Alasdair Macleod – 3 December 2009
The continuing rise of gold is remarkable, with new highs being made day after day. Its performance triggers concerns that it has become overbought, which it has according to technical indicators, and that it is overdue for a decent correction. If it is so overbought, one would expect to see a rush of small investors chasing prices higher, and there is evidence of this, with private investors buying coins and small bars. The largest ETF, SPDR Gold, reflects a degree of this bullishness, having increased its gold stock by about 6.5% since the beginning of August. It has not however quite exceeded the level of gold holdings seen mid-year at 1,134 tonnes, though it is close.
So there are bulls in the market, but their position is not extreme. The majority of investors either take delivery of the physical, or invest through ETFs, and are not short-term speculators. It feels more like a shortage of physical for delivery more than anything else, and to further analyse the position we first turn to the US Commitment of Traders Reports (COT) covering futures and options.
The COT separates positions into commercial and non-commercial traders, or professionals and punters respectively. Conventional wisdom in reading these reports is to understand that the commercials are mostly right, and the non-commercials are mostly wrong, and this is borne out of experience. Therefore, if the commercials are short and the non-commercials are long, you can expect prices to fall, and this accurately describes the position in gold today. However, the position has become extreme, and the commercials are being squeezed badly.
The commercials, which are basically the bullion banks, are short of a net 31,880,200 ounces, or 1,025 tonnes as of last week. This is a record short position, worth a total $38.3bn. Historically, the bullion banks have been able to extract themselves from a short position in a bull market through their special relationships with the European central banks. The relationship has been driven by these central banks, who have acted in concert to suppress the gold price for some considerable time. They have done this through outright sales, and more importantly through leasing. The difference between the two is the former is reportable, and the latter is not, and as the strategy of suppressing gold has progressively failed the central banks have reduced selling and have resorted increasingly to leasing.
Leasing has been one of two sources of liquidity for the gold futures and options markets, the other being forward hedging by producers. So far as the central banks were concerned, their manipulation of the market generally worked, so long as the market did not require physical delivery for long-term investors, or so long as any such physical demand could be generally satisfied from mine production. As we all know, this situation has changed radically. On the supply side, production in the free world is declining, forward sales by producers are being withdrawn, and supply from Russia and China is no longer coming to the market. On the demand side, China in particular, but now India and Russia as well are net buyers, and the development of exchange traded gold funds has developed a demand for physical delivery that over the last five years has amounted to some 1,500 tonnes. This has put the central banks in an impossible position.
Generally, the European central bank cartel is now unable to sell into this market, because of the political consequences. We can be sure that Britain’s experience, when Gordon Brown ordered the sale of half Britain’s gold reserves is now discouraging further sales.
The list below totals major central bank sales from 2000 to the end of Q1 2009, and gives scale to the problem:
The consortium of central banks is entirely European and with the exception of Switzerland, members of the EU. One can imagine the process: EU ministers agree secretly to screw the barbarous relic, and the central bankers are instructed accordingly. The central bankers are becoming increasingly concerned that selling gold is the wrong thing to do (this was the advice Gordon Brown was given by the BoE allegedly), so the ECB and BIS are encouraged to sell instead. Since the beginning of the year the IMF has also sold a further 200 tones to India and 2 tonnes to Mauritius, with a further 200 to go. Why Switzerland sold 60% of her gold is not satisfactorily explained, suggesting that she may have been under pressure to help out her European neighbours in rigging the market.
The Europeans problems go beyond 3,691 tonnes of gold lost to the market. The Chinese, Russians, Indians and even Singaporeans are accumulating gold, and show an appetite for more. The development of ETFs is a further shift of power away from the European central banks. And thanks partly to Gordon Brown’s inept sales it is now politically difficult for central banks to deliver bullion into the market, unless it is certain to be returned.
So, do they extend lease obligations to the bullion banks, which are short of nearly $40bn’s worth of gold?
This has the makings of a serious crisis for the EU central banks and the bullion banks, which are piggy-in-the-middle. The $40bn short position is backed almost entirely by central bank leases, making them ultimately at risk.
There is now a significant risk that the squeeze is only just starting, with the situation likely to attract the attention of sovereign wealth funds (trying to reduce dollar exposure) and even hedge funds (trying to make a quick buck).
Stand by for the biggest game of bluff the world has ever seen.