Sunday, May 5, 2013

Central Bank Activity A Contrarian Indicator For Gold?

There is a popular meme used by both Gold bulls and bears that Central Bank activity in the Gold market is a contrarian indicator for the price (similar to public sentiment recently discussed in this post). That is when Central Banks are selling it's time to get long Gold, when they are buying it's time to get out (or short).

A couple of recent references to this meme have prompted this post, first from an article on Bloomberg:
Central banks are the biggest losers, with about $560 billion of value erased since gold reached a record $1,921.15 an ounce in September 2011. The metal was already in the eighth year of its longest bull market since the end of World War I when reserves started expanding again in 2008. They were also buying in 1980 when bullion peaked at the equivalent of $2,400 in today’s money, and selling in 1999 as prices slumped to a 20- year low.
And a couple of days later I noticed this comment from Dan of The Fundamental View:
But if you are going to go on your central bank thesis then brush up on your history because it has shown central banks always buy near tops and sell near bottoms.
Neither of the above examples provided a reference for their claims/stance. Tweeting 2 of the 3 contributors to the Bloomberg article didn't result in any answers (yet, in their defence neither appears very active on Twitter):

The Gold bulls or bears like to point out Central Bank activity in the Gold market, being selective about the data they use to ensure it supports their view of higher or lower prices.

The Gold bulls like to point out the stupidity of the the Central Banks who sold out near the lows around 15 years ago (and I have been guilty of this on more than one occasion). The below sales which took place near the bottom of a 20 year bear market:

Over the past six months, the Reserve Bank has sold 167 tonnes of gold, reducing its holdings from 247 tonnes to 80 tonnes. The sales were made gradually, taking care not to disrupt market conditions. The new level is consistent with Australia's longer-term requirements, and the Bank has no plans for further sales.
In May 1999, the Government announced a restructuring of the reserves involving a programme of gold sales by auction to achieve a better balance in the portfolio by increasing the proportion held in currency. Auctions of gold were held approximately bi-monthly between July 1999 and March 2002. Around 395 tonnes were sold by this means; the EEA's holdings of gold at the start of the programme had been approximately 715 tonnes.
Other notable Gold reserve sales occurred in Austria, Belgium, Canada, the Netherlands, Portugal and South Africa. Primarily Western Central Banks have been selling Gold over the past 20 years:
The official sector was a net seller of gold in every year from 1989 to 2009 inclusive, disposing of a total of 8,049 tonnes.
The first Central Bank Gold Agreement (CBGA) came into being on Sept. 27, 1999, when the signatories agreed that they would not sell more than an average of 400 tonnes per annum over five years and would not add to the amount of lent gold that was already in the market.

Although there was an immediate spike in the price following the announcement of the agreement, the CBGA and its successors have taken a lot of longer-term uncertainty out of the market.

Because the agreements have been in place now for over 13 years, many market players have forgotten or will not have even experienced the nervousness about potential central bank moves that blew through the markets regularly in the late 1980s and the 1990s.

More than once, the markets were shaken by announcements of official sector sales that had already been executed, including five from Belgium between March 1989 and March 1998. All five amounted to large tranches of 127 to 300 tonnes, and in January 1993 the Netherlands announced a completed sale of 400 tonnes. More followed, and by mid-1996 the market was seriously nervous of any further sales.

