has plunged and dollar has surged. Which is leading which?. Bloomberg 5 necessarily a bad thing, from that perspective it just suggests people having more confidence and less concerned about bad outcomes. But let me end by saying: no one really understands gold prices and I don’t pretend to understand them neither” (Ben Bernanke6). The improving US economy led to a shift in sentiment, bringing the bullion market to be bearish since April 2013. Bloomberg News reports a survey of 27 traders and analysts: 60% of them said that gold will go through a third consecutive negative year. This would be the worst result since 1998, when gold weakened to a 19-year low. According to the survey, prices will drop to US$984. “Gold is out of fashion like flared trousers: no one wants it,” said Robin Bhar, an analyst at Société Générale SA in London. “It’s not going to collapse, but we think it is going to be at a lower level in the not-too-distant future.” He added: “If anyone can show me the bullish case for gold, I’d like to see it (…) I doubt this is the final nail in gold’s coffin. I think we can add a few more.” Even Gerhard Schubert, founder of Schubert Commodities Consultancy DMCC said on Bloomberg News that: “I have to think really hard at the moment to come up with good reasons why anyone would want to invest in gold.” Not everyone seems to be so pessimistic, however: “Not everyone is heading for the exit. Bullion still has a place in portfolios as “insurance” (…) As an investor, you should have gold (…) There are lots of systemic risks out there”, said Frank Holmes, a San Antonio-based money manager at U.S. Global Investors. Investors do not seem convinced, though. The US Commodity Futures Trading Commission estimated that on July 21, speculators were holding a net-short position of 11,345 future contracts on gold, the first net bearish outlook since 2006. The Chinese Banking Corp.’s Barnabas Gan, (according to Bloomberg the most accurate forecaster of precious metals over the past two years) is expecting a price drop to 1050 US$ by December. “Gold is a weird relic of antiquity (…) It’s not a commodity that has much fundamental demand. It’s pretty, so people use it for jewelry. But it’s unlike iron ore or oil, or copper, or corn. There’s not a specific end-use for it. People just like it, so it becomes a discussion about fervor.” said Brian Barish, of Denver Cambiar Investors LLC7. Opinions on gold very much vary according to people’s tastes. Gold can be loved or hated. Its future remains to be seen. Of much interest will be the study of gold’s behaviour after the last financial crisis and particularly in the current bearish trend of the market. A look at new researches taking into account new data could improve the empirical results of gold price modelling, in order to understand better and actually prove the properties of gold that we have highlighted in this research. Moreover, to the best of my knowledge, not many studies have as yet been published on gold behaviour according to behavioural economic factors. Studying how the markets react to news and how this reflects on gold prices could be an interesting behavioural finance argument related to gold, which may be useful to understand better the movements of this precious metal.
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