Alasdair Macleod – 22 October 2010
Having broken out convincingly into new high ground, gold and silver have now paused for breath. Despite the sharpness of this week’s reaction, their performance indicates good underlying strength.
This is not to say there is no speculative froth – of course there is. Rather, speculators play a distant second fiddle in this market. Bullion is still doing what it has been doing for the last year: when the commercials on Comex hit the price it backs off rapidly on little volume, until someone very big takes the opportunity to clean the market out. It becomes another ratchet on the torturer’s rack for the commercial shorts, who find that every time this happens they end up being stretched further.
On last week’s rise there were early signs of panic, as the commercials attempted to reduce their exposure. However, the commercials’ net short position on Comex is still a very high 933 tonnes. Convention suggests that the commercials know best, and even if they have an extreme position, they will still crush you. And indeed, the big commercials, being too big to fail and with the comfort of the Fed’s antipathy to gold, could increase their short positions even further. This is now developing into the biggest game of chicken the markets will probably ever see.
However, the TBTF commercials are not having things all their own way. Ten years of bull market must have pretty well exhausted the central banks’ bullion supplies, but parting with the physical has not been the only way gold has been suppressed. The very structure of the market might have been designed to neutralise speculative demand: on Comex physical settlement is little more than token, and in London forwards and leases are rolled or closed out by matching transactions. These markets encourage users to avoid delivery of the physical. True demand has been siphoned off into side-bets.
Investors may have been unaware of this, and while wheeling and dealing in these derivatives, they will be unaware that the truly wise long-term players have been quietly hoarding the physical, upon which this house of cards rests. In the ‘80s and ‘90s, central banks leased gold to the market that was then bought and accumulated by oil producers in the Middle East, and when it was ridiculously cheap large amounts were converted into jewellery. In this last decade the central banks themselves in aggregate have begun to accumulate bullion. It is important to understand that none of these earlier buyers will resupply much to the markets at higher prices.
The entry of China, Russia, India and a growing list of other politically-motivated nations into the market as limitless buyers of gold has created enormous difficulties for the old guard of interventionists, and a solution is desperately needed. It has developed into a power-struggle between this old guard, which is trying to manage a way through a crisis of its own making, and the new which so far has not managed to acquire enough bullion. Furthermore the new is building up excessive amounts of fiat paper issued by members of the old; paper which they know is loosing value at an increasing pace. On this basis gold is simply underpriced in paper currency terms.
The struggle between the old and new guards is illustrated by the IMF’s gold sales, the stated purpose of which was to raise funds to help smaller nations through the credit crisis. The inner circle at the Bank for International Settlements must have been tearing its hair out to see these Keynesian clots gift half this invaluable ammunition to India. And why is the IMF selling bullion to Bangladesh and Sri Lanka, when their policy objective is to provide “concessional finance” to these struggling nations? (These sales were agreed for this purpose at the London G20 summit chaired by none other than Gordon Brown – second time unlucky.)
But what must have really got under the skin of the BIS is that it knows the real value of bullion is considerably in excess of the market price. It knows gold is underpriced, because the BIS and its senior members have been suppressing the price for the last forty years, which has resulted in an acute shortage of stock. But when they embarked on this course in the 1970s they would not have foreseen how gold would be made available to the masses through yet-to-be-invented ETFs; nor could they have foreseen the emergence of Russia and China from deep communism into aggressive capitalist-style development, generating hundreds of millions of new gold-loving savers. Consequently the old-guard BIS members have lost embarrassing quantities of bullion and cannot confess this to the markets. Presumably they had hoped that by withholding this information they could bluff it out; and they might have succeeded had it not been for the very serious financial and economic deterioration in the global economy, which raises the possibility of a Fed-induced dollar crisis, triggering new demand for physical bullion.
As well as these problems there is growing evidence of disruptive intent behind the gold policy of the ex-communist nations. I recently covered this in an article that tied in the relationships of the Shanghai Cooperation Council. In that article I pointed out that the substantial majority of today’s gold-buying nations are members of, or are associated with this organisation. As if to confirm these fears, in the last few days Iran, which is an associate member of the SCO, announced it is now buying gold. Furthermore, China is restricting the export of rare earth metals, which with the energy policies emanating out of the SCO membership, has the appearance of a coordinated attack on the Western economic system. If such a conspiracy exists, gold is central to it.
The result of forty years of gold price suppression is not only the disappearance from the markets of unquantifiable amounts of physical into the firmest of hands, but also an accumulation of claims for physical bullion through the growth of unallocated accounts at the bullion banks; and the secret we would all love to know is how large this commitment has become. In the absence of hard facts, we have to make a reasonable estimate.
The only major bullion bank that declares its bullion holdings is HSBC, which at the end of 2009 held gold valued at $13.757bn (392.6 tonnes)[i]. We shall assume that this bullion is held against HSBC’s unallocated accounts and we shall further assume a reasonable fractional reserve multiple of 10, which gives us net uncovered liabilities of 3,533 tonnes for HSBC alone.
However, there are 35 banks listed as full members of the LBMA, and it can be assumed that nearly all of them offer unallocated account facilities[ii]. It is also possible, even likely, that the fractional reserve multiple for many of these banks is higher than 10, because banks have been generally reluctant to hold the one reserve currency that pays no interest.[iii] Furthermore, some of these banks are among the largest in the world. Taking all this into account, it is possible that LBMA members are short of over 20,000 tonnes on their unallocated accounts.
This liability is unlikely to be hedged, because it is difficult to see who would take the other side of such large amounts. And this brings us back to the theme of this article: the key market participants are desperately short of bullion.
As a result, the ratio of turnover in forwards futures and options to the underlying physical has become improbably high, and is still rising. The deteriorating economic outlook for the US, Europe, the UK and Japan is now beginning to generate new hoarding demand all over the world. And all this is before portfolio investors have even begun to invest: the statistics indicate that portfolio exposure is amazingly low at less than 1%, so the point where more hoarding triggers market dislocation cannot be far off. Indeed, a small bullion bank worried about its unallocated exposure would be wise to cover its position on Comex, and demand for long futures from these sources may soon become a market factor.
So, before any pundit makes a price forecast, and before anyone lucky enough to own gold thinks about selling, they should dwell on this important question: in this extraordinary market where the central banks are at war, where the devil and at what price are we going to find 20,000 tonnes of gold?
[i] See page 444 of HSBC’s Annual Report & Accounts, Note 25 “Other Assets”
[iii] The fall in interest rates since the credit crunch has reduced the penalty for holding gold as a reserve asset, but it is likely that before that event bullion banks had low cover on unallocated accounts because the interest cost of holding bullion was considerably higher. Furthermore bank balance sheets were stretched by excessive credit demand, so the legacy position for bullion banks is one of high gearing on unallocated accounts. This may partly explain the rise in HSBC’s position.