Sales were not restricted to members of the European bloc. Australia sold 167 tonnes in 1997, and that same year a Swiss expert group proposed a gradual sale of 1,400 tonnes of reserves as part of a portfolio rebalancing. The Swiss disposals started in 2000 and were part of the CBGA. A number of political comments in early 1999 favoured a sale by the International Monetary Fund, and arguably the final straw was the announcement by HM Treasury in the UK of the planned disposal of up to 415 tonnes (58 percent) of its gold reserves. Economic Times
The reasons for the sale of Gold reserves include diversification and a general consensus that Gold was no longer needed (at least not as such a large % of foreign currency reserves).
RBA (Australia): "Following the review, the Bank's Board concluded that, while there was a case to hold some gold as a contingency against unforeseen events, the previous holdings (which amounted to about 20 per cent of international reserves) were no longer justified. The principal reason for this conclusion was that a country in Australia's position, with large gold reserves in the ground and high annual production, derives negligible diversification benefits from holding a significant proportion of its international reserves in the form of gold."
HM Treasury (UK): "The motivation for the restructuring was one of risk reduction. With nearly 50 per cent of the net foreign currency reserves invested in gold, the exposure to a single asset was too great. Historically the volatility of returns on gold has tended to be high relative to the volatility of returns on the fixed income assets held in the reserves portfolio. However, the returns on gold have also tended to be uncorrelated with those on fixed income assets, and even negatively correlated for some time periods. Thus, gold can play an important role in a minimum risk portfolio. However, it is not unique in this role and other assets, such as inflation index-linked bonds, can be usefully employed to diversify portfolios. Optimal portfolio analysis showed that total risk on the net reserves portfolio could be reduced if the proportion of gold in the portfolio was reduced to around 20%.
The Gold bears like to point out that over the past several years we've seen Central Banks turn into net buyers of Gold (and if they are the contrarian indicator that we all think they are then surely lower prices are ahead):

Some of the most notable Central Bank Gold buying over the last few years has included that of China, India & Russia.

China - 2009
China has boosted its gold reserves to 1,054 metric tons, according to a Friday report by Xinhua News Agency, which cited Hu Xiaolian, head of the State Administration of Foreign Exchange.

The increase makes China the world's fifth-largest holder of gold, just ahead of Switzerland, and among the six nations plus the International Monetary Fund that have reserves of more than 1,000 metric tons.

Hu said that China's gold reserves had risen by 454 metric tons since 2003 and that the total was being reported to the IMF per the organization's rules.
India - 2009
India's central bank bought 200 metric tons of gold from the International Monetary Fund last month, in the first major move by a major central bank to diversify its foreign-exchange reserves.

Analysts said the move is potentially bullish for gold, but it is by no means the start of a significant shift away from U.S. dollar holdings. The Reserve Bank of India said in a statement that the move was part of its effort to manage its foreign-exchange reserves.
Russia - 2007 to 2013
Russia has bought up 570 tonnes of gold in the last decade as a bet against any “cataclysm” in the dollar, euro or pound. In 2012 alone it amassed around 75 tonnes, makings its reserves the eighth-largest in the world; so far in 2013, it has added nearly 20 tonnes.
Not limited to the above countries we've seen Mexico, South Korea, Thailand, Mexico, Azerbaijan, Kazakhstan, Turkey, Sri Lanka and Mauritius all adding to official Gold reserves in the last 5 years, to name only some. The below table shows which Central Banks were buying in 2012 (courtesy Casey Research):

The trends resulting in Central Banks turning into net buyers of Gold has been a combination of Western Central Banks stopping sales (after decades of selling) while Eastern Central Banks continue to accumulate Gold. Some interesting charts which highlight the trends (KWN via ShareLynx):

Click Chart To Enlarge

Click Chart To Enlarge
The Gold flows in favour of those countries creating wealth, rather than consuming it.

The turnaround in Central Bank Gold activity (Western Central Banks stopped selling, Eastern increased their rate of buying) at the time of the GFC is no coincidence with many of the countries buying Gold showing disapproval at the US and other western countries efforts to prop up a failing financial, banking and monetary system.

Western Central Banks might have added to their Gold reserves recently except they have been forced to buy mortgage backed securities, government bonds and in some cases even stocks to prop up a failing financial and monetary system. Eastern Central Banks have been buying Gold in order to diversify out of Western financial securities (e.g. China out of US Treasuries), to protect against currency debasement & further financial turmoil and possibly even in preparation for Gold playing a more significant role in any future monetary system.

The below chart shows the turnaround in Central Bank activity in the Gold market, turning from net sellers into net buyers (from Casey Research):

Going back further, global Central Bank Gold reserves were remarkably stable in level from 1960 through to 1990 when Western Central Banks started to accelerate the reduction in their holdings (as this document from the World Gold Council shows).

Click Table To Enlarge

Click Table To Enlarge
The data does not suggest the Central Banks were buying the 1980 peak as suggested by the Bloomberg article I quoted earlier (and have seen suggested elsewhere). Central Bank Gold reserves fell steadily over a decade before the price finally bottomed, which was marked by some of the most memorable Central Bank Gold sales, those we like to point to when when trying to score points against the Central Banks or political parties who were running said countries at the time.

