Today’s Financial Times contains an article “Gold price falls as Asian durchases dwindle” The article points out that purchases of gold by the two largest sources of demand for gold, India and China, have fallen sharply iin recent months “abruptly halting a consumption boom that started five years ago with the onset of the financial crisis.”
The article notes that gold prices, just over $1600 an ounce yesterday, are now about 17% below their all-time high (in nominal terms) of $1920 an ounce set almost a year ago last September.
With weakening Indian and Chinese demand, and a price stagnating well below the peak reached a year ago, speculative demand for gold may be poised to collapse, triggering a self-reinforcing downward spiral. That’s what happened after gold peaked at about $900 an ounce in the early 1980s, ushering in a long downward slide in which gold lost almost 75% of its peak value. That process was helped by historically high real interest rates, but that doesn’t mean that the current gold bubble couldn’t burst even with historically low real rates.
The article concludes with the assessment of Marcus Grubb, managing director for investment at the London-based Worl Gold Council:
The wild card is what will happen to investment in the second half and that will be driven by QE [quantitative easing, or central banks printing money] in the US, the eurozone and even emerging countries like China
So what we seem to have here is two potentially segmented clusters of markets that are dominated by inconsistent expectations. Bond markets are dominated by expectations of low inflation, while gold markets (commodities, futures, gold mines shares) may be the refuge of believers in imminent (or medium-term) hyperinflation. The confidence of the hyperinflationists seems to be wavering, but apparently they are still nursing hopes that the next round of QE will finally work its magic.
Now my question — and it’s primarily directed to all those believers in the efficient market hypothesis out there — is how does one explain the apparently inconsistent expectations underlying the bond markets and the gold markets. Should there not be a profitable trading strategy out there that would enable one to arbitrage the inconsistent expectations of the gold markets and the bond markets? If not, what does that say about the efficient market hypothesis?
Uneasy Money 
A very good question. How would the arbitrage work between both?
short selling gold and buying future of bonds, or the opposite?
Perhaps buying gold is a hedge against the risk of falling bonds (because they move one agaisnt the other)?
I don´t know really. I think in gold market there is always an irrational but strong factor.
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As I see it, the Efficient Market Hypothesis is a pretty solid _heuristic_, or rule of thumb, when we’re talking about medium to long term investments in stock or similar markets. As with any heuristic, I don’t expect it to work at all times, under all circumstancs. We know all too well that Adam Smith’s Invisible Hand sometimes goes berserk. When that happens, all bets are off!
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I think gold prices and bond prices have been rising over the last three years for similar reasons. In general, the economy-wide expected rate of return has been falling (towards zero, perhaps below it) as investors grow fearful of the future. This pushes people into safe bonds. It also pushes them into assets like gold that have very low storage costs, since buying some easily-storable durable asset and holding it over time provides a 0% return, better than most risky alternatives which are expected to fall.
So I don’t think there are segmented expectations in these two markets, nor do I think it is worthwhile trying to arbitrage them.
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Bonds and gold are both priced for slightly negative real returns over the next decade. It’s a “safety bubble”.
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I am not a huge believer in EMH, but I think the idea that gold is primarily an inflation hedge is a bit oversold, especially if we think only of ‘dollar’ inflation. RMB inlfation has been pretty real in the past few years. A good article linked via Thoma about gold also shows that this bubble may be mostly a side effect of Chinese financial repression.
http://www.theatlantic.com/business/archive/2012/08/why-is-the-price-of-gold-falling/261273/
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Interesting post. I think gold demand has been driven by enlarging middle and upper classes in China and India who are buying more for gift-giving and jewelry than as an investment.
Thus gold middles the picture as much as explains anything. Look at the price of pearls or silver or emeralds for that matter.
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A rational explanation for the appeal of gold could be that investors think there is a good chance that currencies will fail or be explicitly devalued. For example the Euro breaks apart, or BRIC nations suffering from recession and domestic discontent alter their currencies’ exchange rate in order to increase exports.
