Alasdair Macleod – 21 September 2010
Last week’s move by the dollar price of gold into new high ground is an event of considerable importance; an importance barely appreciated by the vast majority of market observers – hardly even by gold bugs. They miss the point by slavishly following the interpretation of markets by charts to produce their price forecasts.
This myopic approach is little more than guess-work and is inadequate analysis, because there are powerful forces at play. The two that are most relevant are the economic background and the market dynamics for gold, both of which have arrived at important inflection points, where everything seems about to take on a new direction.
Around the Keynesian world, economies are stalling as the inventory-led recovery of the last eighteen months runs out of steam. What Keynesians never understood is that you do not engender recovery by taking money from the productive private sector to be spent or redistributed by the government, or non-productive sector. It really is as simple as that. Fiscal deficits rob the private sector of crucial savings, without which economic activity is curtailed. Monetary inflation compounds the problem, being a further burden on private sector savings, robbing them of value. The only winners in this Keynesian redistribution are the government’s closest friends, and the ephemeral benefits to them rapidly evaporate as well.
It is wrong to attribute the economic recovery of the last eighteen months to deficit spending and quantitative easing: the recovery was actually a collective sigh of relief that the immediate crisis had passed without a financial collapse. The effect of this relief was enough to obscure the economic negatives of robbing Peter to pay Paul. Now that both confidence and the ephemeral benefits of government reflation are ebbing, it should be no surprise that the rocks of recession are becoming revealed again. The consequence will be even larger budget deficits than currently expected and an increasing desire in central banks to print yet more money to buy off outright deflation.
This is not a stunt that will work second time round, because the starting point is entirely different. The economic negatives of a deteriorating budget deficit and renewed quantitative easing will be there for all to see. In the unlikely event that governments and their central banks find the required room for manoeuvre, increased deficit spending and QE – collectively the Keynesian stimulus – will perversely accelerate the downturn in the private sector. This point must be repeated to drive it into impenetrable Keynesian heads: the private sector cannot function when governments monopolise savings. It is however almost certain that Western governments will not even have the required room for manoeuvre, because the starting point for the stimulus is a grossly overpriced bond market.
The financial world is already awash with government debt, because there have been extraordinary amounts issued. The reality is that governments themselves are insolvent, and cannot repay their creditors; yet with a renewed downturn they are now faced with a further round of accelerating welfare costs and falling tax revenues. The politicians’ answer, which is to clobber the rich, is entirely counterproductive, leading to less and not more tax revenue. These dynamics are for the moment ignored in bond markets, because they are in a bubble where all rational thinking is absent.
Like all bubbles, this one will pop, making it impossible for governments to sell meaningful quantities of debt. Governments in Europe as well as the US have made the position even worse by shortening their debt maturity profiles, so they will have to fund rapidly accelerating quantities of debt on rising yields. For example, the US is faced with the maturity of $5.3 trillion of its sovereign debt over the next three years, representing 60% of its current outstanding total. Imagine for a moment the extra damage from rising bond yields to US government finances while this is being rolled over; and consider this for Italy, which is in a similar position.
So Western governments are in a corner from which there is no apparent escape. It is crunch-time for Keynesian and monetary economic policies. These governments are not temperamentally suited to reducing the size of the state at anything like the pace required. They will persist in their belief that deflation is the greatest danger, and that only Keynesian stimuli can deal with it. But with bond yields due to increase sharply, markets will not give them the room to stimulate, so they will face the alarming prospect of loosing all control over events.
Now that an economic crunch from which there is no apparent escape is upon us, we have arrived at an inflection point. The outlook for bond markets is extremely grim, with the prospect of a global ramp-up in yields as prices collapse. Equities will respond badly to such a development, as will property prices. All of which brings us to gold.
The market position for gold
The prospect of a marked deterioration in government finances can be expected to accelerate demand for gold, and indeed, as we approach the inflection point for government finances, gold is making new dollar highs on cue. It may have much catching up to do, since gold has barely reflected the monetary and credit inflation of fiat currencies since Bretton Woods, and arguably longer. But to simplistically link fiat-money inflation to the gold price is a side issue, since the gold price has been manipulated by governments seemingly for ever.
Modern gold manipulation and currency intervention have had a simple purpose: to facilitate the management of economies and their internal prices. Manipulation of gold prices has become a way of life for the central banks of the US, Europe and UK, together with the Bank of International Settlements and the IMF, who we can refer to collectively as the Cartel.
Over the years the Cartel has sold and leased large amounts of its gold. Some of this has been declared through official sales, but the quantity of leased gold can only be guessed at. There have been credible estimates of 5,000 to 10,000 tonnes of gold leased out by the Cartel since the 1980s, positions which are presumably still being rolled over when they become due. Analysts usually compare these figures to the 30,000 tonnes officially held by all central banks, but it is more relevant to compare them with the 21,000 tonnes declared by the Cartel, and the 2,500 tonnes mined annually.
However, the quantum is not as important as the likelihood that the Cartel is now ineffective. It is up against three basic factors: other powerful central banks have emerged as buyers of gold, such as China, Russia and India; free mine supply is contracting (especially when you take out Chinese and Russian production which is not made available to capitalist markets); and hoarding demand from virtually everywhere is accelerating, driven by pure fear. This is another inflection point, and the Cartel is now virtually powerless to stop it.
The bullion banks have worked with the Cartel for the last thirty years to feed leased gold into the markets in order to suppress prices. These actions have led to the development and maintenance of huge short positions in London and on the Comex futures market. In the past, the ready availability of leased gold from the central banks, coupled with newly mined supply, much of which was accelerated through forward sales, encouraged the bullion banks to run these large short positions. Those easy days are now gone, though market-makers and traders have not reduced their short positions to reflect this reality.
New leasing by the central banks, as opposed to roll-overs, can only be at nominal levels. The miners have unwound most of their forward sales and China and Russia are withholding their production from the markets. The short position in London through unallocated accounts[i] can only be guessed at, but judging by daily settlement volumes running at 530 tonnes per day, it could easily be several thousand tonnes[ii]. The short position on Comex has accumulated to about 900 tonnes. There is no possibility these positions can be covered easily at current prices, which means they have to be maintained.
This is suddenly important, give the deteriorating economic outlook. The inevitable and rapid deterioration in government finances will almost certainly trigger a new wave of demand for gold. This demand is not yet understood by those market professionals who assume that rising prices will generate sufficient supply from profit-takers. This is usually true in other markets, but the buyers of gold today are mostly hoarders, and hoarders tend to buy more on rising prices as their earlier fears appear to be vindicated. So the difficulty for those that want to put a lid on this market is that rising prices will lead to accelerating demand. Since government finances are close to an inflection point, so is the price of gold. As gold prices take off, those short positions in London and on Comex will bankrupt the bullion banks, and in the public mind at least, confirm the worthlessness of fiat currencies and the bankrupt state of governments themselves.
So gold’s move into new high ground is an extremely important event, and we are about to discover how much power this weakened Cartel actually possesses.
[i] Bullion banks run unallocated accounts on a fractional basis. That is to say they maintain physical stock sufficient to meet delivery demand. The ratio between stock held and stock owed to account holders is never disclosed, but analysts have suggested it could be below 5%.
[ii] This is end of day settlement, including forwards. The LBMA states that inter-day dealings are typically five times this level.