Increasingly, folks are questioning the sustainability of the gold’s rally.

From Jan Harvey, Reuters:

A rise in real interest rates is perhaps the biggest threat to stronger gold prices as they increase the opportunity cost of holding the metal rather than higher yielding instruments. In a note this month, Goldman Sachs said a stronger U.S. growth picture may prompt just such a rate rise, and  consequently a turn in the gold market cycle, next year.

“Our… modeling suggests that the improving U.S. growth outlook will outweigh any Fed balance sheet expansion, and that the cycle in gold prices is near an inflection point,” it said.

The latest report by the World Gold Council (WGC) shows data that the speculative money has been rallying gold via ETFs and that an actual, physical demand for the metal is negligible, if that. The most often cited reason for such speculation has been a belief that Fed’s QE is somehow bullish for the metal.

“The environment for gold is good, but it isn’t improving further by the day, so some slowdown in the uptrend in gold should be expected. The days of very easy gains, when you could just buy gold, hold it, and see it rise 10, 11, 12 percent each year are over,” says Credit Suisse analyst Tobias Merath.

Meanwhile, many have forecasted some sort of a blow-off rally in gold, similar to the one in oil in 2008, as a culmination of the gold bubble. It may turn out, regrettably, that no such repetition could clearly mark the end of the rally.

Instead, the slowly creeping rise in interest rates – as is foreshadowed by the move in the bank stocks and the turn in their long-term moving average curve -  could grind out the gold bugs into slow losses and continuing whining.

From the latest Gold Demand Trends Q3 2012, World Gold Council (WGC):

Q3 investment demand (the sum of ETFs and similar products, and total bar and coin demand) was 79.5 tonnes – or 16% – lower than Q3 2011. In value terms this amounted to US$22.8bn.

So, while overall demand dropped, demand by the ETF – the speculative class not interested in the metal per se but interested to speculate on price – has gone up:

On a year-on-year basis, ETF demand was the strongest performing sector, generating a 48.6 tonne increase in demand. At 136.0 tonnes, Q3 was the strongest quarter since Q2 2010 and compares with a 5-year quarterly average of 88.9 tonnes.

Noteworthy is that ETFs tied up 17% of gold tonnage in Q3’11 versus the larger percent of 32% in Q3’12.

This means that gold paper holdings – the ones that can be liquidated much faster than the physical holdings – have gone higher in proportion to the physical stock. This further means that risks on the downside, due to the fast liquidation, have also risen.

In China, speculators took to the side because there was no price appreciation momentum, while in Turkey, where gold gifting is popular, people sold off their holding taking profit.

Full report available here.

UBS commodities analyst Tom Price says that gold is set up for a fall because people are deleveraging while those who hold gold positions are too crowded into an ETF which will have to liquidate the huge amounts of gold it is tying up out of the world supply.

“Instead of spending you have deleveraging going on, people are taking cash and paying down debt, that’s a bearish sign [for gold],” says Price.

Put another way, people find equity-building of their non-gold asset a more valuable financial endeavor than stashing cash in gold. If so, than there is an upper limit to the gold price.

Price also says that the ETFs are tying up too much of the global supply of gold.

“The SPDR gold fund has more gold holdings than the French central bank, if investors decide to get out, you have physical sales which will impact the price of gold,” says Price.

The CPI index growth has been declining during most of the years when gold was the raging bull.

Of course, we do not have a time frame on this bearish gold call but one is to surmise that once we move into a decreasing negative yield environment all of the currency hedgers would spark the sell-off in the gold ETF.

What makes Price’s argument about gold more consistent with reality is that it is not predicated on beliefs that are yet to materialize if ever.

For example, recent report by the World Gold Council’s (WGC) says that, besides negative yields, the inflation and uncertainty risk are one of the variables that fuel the piling into the gold ETF trade.

However, the CPI index growth, as the chart above shows, has been declining during most of the years when gold was the raging bull.
 
Uncertainty risk is another fav of the gold bulls saying that owning gold is the best way to protect one’s wealth but this goes against the fact that people are more interested in building equity in the non-gold asset they already own rather than holding gold bars.

All of these rather imaginary bullish arguments may drive people into the gold ETF but the longer this phantom reason fail to materialize the greater the chance of an outcome Price is talking about.

The worst part is that some folks are formulating an economic policy based on some of these rather fictitious gold-based reasons.

Commodity funds saw a strong inflow of funds in September registering a $2.37 billion in net cash inflows, a number just shy of the August record of $2.45 billion, Lipper data showed on Thursday.

There are some 230 US regulated commodity products of which precious metals, gold in particular, saw the biggest cash inflow.

Of the $2.37 billion in inflows, $1.74 billion was moved into SPDR Gold Shares in September, a number little lower than the August inflow of $2 billion into this gold ETF.

Second place went to the iShares Gold Trust with $610 million.

Largest gold ETFs are now holding up 75 million ounces of gold for the speculative purposes of traders which accounts for about 84% of world gold annual production.

ETFs are estimated to now hold 2,126 tons of gold against annual gold production estimated for 2011 to be about 2,500 tons.

Total net value for all commodities and fund gained in value in September to $178 billion from August’s level of about $167 billion.

World Gold Council’s (WGC) latest Quarterly statistics blames the unconventional monetary policies across the globe aimed at reflation and says that such policies create 4 rationales that drive cash into gold and subsequently fuel the price higher.

