The Silent Gold Rush is on
Friday, December 18th, 2009
“ …It is, in short, the only unquestioned and generally acceptable means of payment among nations, as dollars are the only unquestioned and generally acceptable means of payment among Americans, francs among Frenchmen, sterling among the British, and so on.”
Peter Bernstein, ‘A Primer on Money, Banking and Gold.’
Peter Bernstein is no gold bug. Rather, he is one of the world’s foremost authorities on capital markets and economics. A Primer on Money, Banking and Gold was first written in 1965, when gold was still the international currency. It is our contention that in the years ahead, gold will once again resume that role.
Prior to 1971, gold was effectively the commodity with which international payments were made. The flow of gold into and out of countries said more about a nations’ economic health than anything else. Indeed, the outflow of gold from the US in the late 1960s ultimately triggered President Nixon’s decision to suspend gold convertibility. In a fateful decision, the global financial system’s link to sound money was broken.
Ever since, the world has been on a US dollar standard, a monetary system where only one country has the benefit of borrowing and repaying debt in its own currency. In order for this system to prosper, the true international currency, gold, needs to be discredited. We believe gold has been held down for many years in order to allow the US dollar based international financial system to survive. But the official grip on the gold price is beginning to weaken, perhaps this time for good.
The smart money knows this and is beginning to move into gold. There is a silent gold rush taking place all around the world. Investors who understand gold’s role as an international currency are selling their surplus paper dollars and buying the yellow metal. This has led to unprecedented demand for bullion and coin dealers everywhere are struggling to meet this demand.
The Australian newspaper reported over the weekend that the Perth Mint is not taking any more orders for gold until January. Our guess is that the Mint does not want to expose itself to higher future prices given that it does not have the inventory to meet the demand for bullion. In a recent report, The World Gold Council said investment demand for the September quarter was $10.7 billion, double last year’s quarterly total.
Yet the price of gold in US dollars has been under pressure and gold producers have little incentive to increase output at these price levels. Even in Australian dollars, the price of gold is not high enough to encourage increased production. According to Bloomberg, Australian gold production was down 8% in the third quarter.
Strong demand and weak supply should be creating much higher prices. One explanation as to why this is not happening relates to the short term impact of hedge funds selling gold to meet investor redemptions. However, we do not see this as a major cause. Hedge funds are more likely to deal in gold futures rather than physical gold. We will discuss the futures market in a moment.
More ominously, we believe central banks and bullion banks (basically large international banks) are attempting to keep the price of gold down to reflect the ‘strength’ of the US dollar monetary system the world has operated under since 1971. This theory has been convincingly argued for many years by the Gold Anti-Trust Action Committee (GATA) in the US.
In summary, the argument is that central banks loan or lease gold to the bullion banks, who then sell the gold on the spot market and invest the proceeds in higher yielding treasury securities, earning a positive spread and easy money. In this way, central bank gold holdings are monetised and the proceeds are reinvested back into US government debt. More importantly, the additional supply of gold coming onto the market from the vaults of the central banks helps keep the price down.
Central bank officials certainly deny that they lease gold in order to keep the price low. Their explanation is that they simply lease gold to earn a small return on an asset that does not pay interest.
This is an ingenuous argument. Gold is an insurance policy – a wealth protector not a wealth generator. The benefit of earning a tiny return is more than offset by the risk of losing control over a country’s gold reserves. This fact will soon become painfully obvious to a number of countries.
The gold leasing and carry trade has in effect created a huge short position in the gold market. That is, the loaned gold must be paid back at some point. So central banks have considerable counter-party risks as they are relying on banks to repay the gold loaned to them.
How much gold is loaned out? That is an impossible question to answer, as there are no requirements for central banks to disclose this information. According to IMF (International Monetary Fund) accounting standards, central banks can include swapped or leased gold as a part of their official reserves, a practice that would lead to double counting of gold. So there is a decent likelihood that some of the world’s official gold reserves are not safely stored away, but have instead been leased and sold on the spot market.
This is certainly the contention of GATA and others. Recent efforts to obtain an updated audit of the US’ official gold reserves, stored mainly in Fort Knox, Kentucky, have been met with silence by the authorities. Despite the gold being the property of the US public, the facility is completely off limits and no official tours are conducted. Conversely, tourists and US citizens alike can see foreign central bank gold held in custody at the New York Federal Reserve in Manhattan.
If the market for physical gold is confusing and opaque, then so is the market for gold futures. The futures market is a way for investors, or more correctly, speculators, to gain exposure to the gold price without owning the physical metal. And futures provide leverage.
For example, the active futures contract at the moment is the December contract. One contract represents 100 ounces of gold. So the buyer of one December contract at US$820/oz will pay the seller US$82,000 in exchange for 100 ounces of gold. In practice though, most contracts are settled with cash rather than delivery of the physical metal.
There are increasing rumours that the COMEX, the exchange that runs the gold futures market, does not have the required physical metal should buyers of the contracts demand bullion as payment instead of cash. This is not surprising, as many of the players on the futures market are hedge funds. Such speculators look to capture leveraged price moves rather than buy contracts to receive physical delivery.
The ‘open interest’ in the gold futures market reflects the amount of activity in gold futures and since peaking in early 2008, the amount of contracts ‘open’ have declined considerably.
Part of the decline obviously reflects lower participation from the hedge fund players. More importantly though, we believe the decline in open interest represents investor distrust in the exchange to deliver on its promises of gold delivery. If you really want to own bullion, why buy a futures contract? In the past, the gold futures price led the spot gold price. If participation in the futures exchange continues to decline, we wonder how long this will continue.
Given the anecdotal evidence of physical accumulation around the world, we sense that investors large and small are beginning to wake up to the fact that the days of the US dollar as the world’s sole reserve currency are numbered. The fiat money experiment that began in August 1971 is drawing to a close.
Not that anyone in an official capacity wants to recognise this. In a recent meeting of the House Financial Services Committee in the US, Republican Senator Ron Paul asked Fed Chairman Ben Bernanke whether central bankers ever discussed gold in the context of a new international monetary system. Bernanke’s response was to the effect that they only discuss gold in terms of how much they plan to sell.
If this is true, the trade by central banks has so far been a poor one. Central bank sales (separate from the leasing of gold discussed earlier) have been co-ordinated since the Washington Gold Agreement was signed in 1999.
The agreement was precipitated by Gordon Brown, the country’s then chancellor, selling half of England’s gold reserves in 1999. The fact that Brown inexplicably advertised the government’s move prior to the sales saw the gold price plummet and threaten the gold mining industry, so a formalised gold selling agreement was put into place.
The first agreement, from 1999-2004, stipulated that the 11 member nations of the new euro, plus a few other European nations, limit their gold sales to 400 tonnes per year, or not more than 2000 tonnes over five years. The countries signed a second agreement in September 2005, limiting sales to 500 tonnes per year, or not more than 2500 tonnes in total.
There are a few points to note about these agreements. Firstly, the sales represent supply over and above annual production and the gold price has increased considerably since the agreements began. There is now less than one year left in the second agreement and sales in the first four years have all been under the 500 tonne limit. Evidence to date suggests that sales in the final year will be well down on the proposed limit, as banks decide to hold onto their remaining gold.
The fact that central bank sales have added supply to the market while the gold price has continued to rise over the past 9 years suggests the unfolding bull market is a powerful one. While unelected officials sell their citizens’ gold wealth, individuals are taking matters into their own hands and buying the gold back. We believe this will prove a great trade for the individual, and a poor one for the central banks, with major ramifications.
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