x Abu Dhabi, UAESaturday 22 July 2017

Gold is losing its lustre as markets show signs of recovery

The investors that bought gold during the past year have been rewarded, but the precious metal is now at a price that cannot be sustained.

Many investors have bought gold during the past year in response to concerns about financial market stability and inflation, and those who did have been rewarded for taking that view. For example, since January 4, the metal has risen US$18 (Dh66) an ounce. I believe, however, that gold is now significantly overvalued. Investors holding the metal should think of selling or "collaring" positions to lock in gains. Investors with a more aggressive approach should consider asymmetrically shorting gold to profit from this market opportunity.

Following the suspension of the implicit international gold standard in 1971, the precious metal has been a good investment in two distinct types of periods: financial market crises and sustained periods of overly accommodative monetary policy During crises gold is viewed - correctly or not - as the last resort of value. This was reflected in the second half of 2000 and 2008, as well as the mid-1970s and 1980s.

As we enter a calmer financial environment and the fear factor dissipates, I expect this source of demand to disappear. Over longer periods, the price of gold tends to be a reflection of monetary policy. The US has had the distinct policy regimes in the past 40 years: accommodative ones between 1968 and 1980 and from 2002 to 2009, which were accompanied by rises in the price of gold, and one marked by restrictive policy, 1981 through 2001, when the price of gold fell by upwards of 60 per cent.

It may be logical to maintain that central banks are administering a massive monetary stimulus, and in the process will debase their currencies, leaving gold as the only reliable store of value. But on further reflection, current monetary policy is not as accommodative as it might appear: the standard method of calculating what the correct central bank target interest rate should be - the Taylor Rule - suggests that, using the US as an example, with unemployment at 10 per cent and core inflation trending to zero, the rate should be below zero. Negative nominal interest rates are of course not possible to institute, but what this does imply is that policy may be too restrictive, rather than too accommodative.

Policy makers globally have signalled a willingness to prevent further financial crises, and we expect the premium in gold to dissipate rapidly at some point in the next two years. One cause for the disconnectbetween the price of gold and economic reality is the relatively recent "financialisation" of the metal. The advent of gold-backed exchange traded funds (ETFs) in 2003 meant that one could invest in the metal without actually owning it, the ramifications of which have been substantial.

Indeed, gold held by ETFs now accounts for between 5 per cent and 6 per cent of all reserves, equivalent to 17 years of industrial demand. And it is important to remember that marginal demand from investors dwarfs demand from central banks. This gold based-ETF demand has caused much confusion about how monetary policy works in a zero interest rate environment; this and the "fear premium" has made gold overvalued.

Given the recent momentum in the price of the metal, and keeping John Maynard Keynes' famous words in mind - "the market can stay irrational longer than you can stay solvent" - investors should deal with gold in a way that limits losses. Buying longer-dated put options on one of the ETFs is a way to gain this exposure. My closing advice is that investors who already own gold and have realised significant gains should consider selling their positions, or at least part of them.

Khurram Jafree is the director and head of Investment Advisory, MENA, at Barclays Wealth