As it stands, we are seeing wild swings in the currency markets. The only currency that’s performing well is the U.S. dollar. Other currencies, like the Canadian dollar, euro, Japanese yen, Australian dollar, and British pound, are in a definitive downtrend. The Swiss franc is seeing historical moves due to its central bank’s interventions.
How long these trends will last is hard to tell, but from my experience, I know that trends in currencies can last much longer than those in the stock markets and commodities.
With all this comes one question: what will happen to the reserves of the central banks that hold these currencies? Well, the answer isn’t rocket science: their reserves will fluctuate as well. And that’s good news for gold investors.
Huge Foreign Exchange Reserves at Stake
Please look at the table below. It shows how much central banks around the world hold in currencies other than the U.S. dollar as of the third quarter of 2014.
Central Bank Reserves, Currency Holdings(1)
|Currency||Reserves in U.S. $ (Millions)|
With this in mind, I ask: how will the central banks protect their reserves? One way I see them protecting their reserves is by buying gold. The yellow metal works seamlessly when it comes to reducing the variance in reserves. To give you some perspective, look at the chart below. It essentially provides an idea about what happens to the price of gold as the value of the euro declines compared to major global currencies.
Chart courtesy of www.StockCharts.com
As the sell-off in the euro increased, the value of gold, in terms of the currency, increased. Simply put, gold reduces the downside risk of currencies.
When Will Central Banks Buy Gold?
If central banks do start buying gold to protect their reserves, don’t expect them to announce when and how much they will be buying. This will result in investors front-running them and the price will move out of their desired range. They will report how much they bought after they have purchased it.
The amount they will buy isn’t clear either. If we assume they will buy 10% of the $2.1 trillion they have at stake, then it will mean roughly $210 billion worth of gold bullion. This amount can significantly move the market to the upside and distort the demand and supply situation. Also, don’t be surprised to see more gold buying coming from relatively smaller central banks compared to the major ones; they are more exposed to the currencies and will need to adjust their reserves to reduce volatility.
Considering all of this, I question if the gold buying has already begun. Consider this: the central bank of the Netherlands recently purchased 9.61 tonnes of the yellow metal in December, increasing its gold holdings to 622 tonnes. This was the first purchase by the Dutch central bank since 1998.(2) Meanwhile, Russia has been buying the yellow metal for nine consecutive months as of December.
Why I Remain Bullish On Gold
I don’t know how one can be bearish on gold when looking at the currency markets across the globe. Gold essentially provides a hedge against currency fluctuation—it has done that for a very long time, and I doubt it will be different this time around.
Since the beginning of 2015, we have seen an influx of buyers in the gold market. More of the same can follow if volatility in the global currencies persists. I will not be surprised to see gold prices rise throughout the year and finish positive (unlike the previous two years).
As I have said before, investors will be able to benefit from this through mining companies. They are selling for huge discounts. With gold prices up roughly 10% year-to-date, few companies I am looking at closely have increased immensely. If precious metal prices keep increasing, these companies still have more upside.