Blanchard Economic Research Unit believes the recent failure by the gold price to break through above the $700 level has been due to the selling of bullion by Central Banks which has depressed the price, but this cannot continue indefinitely.

Neal R. Ryan (Blanchard Economic Research Unit)
Thursday , 26 Apr 2007

NEW ORLEANS

It is our firm belief that the reason we have seen the gold market fail to take the $700 level over the past week is due to the continued increase in Central Bank gold sales, specifically those out of the European Central Bank (ECB) system.

Central Banks around the globe can influence gold prices via two methods. CB’s can make outright sales and purchases of gold, or CB’s can loan/swap gold into the market or call those loans/swaps back into their reserves. For the sake of this explanation, we’ll leave the loan/swap segment out because until the IMF changes are implemented in the market allowing for correct accounting of those loans/swaps, we would only be using guesstimates and dumb luck to quantify those levels.

Before the Washington Agreement on Gold (now referred to as the Central Bank Gold Agreement – CBGA) was implemented in 1999, CB’s were free to sell gold willy-nilly into the marketplace with no thresholds on volume or timing. Recognizing that the lack of oversight or control was destroying the value of their gold reserves, the CBGA changed that with signatories agreeing to only sell 400 tonnes annually from 1999-2004. Those levels were augmented in the 2nd Agreement to 500 tonnes annually for the 2004-2009 period. Starting in 1999, CBGA signatories were now restricted to only selling 12.8 million ounces and starting in 2004, 16 million ounces annually into the market. (1 tonne = 32,150 oz.)

Annual supply usually floats around the 120 million ounce level, so CB sales, assuming they fill their allotment each year, represent roughly 10-13% of annual supply into the gold market.

For the first time in the life of both agreements, signatories to the CBGA failed to reach their annual sales allotment coming up nearly 120 tonnes short in the 2006 calendar year. That 120 tonne shortfall in 2006, represented a decrease of about 3.2% in supply into the market.

This 3.2% decrease in supply has come at the same time we’ve seen an 8% decrease in annual mine supply over the past five years, 80 million ounces of demand via dehedging in the gold market, 2nd and 3rd tier central banks adding to reserves and increased investor demand across the globe.

ECB banks have sold over 76 tonnes of gold into the market over the past five weeks. This is in sharp contrast to the past 6 months when ECB banks had sold only 112 tonnes of gold into the market. We believe that we are still experiencing increased levels of sales this week, so we may yet revise the 76 tonne figure higher in the coming weeks. This huge influx of supply into the market has, in our opinion, been the one drag on the market, but it certainly has its upside.

So what’s the upside?

History has shown that pressure is certainly applied on top of the market during each period of elevated CB sales. This can be no clearer illustration than what happened after the Bank of England and Gordon Brown announced they would sell over 400 tonnes of gold reserves, causing prices to hit 20-year lows in what most traders now refer to as the Brown Bottom. In the last decade, we have also seen the Bank of Canada sell off all of it’s gold holdings, the Banks of Switzerland, Australia, Denmark, Spain, Portugal, Norway, Sweden, and France, amongst others, also sell off a major percentages of their gold holdings into the market. The one thing that has held true is that the gold price has continued to bounce back and head higher as these sales have concluded.

In the past, increased sale levels have had a significant impact on the market, most recently when 80 tonnes were sold into the market over 4 weeks in May of 2006, we saw prices fall from $730 per ounce and test the $575 level. To a lesser extent, we saw +50 tonnes of sales hit the market in September of 2006, sending prices from $605 to $565 per ounce. What we are seeing presently is that sales have increased considerably without the bottom falling out of the market as has been the case in the past. The market is experiencing some price weakness as it struggles to continue to digest these massive sales, but the price has continued to trend higher in the face of these increases. This is a watershed event for the market and investors need to understand what this means to them. The days of massive bank sale increases tanking the market are coming to a close for two reasons.

1. The market has finally demonstrated the ability to gobble up these sales and continue trending higher, even if the increased supply is keeping us from the major price increases we have been expecting.

2. Central banks have shown that they are simply running out of the gold they will part with via sales into the market. It is our belief that the Bank of France is the lone seller of any magnitude left out in the marketplace. Other ECB captive banks have completed their announced sales programs. The two others left with any sizeable gold reserves, Germany and Italy, have never sold gold of any significant amount under the CBGA agreements.

When the Bank of France is finished selling which we believe is coming close to being a reality, the market will have potentially lost a large portion (10-13%) of it’s annual supply. We do expect at some point in the future to see CB sales to increase, but not until the price has had another significant increase as well. The IMF gold sales have been trotted out lately to solve IMF funding issues. Without approval from Congress, which we believe is quite remote, these sales will never take place.

While gold sales have increased over the past five weeks, levels should still be short of the annual allotment from the CBGA, the second time in two years. Look at these sales increases as a gift. They are allowing investors to add to metal holdings at lower prices while not tanking the market and causing investors to lose interest. When the banks are done selling, gold will be in the strongest hands, those of individual investors.

And taking a page from history, the gold price will also be considerably higher.

Neal Ryan is Vice President and Director of Economic Research for Blanchard Economic Research Unit – http://www.blanchardgold.com/