There is a consensus that these policies drive investment into gold purely due to inflation-risk impact. We believe that there is not one but four principal factors that provide further support to the investment case for gold:

– Inflation risk
– Medium-term tail-risk from imbalances
– Currency debasement and uncertainty
– Low real rates and emerging market real rate differentials

WGC says that inflation risk is the strongest rationale for stashing cash into gold although we are yet to see these high inflation numbers in the actual data. As a result, among the beautiful charts that the WGC has published in this report we, for sure, do not see the gold price vs CPI overlay.

“There is a well-established relationship between the amount of money in an economy and the rate of inflation – whereby too much money chasing too few goods causes price appreciation. However, this is not a straightforward relationship,” says WGC.

Hm? A “well-established relationship” that is not “straightforward”?

Aside from the list of beliefs in the quote box above, it is rather hard to find any actual end use demand for gold: Jewelry is unpopular in many places where it is prized, while gold stashing by central banks in Turkey, Russia and elsewhere not only has a mild demand impact but could perhaps be used as a contrarian indicator because central banks are not just less investment savvy but are more concerned with things like liquidity, Forex reserve size and stability, balance sheets…

This leaves us with the ETF demand which, obviously, WGC loves to be obscure about or skip altogether.

For example, in December 2011, gold ETF, GLD, experienced 2.247 billion net outflow meaning speculators who have no interest in physical gold cashed in and the gold price went from circa $1,800 to about $1,500.

Now, none of the variables in the quote box in December have had any substantial change in August of 2012 when gold price took off and commodity ETFs got a positive 2.4% inflow.

In fact, the CPI number in December was on the decline yet the gold price was on the rise – so much for not so “straightforward” and WGC’s bogus reasons as to why gold is being whip-sawed.

We can, meanwhile, peruse WGC’s report to enjoy all kinds of reasons that attempt to justify gold’s high price even though none of them are major causes.

More on M1, velocity & gold price here.

Barclays has opened its first precious metals vault in London in response to the huge demand for holding gold.

“We’ve built the vault in response to customer demand, people wanted to store gold in a Barclays vault. There’s a changing nature that we’re seeing in the gold market that now people want an asset that is either allocated or unallocated metal. Since QE3, the number of inquiries to store precious metals has gone up,” Barclays product manager for metals said.

Barclays “anticipates demand from pension funds, central banks and sovereign wealth funds who have been scooping up the precious metal that has doubled in value since late 2008.”

“For many years, vaulting wasn’t particularly interesting. It has changed dramatically along with why people want to do it. Ten years ago, people were not that bothered about gold or what it was or where it was held, but now they are very bothered,” saysBarclays.

Gold ownership, for many is done via the ETFs, so along with them as customer BArclays sees large pension funds and sovereigns.

“It’s been remarkable enough since QE3 (was announced) that we’ve had people come on. I was on the phone to a sovereign wealth fund who haven’t been involved with precious metals at all. So you are seeing new faces and new names come in like that, so there is no particular let-up,”  says Barclays.

Just because all these folks have so much cash, are they the smart money or dumb money?

With bullish technicals and an automatic sentiment that drives cash into the gold ETFs on any QE, gold may perhaps hit into new highs – say $2400 – but as the chart above shows, monthly gold price changes as a proxy for volatility has been on a steady rise since 2004 and if we are to look at what happened to bond yields during such volatility spikes in 1972 & 1980 one may extrapolate that we could be setting up for the same soon. If so, interest in these vaults may go back to the way it was.

Finally, there could be some discussion as to whether non-producing gold ownership can be classified as an “asset” given that it has no capacity to provide, based on the International Accounting Standards Board definition, “future economic benefits [that] are expected to flow to the enterprise” other than price gains via speculation. This issue also touches upon the legal premises upon which many of the ETFs issue shares against gold holdings given that shares are claims to assets engaged in income production rather than price speculation. Legislators need to indeed reexamine all this.

Gold demand for the second quarter of 2012 was down 7% from previous year’s Q2 and down 10% from the previous quarter says the latest report by the World Gold Council (WGC).

Even though central banks were the biggest buyers of gold, that increase was offset by a decline in jewelry in India and China, countries that account for 45% of global jewelry demand.

“Demand for ETFs and similar products in Q2 was broadly flat year-on-year, as new demand was marginally outweighed by selling. The lucklustre net figure was reflective of the directionless price action in gold,” says WGC.

Demand for physical gold – bars and coins – was up in Middle East, Turkey and Europe while demand was down in the US.

“A 15% year-on-year increase in European demand for gold bars and coins confirmed the strength of conviction among investors in gold’s capital preservation properties,” notes WGC alluding to fears of the break up of the Euro.

Central banks were also big gold buyers while c.bank sales were “muted” with Germany selling 0.7 tons in June to mint commemorative gold coins.

The 157.5 Q2 tons of c.bank purchases in Q2 is more then double the 66.2 tons bought by central banks last year. For the H2, central banks bought 254.2 tons, up 23% from same time last year.

WGC notes purchase plans by Kazakhstan, Philippines, Russia, Ukraine, Korea along with small purchases in Europe (Serbia) and South America (Guatemala) and Asia (Kyrgyz).

“Turkey continued to record increases in gold reserves… recent legislation allows [Turkish] commercial banks to pledge gold as part of their reserve requirements to the central bank… the increase in reserves reflects the growing role of gold in the evolving international financial structure,” says WGC.

WGC puts Russia into gold focus as its c.bank is very aggressive in buying gold with its reserves swelling up in the metal.

“Over the past decade… 1,300 tonnes of gold have been accumulated in Russia… over half of these above ground stocks are held privately in jewelry form and approximately 36% as official stocks,” says WGC.

Full report available here.