That could cause holders of those currencies to flee to an external and/or independent store of wealth, and they could decide that all currencies are to be distrusted and choose gold. I’m guessing that is Soros’ play, though he doesn’t always run with the herd. I think most gold buggers don’t understand that an increase in monetary base (QE) will not increase money supply unless lending increases substantially, and that has not been the case.
It is immoral and a failure of capitalism to direct savings to something as unproductive as gold. Whoever sells them the gold hopefully has plans to consume or invest in something more useful or fun. If a gold bubble distributes money from the unproductive wealth hoarders and speculators to the rest of the economy, then that will be an efficient market for me, even if it doesn’t support the efficient market theory.
ps: EMT is at best a generalization for simplifying models, and at worst is a a totem for rent seekers to argue against government regulations.
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There was a Krugman post effectively arguing that the high price of gold reflects low real rates.
http://krugman.blogs.nytimes.com/2011/09/06/treasuries-tips-and-gold-wonkish/
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Luis, Because there are multiple factors driving the price of gold, it is difficult, maybe impossible, to infer the implied expectation of inflation for any given price of gold. If so, it is hard to think of what the appropriate trading strategy would be to arbitrage the gold market and the bond market.
Robert, But my question is if there are two markets or two clusters of markets with inconsistent implicit expectations of inflation, why is the not some tendency for those inconsistent expectations to be reconciled just as we would expect to see price differences for the same commodity in two different locations eroded over time.
JP, Yes that is another explanation for the increase in gold prices over the past several years, and if so there is no price difference to arbitrage. But the increase in the gold price seems pretty large relative to the change in the interest rate.
Steve, That’s also a possibility.
OGT, Thanks for the link.
Benjamin, According to the FT article, the Indian and Chinese demand has been falling of late.
Kent, In a capitalist society, resources are directed to their most valuable uses irrespective of what source of that value is. Morality has nothing to do with it, which, on balance, is a good thing, because you wouldn’t want an authority vested with the power approve or disapprove of how resources were being used based on his or her conception of what is morally worthwhile.
Martin, Barsky and Summers wrote an article in the Journal of Political Economy in the late 1980s that worked out the relationship between the market value of gold and the real interest rate. I have no problem with the reasoning, but as I mentioned to JP above, it is not clear to me if the increase in gold prices can be entirely explained by the change in real interest rates.
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David- Here’s another link, this one to a different perspective on financial markets that doesn’t utilize EMH. Rajiv Sethi has an interesting post on financial markets as a ‘clash of narratives’ that I think better captures the reality of financial trade volumes and volatility.
Here’s the link:
http://rajivsethi.blogspot.com/2012/08/on-prices-narratives-and-market.html
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I don’t think any bubble is about to bust. Soros just invested billions in gold a few days ago~
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If not, what does that say about the efficient market hypothesis?
Answer: Once again, it has been shown to be a false theory
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Perhaps you want to be short gold and long TIPS spreads and platinum/palladium… the gold/TIPS part is the arbitrage, and the gold/PGM part hedges your risk of demand from EMs…
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Ravi has the best answer so far. Oftentimes arbitrage (used losely here since it’s really just a relative value play) is too difficult. The smartest trade is simply to avoid that which is obviously overpriced (gold) and invest that portion of the portfolio in something cheaper with similar characteristics (PGMs, TIPS, silver, copper, oil, natural gas)
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OGT, Thanks for the link. Very good stuff.
Buy gold today, That’s the thing about bubbles. People can never agree if there is one or not.
John, I am not a fan of the efficient markets hypothesis. But it is still a good starting point from which to think about how asset markets work. Any good theory of asset pricing must explain why the EMH doesn’t work.
Ravi, Sounds reasonable.
Steve. Correct it’s not arbitrage in the strict sense.
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I love the gold market. The price went dramatically down from it’s highs. We will see the price go up again to 2000 an ounce. For the time being, buying physically metal is the way to go. Also, Indian demand can only go one way and that is up.
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