Alasdair Macleod – 8 January 2010
Now that we are in a period of accelerated monetary inflation, and as the impact on prices is likely to be felt later in this new year of 2010, investors will probably turn to gold and gold shares for some protection. In the last bout of inflation in the late 1970s, stockbrokers often recommended their clients invest 5-10% in gold shares. Today things are different, with an array of investment opportunities, including inflation-linked government bonds and ETFs as well as mining shares. Thirty years ago, the mines paid good dividends; today most of the good mines are worked out and the international mining industry has to subsist on far lower ore grades. Global production is declining.
So when it becomes obvious to the wider investment community that the inflation of the 1970s was a warm-up act for what’s to come and they turn to investment protection, mining shares are unlikely to be the first choice, and this has been already reflected in the market today. Private individuals have been persistent buyers of coins, and even the moderately wealthy have been taking physical delivery of 400 oz (12.5kg) bars. The largest gold fund, the SPDR Gold Trust has grown from inception five years ago to over 1,100 tonnes today. This fund, together with other ETFs add up to well over 1,500 tonnes, making these funds collectively the sixth largest known holding, after government holdings in the US, Germany, the IMF, France and Italy. It is worth noting that today’s private investors are not speculators, so the coins, bullion and ETFs they have bought represents gold that has basically gone from the market. Or so they think: the problem is that for those that have not actually taken delivery of coin and bullion, or have not invested in a properly constituted ETF, the gold may not actually be there. To understand why, we need to understand how the market operates.
The London Market
The largest bullion market by far is in London, which is an over-the-counter market run by six major banks: Barclays Capital, Deutsche London, HSBC Bank USA London Branch, JP Morgan Chase, The Bank of Nova Scotia – Scotia Mocatta and UBS AG. They act as principals matching client business, and dealing with each other, the daily fix sessions being part of this process. Daily turnover between these banks is about $20bn for both gold and silver, excluding matched bargains, which when included probably takes the total to $60bn. So this is a big, efficient market.
It is so efficient because physical delivery is a miniscule part of the business, which is almost entirely book-entry. Rather than take delivery, clients have two options: to have the bullion bank hold their gold in allocated or unallocated form. If the gold is allocated, the client is given a list of actual bars held to his account, so the bullion bank is acting as a custodian. If the gold is unallocated, the client is merely a creditor of the bank, just as if he had deposited dollars or sterling. Allocated accounts are costly for the client, so they are discouraged from having them. Unallocated accounts face counterparty and systemic risk, and one wonders how many of them really understand this.
Less than one per cent of bullion held in these accounts is allocated, so for practical purposes the market works on an unallocated basis. The question immediately arises, as to how much bullion the bullion banks actually hold? The answer is no one knows, this being an OTC market, but from a regulatory point of view, bullion is seen as a liquid asset, and the regulators merely require the banks to hold sufficient overall liquidity to comply with banking regulations. Therefore, it is very unlikely that the bullion banks will hold more non-interest-paying bullion than they need to meet day-to-day deliveries, which as we have seen is a very small part of the market. Of course, bullion dealers are not stupid, and they will take steps to manage their risk by trading in futures and options.
This means that in rising markets, the bullion houses have to be buyers of derivatives on balance to cover their lack of gold bullion. So someone else has to supply the bullion required to back the futures and swaps, which in turn secures the options markets, and that supply traditionally comes from central banks and mining companies. The mining companies supply about 2,400 tonnes per annum, which is not even enough to cover jewellery demand, running at 1,630 tonnes annually, plus industrial and dental at 350 tonnes, and identifiable investment at 1,415 tonnes. This shortfall of 1,000 tonnes is further exacerbated by the fact that mines use higher bullion prices to extract lower grades, reducing the overall supply on rising prices, rather than increasing it as one would expect. The only other suppliers of gold collateral are the central banks, so we have to understand their motivation.
