HardAssetsInvestor

Written by Amine Bouchentouf  |

May 22, 2012

The Commodity Investor: Central Banks Becoming Biggest Gold Bulls And GLD Provides One Ride

Details

With central banks all over the world buying more gold in reaction to currency devaluation, a new bullish dynamic for the yellow metal grows.

As I wrote in my column last week on gold, financial markets are spooked by the prospect of Greece leaving the eurozone and leading to a possible breakup of the union. Ever since the Greek elections in early May, markets have been on a free fall and the name of the game has been “flight to safety.”

In this environment, it’s no surprise that gold got caught up in the panic selling during the last few weeks. However, as I have said before, any sell-off in gold would be temporary and investors would flock back to the inherent safety provided by this asset.

In this column, I’m going to provide further analysis of why gold should perform well during a eurozone crisis by focusing on the actions of a key player in the global financial system: the world’s central banks.

Central Banking 101

Central banks are an integral part of the global financial infrastructure and play a crucial role in the global economic agenda. Central banks in every country are tasked with maintaining order in the banking and financial system through a variety of policy and market tools, including interest rates, dictating banking-reserve requirements, controlling the money supply and intervening in the marketplace to prevent a collapse in the financial system (quantitative easing anyone?).

Central banks around the world are also tasked with preserving a country’s financial stability, and one way they do that is by holding domestic and foreign exchange reserves in the form of gold bullion. Central banks are some of the biggest holders of gold bullion on the planet. Germany, for example, holds more than 3,500 tons; China has more than 1,000 tons of gold; even the International Monetary Fund has almost 3,000 tons of gold reserves.

The largest holder of gold reserves in the world is the U.S.’ very own Federal Reserve Bank, which holds more than 8,000 tons of bullion in its vaults.

Every central bank in the world holds gold reserves, because the yellow metal is perceived as a stable and reliable store of value. In fact, central banks are so reliant on gold that more than 20 percent of gold reserves are held inside the vaults of the world’s central banks. What’s even more important is that central banks are increasing their purchases of gold and are becoming extremely important buyers in the gold market.

If central banks keep up their recent buying activity, they may become the most important factor in determining gold prices in the future. Therefore, it’s critical to understand what central banks are doing in the gold market, and how that’s going to influence prices in the future.