Perhaps it will be the case that Central Bank Gold buying will also mark the top, but similarly to the way the bottom was formed, we could see a decade of Central Bank net Gold buying before that top comes around. Those who think Central Banks could be nearing an end to the buying should consider some earlier comments we've seen out of China:
Back in September, when we provided the monthly observation on what has become a record year to date surge in Chinese imports of gold from Hong Kong, we reminded readers that "in December 2009, the China Youth Daily quoted State Council advisor Ji as saying that a team of experts from Beijing and Shanghai have set up a "task force" last year to consider growing China's gold reserves. "We suggested that China's gold reserves should reach 6,000 tons in the next 3-5 years and perhaps 10,000 tons in 8-10 years," the paper quoted him. Zero Hedge
Current estimates on China's Gold reserves range from a conservative estimate of 1,560 tonnes from Bron Suchecki of Perth Mint to a speculative estimate of 4,000 tonnes from  Jeff Nielson. Either way they've got a lot of buying to go before suggested reserves are met.

One might say the Central Banks don't need the same level of Gold holdings as they had when the world was forced off the Gold standard when Nixon closed the Gold Window in 1971. Since 1971 we've seen the world population grow by around 85% and total above ground Gold increase by roughly double. That means as a percentage of above ground Gold, Central Banks hold 20% today where in 1970 they had almost 50%. While I can't see Central Banks ever getting back to that level of control (50% of above ground Gold), I wouldn't be surprised to see them increase back to around the 36,000 tonne level (probably even higher), which would require an additional 4,000 tonnes to be purchased. Given the price of Gold doubled over the last few years as Central Banks only added an additional 1,000 tonnes, you can be sure there will be further upside pressure on price should they wish to build further reserves in a short time frame. Newly mined Gold in 2012 only added 2,700 tonnes to above ground supply.

The bottom line here is that Central Banks buy and sell Gold based on their expected need for the metal (to diversify, protect or as insurance) rather than to scalp a profit like a trader. There aren't clear examples in the data where you could draw a conclusion that Central Banks are a contrarian indicator for price.

Central Banks turning into net buyers of Gold is a warning signal, but not of the topping variety. The Eastern Central Banks can see that trouble for the global monetary system lies ahead and are preparing accordingly by increasing the rate at which they are buying Gold, it may be a good idea to follow suit.

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  1. I would agree with you about Central Banks purchase/sell with other goal in mind than capital gain.
    Its almost seem like any gain or loss of capital in purchasing or selling of currency/assets is ignored to some degree. They obviously have different targets listed in the operation manuals.
    On the other hand, was it French who tried to trial RB Head over selling gold reserves at the bottom of the market? Could be a political move due to pressure created by media. Or they DO care about loss of Capital. Hard to say from the info available.

    1. Indeed, their aims aren't to profit, exact mandates differ between central banks, but usually it's to promote monetary and economical stability and diversification is often key, in the case of Western CBs they diversified out of large Gold holdings and now Eastern CBs who are still light in their holdings are increasing positions.

  2. Since it's only been recently that CB's have begun purchasing gold I would think this could go on for several years before considering it a contrary indicator. The selling of gold certainly went on for years and years before it finally signaled a bottom.

    Contrary indicators are only applicable when they get to extremes.

    1. Yes, agreed:

      "Perhaps it will be the case that Central Bank Gold buying will also mark the top, but similarly to the way the bottom was formed, we could see a decade of Central Bank net Gold buying before that top comes around."

      I think it's also worth observing the differences between East & West Central Bank activity, Central Banks should not all be lumped together as an indicator.

  3. I have heard that the market sentiment has become increasingly negative regarding paper gold; central banks around the world continue to accumulate gold while at the same time they continue to print more money. Guess no one can predict when the low would hit for gold.

  4. The timing of a bottom certainly has me stumped. We have all the conditions to form a strong rally, commercials positioned favorably, hedge funds/money managers in precarious position if needing to cover, sentiment in the gutter and central banks continuing or advancing their stimulus measures (via rate cuts and QE), just waiting on a catalyst to send the price higher...