Central banks and leasing
Ever since President Nixon suspended gold convertibility forty years ago central bankers have been waging a war against gold, trying to convince international markets it has no monetary role. Initially the central banks and the IMF held regular auctions to swamp the market, backed by their anti-gold rhetoric. This policy failed, and the market easily absorbed this supply as gold rose from its suspension price of $35 to a peak of over $800 in 1980. Yet more gold was fed into the market during the twenty year bear market that ensued, culminating in Gordon Brown’s ill-timed sales in 1999/2000. These sales were always well absorbed with the gold disappearing from the market entirely, so the central banks’ next tactic was to pre-announce sales programmes, which to be effective were under binding agreements. Not even the knowledge that future sales of many hundreds of tonnes were to hit the market fazed it. The decline in the gold price coincided with the diminishing inflation risk as a result of Volker’s interest rate policies and Reaganomics, and was not as a result of the extra supply. Consequently, the central banks resorted to leasing gold, which did not have to be reported under IMF guidelines.
Leasing contracts amount to extra supply, because the leased gold is sold into the market either to finance a carry-trade deal, or to satisfy futures and swap demand. The carry trade business can only sensibly be conducted when spreads are favourable and futures and options premiums are low enough to permit the price risk to be covered. Except to the extent the price risk is not covered, the carry trade has no net effect on the market, because one side of the deal offsets the other. Therefore, the size of the futures and swaps market is a proxy for the amount of gold leased out by the central banks, and on the latest BIS estimates (June 2009) the net value of this market stands at 1,400 tonnes. It is interesting to note that this figure has declined from 2,360 tonnes in June 2008 and estimates of as high as 5,000 to 10,000 tonnes earlier in the decade, which is consistent with the realisation that leasing is failing as a mechanism for lowering prices. The reduction in leased gold is effectively adding to demand, since it is gold withdrawn from the market.
We can therefore see that between the global supply and demand change and the contraction of leasing approximately 2,000 tonnes of physical is being withdrawn annually from the market at current rates.
The tightening supply of bullion creates problems when a buyer insists on delivery of physical bullion. Periodically, stories go the rounds of bullion banks having to be helped out by central banks. One would have thought with all the daily turnover in London estimated at $60bn that there would be enough physical around to make any deliveries required. If not, then the market is seriously short of stock; but given that the bullion banks are not required to own bullion themselves this is not surprising.
The rumours of shortages are also likely to be true, because as well as reducing their leasing activities, the central banks have themselves turned net buyers. The only significant sellers over the last ten years have been the Europeans, particularly the UK, Switzerland, France, and to a lesser extent Portugal and Spain. Except for Switzerland, these sellers represent a bloc whose purpose in selling has been to discredit gold as a store of value compared with their own paper currencies, now mostly consolidated into the euro. These sellers now have a problem: they have run out of fire-power, because the market is now more powerful than them. Furthermore, China, Russia and India are willing buyers with the capacity to absorb all these countries’ remaining bullion. The miners, who used to supply the market with forward production, are no longer doing so.
So we can see that all supply factors have gone into reverse. With respect to demand, we have already touched on growing private investor hoarding, but it is impossible to estimate the demand from the rich and super-rich. In my experience, a significant element in this category is likely to be hoarders through discrete private banks in Switzerland and elsewhere and which offer storage or custodial facilities. Sovereign wealth funds in Asia and the Middle East are educated investors turning away from dollars towards metals and precious metals generally, and are known buyers of both physical metals and mining companies. Meanwhile, the new middle classes in China and India are a growing source of wealth and therefore demand.
The reason all this is important is the rise in the gold price, having been artificially depressed for at least twenty years, does not yet fully reflect the dilution of fiat currencies. Furthermore, over the last eighteen months this dilution has accelerated substantially, acting as a likely catalyst for increasing demand in the physical market. But even without such a trigger, the acute shortage of physical bullion has the potential to develop into a massive bear squeeze. There is even a short position in the SPDR Gold Trust, which on 7th January stood at $1.9bn, so at some stage this has to be converted into bullion, which at today’s price is nearly 50 tonnes. This is small beer given the scale of the developing shortage in the global market, but indicative of investor attitudes: they are focusing on economic analysis and perhaps on technical interpretations, when they should be looking at what is actually happening in the market.
And if the purchasing power of the dollar measured in commodity prices continues to decline, and portfolios respond by seeking to increase their exposure to gold, there is simply not enough at anything less than a multiple of current prices to satisfy demand. Analysis of what the price should be is for the birds. Rather like a global version of the Madoff scam, we will find that the gold we thought was there when we want it isn’t actually there at all.