Demand for gold can be divided into two: monetary and non-monetary demand. The latter mainly consists of jewelry and industrial demand for dental or electronic products. Monetary demand can be classified as demand from financial investors, central banks and "hedgers," who use gold as a protection against US dollar weakness, rising inflation or as a general safe haven. 

Monetary Demand for Gold

Traditionally, investors buy the metal as a safe haven during times of crisis. The gold price rally that took place during the second half of 2008 was mainly driven by safe haven buying. Likewise, the period of profit-taking which has taken place since March 2009 was mainly a reflection of reduced safe haven holdings amid soaring risk appetite. Monetary demand is highly flexible and the main source of market dynamics, according to Credit Suisse research. Despite this recent dip due to reduced safe haven buying, the prospects for further substantial increases in monetary gold holdings are good. Since Credit Suisse’s economists expect the dollar to weaken and inflation to rise, this should support demand from investors that like to hedge against these factors. Moreover, low real interest rates should keep the opportunity cost of holding gold low. They also forecast central banks worldwide to keep interest rates at the current low level for the next 12 months. Since inflation is expected to increase toward the year-end, this should then bring down real interest rates, potentially even into negative territory. In the past, gold reacted strongly positive to negative real interest rates and it is expected to be an important driver this time as well.

Non-monetary Demand for Gold

Non-monetary demand is likely to remain relatively stable over the longer term, driven by rising living standards in the large gold consuming emerging markets - India and China. Nevertheless, it is quite price sensitive and dependent on the business cycle in the medium term. Over the last few months non-monetary gold demand suffered strongly from the recent price spikes. But until now, the surge in investment demand for gold has more than offset the shortfall in jewelry demand, thus pushing total demand higher.

Declining Supply Is Creating a Longer-Term Floor

Gold supply is likely to decline in the long term, effectively limiting the downside risks to gold prices, according to Credit Suisse research. The higher scrap supply due to current high prices should be offset by a drop in gold sales by institutions such as central banks and lower mine production. According to the World Gold Council, the outlook for mine production has deteriorated due to financing constraints imposed on the industry, in particular on the smaller players. Another factor limiting supply are low central bank sales. Credit Suisse research does not expect central banks’ gold sales to increase substantially, as last year's sales were well below the agreed quota under the Central Bank Gold Agreement (CBGA). Additional institutional sales are thus only likely to come from the IMF. The Washington-based institution has already proposed the sale of about 400 metric tons of gold. However, those sales are likely to be carried out under the current and a future version of the CBGA. So if the IMF joins the quota system as a seller, it means that the selling quotas of other CBGA members will be reduced, thus limiting the impact of those sales. Moreover, part of the IMF gold sales is expected to be purchased by other central banks. Apart from that, any IMF gold sales will still require legislative action by several member countries including the US.

Gold Prices May Rise to 1,200 Dollars

Strong monetary demand coupled with a muted supply outlook should keep gold prices well supported over the next few months. However, the decline in jewelry demand should limit the medium-term upside potential, since it is likely to diminish quickly when prices increase too high or too fast. But in turn, jewelry demand is set to provide a floor to prices when investment demand abates, as the lower prices should see non-monetary demand recovering. Credit Suisse therefore forecasts gold prices between1,100 and 1,200 dollars per ounce by the end of the second quarter of 2010.