The bank’s argument for why gold should trade at this level revolves around the balance sheet expansion of central banks during the past eight years. The aggregate balance sheet of the world’s four main central banks, the European Central Bank, the Federal Reserve, the Bank of Japan and the People’s Bank of China has increased by 300% since the beginning of 2005. During the same period, the global aboveground stock of gold increased by 19% in tonnage terms or by 200% in value terms. Assuming the price of gold should appreciate to keep the overall value of the big four aggregate balance sheet equivalent to that of the value of the above ground gold stocks, then the gold should be trading closer to $1,700/oz.
Gold is worth $1,700/oz
Deutsche’s analysts have some evidence to back up this extremely bullish claim. In the past, there has been a strong correlation between the price of gold and the rate of the aggregate balance sheet expansion of central banks. However, this trend broke down during 2013 and has since failed to re-establish itself. The only other period in recent history when the pattern gave out was during the financial crisis. During both periods there was a clear-cut reason to explain why the correlation fell apart.
In the financial crisis, gold was sold to meet liquidity requirements putting downward pressure on prices despite a sharp increase in the size of the Fed’s balance sheet. Similar reasons were to blame for the disconnect in April 2013 when gold suffered one of its biggest falls over a period of two days. The selling was driven by indications from the Fed that the bank would QE programme, rumours that the Bank of Cyprus would have to liquidate its gold holdings to meet debt obligations and a mystery seller, who dumped 400 tonnes of gold in the market via the COMEX, which led to a wave of panic selling.
So, the two times where the relationship between the gold price and the size of the aggregate central bank balance sheet has broken down during the past decade can be traced to heavy panic selling in the market.
Morgan’s analysts believe that relationship between the price of gold and the size of central banks’ balance sheets is beginning to re-establish itself, and unless there is a new wave of panic selling, this relationship should drag gold prices higher.
“Arguably the gold market has taken over two years to recover from this event. Our conclusion however is that as long as the central banks’ balance sheets continue to expand, the gold price should maintain some momentum. The rate of gold price appreciation is however likely to slow, given that the momentum so far this year has outpaced that of the central bank expansion.”