Gold Paper Problems

Paper Problems

•Investment Demand Dominates — Investors and speculators are the main driver of the gold price. There is no support at current prices from mine and scrap supply (which is rising), or fabrication demand (which is plummeting), in our view.

•USD the Driver — USD weakness and increased money supply has been the main driver of investment demand and speculative flows, we believe, and any strength in the USD is the main risk to prices. Other drivers could offer support: low interest rates, especially low real rates; inflation worries (but we do not foresee inflationary pressures in developed markets); consumer price inflation in China; asset price inflation.

•Physical Fascination Fading — The strength of investment demand over the last
few years has been reflected in physical bullion and ETF demand although both
are showing signs of dissipating. Investment in physical bullion has slowed
sharply. ETF holdings are stable at high levels, as concerns about a global
banking crisis abate.

•Paper Problems — Long positions in paper markets, have retreated recently from
near record highs. Positions held by money managers and broader noncommercial
positions have fallen since November 2009 when the USDstrengthened. Non-commercial net long positions are at 5x the average levels seen
over the last 17 years. We see this as the major risk to gold near term.

•The Bull Case — The key bull arguments for gold are continued USD weakness,
and possible escalation of inflationary concerns. What’s new is the re-emergence
of asset price inflation and negative real rates in China. We view China as the
most important source of future demand growth and in 2009 demand increased
10% with particularly strong retail investment demand.

•Underlying Support — Other important long-term planks of support are reduced central bank selling – central banks may actually become net buyers in the next 2- 3 years – and continued producer de-hedging. China and Indian central banks remain underweight gold with only 1.5% and 4.1% of total reserves in gold (vs. Euro Area average of 54%).

Outlook for Investment Demand
We believe USD weakness has been a main driver for the gold price increase over the last few years. Investment in gold (underpinned by USD weakness) has been in both physical and paper investments. We see both drivers at risk of further weakness in the near term. Physical demand has stablised as USD depreciation and money supply slows and risk aversion eased. While long-term drivers of physical gold investment remain, we believe the level of inflows seen in the last 3 years are unlikely to be sustained given the worst of risk aversion and USD depreciation appears to have past. Recent speculative activity in gold seen through increased paper trade and a surge in CFTC net long positions is a greater risk if USD show signs of strength as we believe these positions could be quickly liquidated. The positive drivers for investment demand are inflation. We are not concerned about inflation in the OECD. However China's inflation and potential assets bubble offer gold greater support note the recent increases in investment demand in China over 2009 (Figure 19). Longer-term China demand will likely be supported by wealth effects as middle class income builds.

Central Bank Buying – Balanced…For Now

Reduced central bank selling is, together increased investment inflows and
increased produce hedge buy backs, one of the important bull factors for the
gold market. Potentially central banks will turn net buyers over the next 3 years
or so — an important bull point. However, effectively the flows may be a
simple transfer from the IMF and European central banks to China and India in
off market transfers (as has been the case recently).

Sales by the central banks who are signatories to the Central Bank Gold
Agreement (CBGA) have all but dried up (112t in the year to September 2009).
The IMF reported sales of 212t. The sales were effectively off market transfers
to other banks, India bought 200t.

These sales constitute part of the IMF’s previously announced intention to sell
403t of gold (~11% of annual supply). The 403t (~US$12.8bn) provides three
quarters of the US$17bn in proposed new loans to developing economies and
sees the IMF selling 12% of their 3200t gold holding. It would appear that if
other central banks are not prepared to take the remaining 200t, then this gold
will be sold on the open market during 2010.

China is the most likely buyer of gold for central bank reserves. Beijing has
made no secret of its dissatisfaction with its USD denominated holdings, and
its wish to diversify. China's foreign reserves are estimated at US$2100bn of
which US$1905 is in foreign currency reserves, 70% USD assets, 20% Euros
and 10% other currencies.

The PBC has been increasing its gold reserves and announced a 75% increase
in Q209 (although the position actually built progressively over the previous 12
months). This added ~450t to their reserves previous stated reserves of 600t.
Even so, at US$31bn gold holdings account for only 1.5% of total reserves,
among the lowest in the world.

De-hedging – to Continue

The world gold hedge book now stands at around 300t, following the reduction
in the Barrack Gold hedge position. AngolGold Ashanti how has the largest
hedge position, and a buyback of some form is possible in 2010, although we
natural expiry will result in the company being hedge free by 2014.

Supply and Demand

There is no support for the gold price from the fundamentals of supply and
demand, outside investment demand, in our view.