Japan and Gold

The following is an extract from commentary that was posted at www.speculative-investor.com on 28th April 2002.

It has been widely reported that the Japanese have ramped-up their buying of gold over the past several months, with this heightened investment demand usually being attributed to a) the removal of government guarantees on some bank deposits, b) the depreciation of the Yen, and c) fears regarding the solvency of Japanese banks. The amount of gold being imported into Japan each month is still quite small in comparison to the size of the world's gold market (only 13 tonnes were imported in March). However, a continuation of the current trend would have enormous implications for the gold market due to the immense quantity of money sitting in various types of savings accounts in Japan. By our calculations, 2% of total Japanese savings would be sufficient to purchase all of the gold currently sitting in the coffers of the world's central banks (we are assuming here that after all of their loaning, swapping and selling the central banks have been left with about 20000 tonnes of gold). In other words, a very small shift from savings accounts paying near-zero rates of interest to gold would create a surge in the gold price that central banks would be powerless to stop. The question is, will that shift happen.

We think the shift will happen, but not for the reasons that most people expect. The consensus view is that the Japanese economic and financial situations are going to keep deteriorating for the foreseeable future, further weakening an already severely-damaged banking system and causing the Yen to fall. Many gold bulls expect the resultant loss of confidence to cause the Japanese people to buy gold at an accelerated pace. This could certainly happen. However, as discussed in our 24th April commentary the financial markets and the most reliable of all leading economic indicators are currently telling us to expect a recovery in Japan to begin in the second half of this year. If the situation in Japan improves later this year, rather than gets worse as almost everyone in the world currently expects, will Japanese investment demand really have a substantial impact on gold?

To answer the above question we need to understand two things. Firstly, the reasons given to explain the recent increase in the Japanese public's appetite for gold provided fundamental justifications for a trend that had already been in place for 2 years. As the following chart clearly shows, the gold price in terms of the Yen began trending higher in September of 1999 and embarked on an accelerated up-trend in October of 2000. The removal of guarantees on bank deposits, etc., are valid explanations for the recent increase in demand for gold, but the reason that many Japanese chose gold as their safe haven and not something else was that the gold price, in Yen terms, was already in an up-trend. Had the Yen gold price been trending lower during the 2-year period preceding the fear over bank deposits we seriously doubt that gold would have been a beneficiary of this fear. What this means is that Japanese investment demand for gold will continue to rise as long as the Yen-gold price remains in an up-trend. However, the fundamental news that is used to justify the increasing demand may not turn out to be what many people are presently expecting it to be.
 

The second thing we need to appreciate is that in terms of importance to the gold price nothing comes close to the trend in the US$. By "trend" here we don't just mean the US Dollar's value relative to other fiat currencies (although that is certainly an important factor), but also the general level of confidence in the US financial establishment (the government, the Fed, the banks and the large corporations). When confidence in the Dollar is in decline, as it has been since October of 2000, then the investment demand for gold tends to increase throughout the world because the US$ is the linchpin of the world's fiat money experiment.

We don't know of any objective way to measure changes in confidence in the US$ except by looking at prices. The recent bounce in the gold price is evidence of a decline in confidence, but as noted above we can trace the current trend back to October of 2000. Several long-term trends reversed at this time including some important currency market trends. As illustrated by the below chart, the Swiss Franc reached a major bottom against the US$ in October of 2000. It went on to make higher lows in July of 2001 and January of 2002. 
 

There has been a lot of talk over the past 12 months about the continuing strength of the Dollar, but the Dollar's apparent strength during 2001 and the first 2 months of 2002 was mostly a function of Yen weakness. In actual fact, the US$ peaked against the SF and the euro way back in October of 2000, it peaked against gold stocks in November of 2000 (it is not coincidental that a bull market in gold stocks commenced 3 weeks after the US$ peaked against the major European currencies), it peaked against gold in February of 2001 and it peaked against the A$ in March of 2001. It has recently peaked against the Yen.

Getting back to our topic (Japan and gold), we expect Japanese investment demand for gold to increase. However, rather than being stimulated by falling confidence in the Yen and the Japanese financial system we expect the primary driving force behind this increased investment demand to be falling confidence in the US$ and the US financial system. The Japanese have a lot of money invested in US$-denominated assets and debt. Gold is likely to benefit as these US$ investments are exited.

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