Central Banks Buy Their Most Gold In Years As They Look To Reduce Risk

Adem Tumerkan November 2, 2018
Category: Research

– This is a repost of the recent Palisade Weekly Letter –

 

Less than a month ago  – Hungary’s Central Bank announced that they increased their gold holdings from 3.1 metric tons to over 31 metric tons.

That’s a tenfold increase – meaning 1,000%. . .


 
The Hungarian Central Bank governor – Gyorgy Matolcsy – called this a significant move of “economic and national strategic importance”. He also boldly stated that this was a way to improve the security of the small nation’s wealth.

This news comes right after Poland’s recent decision to charge into gold as well. . .

Poland also added nearly 10 metric tons of gold to the country’s reserves in July and August as prices fell.

This marks the country’s largest gold purchase since 1998. And bullion reserves now sit at the highest they have since 1983.


 
True – Poland and Hungary both still rank outside the world’s top 30 largest gold holders.

And to give you a little context – Russia’s adding 20 tons of gold on average each month to their vaults. . .

So – in the bigger macro picture – their recent gold purchases aren’t that noticeable. And is probably why many mainstream analysts didn’t care much about it.

But it actually is a big deal. . .
 
This highlights the trend we’ve seen by central banks charging in to gold since after the 2008 crisis.

I wrote two weeks ago (click here if you missed it) that post-2008, central banks – especially the Emerging Markets – have insatiable gold appetite. And I believe this is helping to put a floor under the price of gold. 

Just look for yourself. . .


 
After two decades of selling – throughout the 1990’s and early 2000’s – central banks worldwide are now diversifying their dollar reserves with gold. 

The latest report by the World Gold Council (WGC) showed that central bank gold reserves grew 150 tons in the third-quarter 2018.

That’s up 22% from 2017 – one year ago.

This marks the 8th straight year of central bank gold buying – and the highest level of net purchases since 2015 – both quarterly and year-to-date. 


 
But most importantly – the number of central banks doing the buying was notable.

To name just a few: India – Turkey – Kazakhstan – China – Russia – Poland – Hungary – Iraq – and Mongolia. . .

What did all this buying from various central banks have in common? It was the lower price of gold triggered a buying opportunity. Meaning central bankers wanted to take advantage of the stronger dollar and buy cheaper gold.

Remember – when the dollar’s stronger, gold costs less (i.e. it takes fewer dollars to buy that same gold ounce – vice versa.)

And this trend of heavy central bank buying doesn’t seem like it will be slowing down anytime soon.

According to JP Morgan Chase & Co – central banks will buy another 300-plus tons in 2019. And I expect that to continue throughout the 2020’s.
 
So – here’s the bigger question. . .

Is all this central bank gold buying signaling trouble in the global economy?

I think so.

Let’s just go over a few troubling issues:

We’ve seen slowing growth in the Emerging Markets, European Union, and China. All while the Federal Reserve continues tightening – spurring a global dollar shortage (read more here).

There’s also the three-plus trillion in Emerging Market debt coming due (i.e. bonds maturing) over the next two-and-a-half years (I just wrote about this problem – you can read here). 

With short-term rates rising and a stronger dollar – these debtors will have trouble rolling the debt over (refinancing it). Now markets must worry about a wave of dollar-debt defaults – like we’ve already seen in China this year (read more here).  

We also can’t ignore the market beginning to worry about next year’s corporate earnings – which I fully believe will be horrid (more here). Equity prices have been volatile because of this – leaving the NYSE nearly down on the year. 

Another troubling indicator is the Chinese currency – the yuan – has devalued significantly over the past few months. It’s getting close to breaking through the $7.00 USD-to-yuan mark.

The last time we saw the yuan devalue so much – August 2015 – global markets imploded.
 
So yes – it’s no surprise central banks and retail investors are buying gold.

Going back to what Gyorgy Matolcsy – the Hungarian Central Bank Governor – said. . .

‘Gold is key for risk reduction’

Having a certain amount of gold in a portfolio works well to protect against sudden market drops – as I’ve shown previously (read here).

As I wrote then – Just look at the average price of gold during times when the S&P 500 fell more than 15% over the last 20 years. . . You can see that during times when market’s collapse more than 15%, gold positions would do very well. The gold mining equities and warrants do even better. . .”


 

Therefore – we see that during large market drops – the price of gold increases enough to offset any losses.

But that’s not all. . .

Having gold also improves a portfolio’s Sharpe Ratio.

For those of you that don’t know – the Sharpe Ratio is a popular metric that helps investors understand the return of an investment compared to its risks. Meaning it measures a portfolio’s risk-adjusted returns relative to peers based on a ‘standard deviation’ (a black swan event).

Thus the higher the ratio – the better the risk adjusted returns. . .

And as New Frontier Advisors and U.S. Global Investors discovered – an institutional portfolio with at least a 6% weighting in gold has a significantly higher Sharpe Ratio compared to portfolio’s that didn’t have any gold at all.

What this means is – gold in a portfolio greatly reduces volatility without hurting overall returns. . .
 
Now that we know this – It’s not hard to see why Hungary’s Central Bank Governor increased gold holdings tenfold.

This also helps explain why other central bankers worldwide are opting for gold as well. 

That’s because of Balance Sheet Theory – coined by Michael Pettis (one of my favorite economists). 

Balance Sheet Theory basically means that investors – during a crunch period – look at governments and central banks as if they are looking at a corporate balance sheet. 

The better the assets are against the liabilities – the more robust things are. . .

But the worst the assets are against growing liabilities – the more fragile things are. . . 

And as we watch the Emerging Markets get slaughtered this year in 2018 – it’s not hard to see why. They have horrid balance sheets with mounting liabilities against diminishing assets. 

So keep all this in mind when you ask yourself, ‘why are central banks buying so much gold since 2008?’

They are doing it to protect themselves. . . 

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