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The key thing oddly missing from the gold rally: physical buying

A stack of gold bars.

MICHAEL DALDER/REUTERS

Gold prices are up about 14 per cent on the year as investors return to commodities and the yellow metal gets a safe-haven bid on geopolitical worries, but one key market participant is largely absent.

Physical buying, particularly out of Asia, has been subdued at best for the past few weeks, as seen by the small premium or occasional discount Shanghai Gold Exchange prices trade versus spot. Additionally, gold-market traders pointed to positive gold forward rates, known as "gofo" rates, or lease rates, which also suggest the physical market isn't tight.

That has some gold-market participants viewing the current price rally cautiously. Gold prices may continue to rally as tensions between Ukraine and Russia remain taught, and the yellow metal may continue to see a bid because of increasing worries about China's economy, but if those price supports fade, values for gold may also wither without a pickup in physical buying, they said.

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At 1:11 p.m. (ET), Comex April gold prices were up $2.80 at $1,373.30 an ounce.

Robin Bhar, head of metals research at Société Générale, said earlier in the year, the SGE premium to spot prices was at a large premium and there was a sizable amount of Chinese gold buying for gifts ahead of the Lunar New Year. Since then activity has slowed, he said.

"Now it's at a small premium, sometimes discount, which reflects slack demand," Bhar said. "We're also seeing (gold) lease rates move back to contango from being in backwardation, which means the supply is good, there's less stress in the market."

Indian demand remains low because of duties and tariffs placed on the metal by the Indian government to cut its current-account deficit. India has historically been the top gold buyer globally.

Joni Teves, analyst at UBS, said seasonally gold demand is slower at this time of year, so it's not surprising to see the physical market taper off, but what is surprising is how strong gold prices have risen in the face of sluggish demand.

"The rally is being helped by uncertainty in Russia and Ukraine, and the Chinese economy worries, but the gold rally is getting stretched," she said.

Not only is physical gold demand soft, the net-long positioning for speculative traders at the Comex is high, Teves said. According to the most recent commitments of traders report from the Commodity Futures Trading Commission, managed-money net-long positions are at 118,241 contracts, futures and options combined, their highest levels since Dec. 11, 2012.

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Sterling Smith, futures specialist, commodity research, Citibank Institutional Client Group, noted much of the gain in the speculative positioning comes on short covering, which is buying back of previously sold positions, rather than newly established bullish positions. Smith said there needs to be a catalyst for those large speculators to turn from exiting bearish positions to entering bullish trade.

There has been a pickup in exchange-traded fund buying, with the world's largest ETF, SPDR Gold Trust (NYSE: GLD), registering inflows this week. While the GLD is physically backed, Teves said she really doesn't consider this type of buying traditional physical market demand.

Peter Thomas, senior vice-president at Zaner Precious Metals, who deals in the wholesale gold market, said he thinks it's not so much a lack of demand than it is an abundance of supply.

"The physical demand has shifted from India to China, and they have a sweet tooth for the kilo bars," Thomas said. "We've seen some huge numbers. But we're also seeing a flood of metal that's hitting the market and that's putting pressure on premiums."

He said the supply is coming from new manufacturing along with "a tremendous about of reclamation. We're also not seeing any manufacturing demand pick up, so we're getting a glut. But at the same time, I have seen gluts clean up in a matter of days, too."

Price differentials between different key spot markets have created arbitrage opportunities for traders, but haven't been so kind to long-term investors. "We've seen differences between Dubai, Singapore and the LBMA (London Bullion Market Association). It's good if you're a trader and can think quick on your feet, but if you're a long-term physical buyer, you're having a hard time," Thomas said.

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As long as geopolitical tensions stay heightened, analysts said gold prices could hold their gains.

Kevin Grady, president, Phoenix Futures and Options, said gold is definitely getting strength from the safe-haven bid on geopolitical worries. He said the recent concerns about shakiness in the Chinese economy after weak economic data and reports of at least one company defaulting on loans have some investors worried.

"I'm telling you, people are spooked about China. People are worried about what else is going to come out," he said.

But as prices rise, gold analysts said that gives physical buyers even less incentive to step in. Because of that, gold traders need to be nimble because the yellow metal historically has had short-lived rallies off of geopolitical events.

"If you are long gold, be flexible in your position because it could move very quickly," Teves said.

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