Gold Down 5 Per Cent: Thank You Mr Market!

‘But…but…I thought gold was a safe haven…’

If you’re having thoughts like that after gold’s horror $115 slide over the last 30 days… relax. Gold is, was and always will be a safe haven.

Before we get into the gold story and see just why it’s price has plunged in recent days, check out Slipstream Trader Murray Dawes’s latest stock market update on YouTube. Murray is STILL bearish on this market. Click the market update link to see why…

Now… Back to gold.

It fell around US$60 overnight, or nearly 5 per cent. After hitting highs of around US$1,900 a few months ago, the yellow metal seems like it’s got yellow fever. It’s looking sick at US$1,575.

Now, that’s probably not what you would call safe-haven type behaviour.

And you know what? We agree. But in this market looks can be deceiving. You see there’s a reason Mr Market is offering gold at bargain prices. Let us explain…

First, you have to accept that the producers of fiat currency, i.e. governments, have a vested interest in managing the price of gold. In 1934, US president Franklin D Roosevelt confiscated all the gold holdings of US citizens right before he increased the official price of gold from US$20.67 to US$35. This theft allowed US Treasury to establish the US$2 billion American Stabilisation Fund.

During the 1960s, central banks around the world colluded to keep the price of gold at US$35 an ounce, all while they were printing more and more paper money to fund wars and social programs. This was known as the London Gold Pool.

But guess what? The market price of gold broke away from the ‘controlled’ price and the gold price soared in the 1970s.

We’re again at a point in history where gold (and silver) are in the process of breaking away from official price management.

This may seem like a strange thing to say when prices are tanking (just when you think they should be soaring). But that’s the point.

The global monetary system – in which gold and silver are inextricably entwined – is in all sorts of trouble. The sovereign debt problems in Europe and China’s imploding credit bubble are flesh wounds compared to what is happening under the surface.

In the murky world of global finance, ‘under the surface’ means the shadow banking system. I wrote about this extensively in a recent update for Sound Money. Sound Investments subscribers.

Without going into detail, the shadow banking system is a world where brokers and investment banks, among others, make money by investing other peoples’ money. This has always been the case. But the collapse of MF Global has shone a very bright light into this previously dark and profitable corner of the world.

You probably know that normal banking is based on the principle of fractional reserve banking. That is, the banks lend out the money you deposit to someone else – and so on and so on.

The shadow banking system works in the same way. But it’s much bigger and is completely unregulated. This is the world of hedge funds, prime brokers and derivatives. If that sounds confusing, it’s because it is.

These two systems are linked. But for the purposes of our story, which is about gold, that’s all you need to know.

The collapse of MF Global opened speculators eyes up to the fact that when you’re dealing in derivatives, including gold futures, what you think you own may not be what you own. What MF Global did (and what other brokers no doubt do, because it’s actually legal) is take the assets you think you own and use them as collateral for their own investments.

If the bets pay off, they win. If the bets go wrong – as in the case of MF Global – you lose. It’s the old ‘heads I win, tails you lose’ trick.

Bloomberg recently reported on a case of two parties claiming gold ownership following the collapse of MF Global.

An HSBC Holdings Plc (HSBA) unit sued the MF Global Inc. brokerage trustee to establish whether he or another person is the rightful owner of gold bars worth about $850,000 and silver bars underlying contracts between the brokerage and a client.

Five gold bars and 15 silver bars underlie eight Comex contracts between the brokerage and its client Jason Fane of Ithaca, New York, the unit of London-based HSBC said in a court filing yesterday. Both parties have asserted claims to the bars, creating difficulties for HSBC, which is storing them, the bank said. HSBC asked a judge to decide who the rightful owner is.

That is what happens when a security, representing a claim to an underlying asset, is used a number of times by different parties. MF Global has used their clients’ gold futures contract as collateral for their own trading. So MF Global’s collapse has triggered a number of claims on the one asset.

What happens when people realise their assets are being used as collateral for the investments their broker is making? The loss of confidence and liquidity increases volatility. That’s what you’re seeing now.

But it’s the paper price of gold that is leading the physical price down. Don’t be scared out of your position because of the shenanigans in the paper gold market.

Just as the London Gold Pool split into two in the 1960s, the physical gold market will soon diverge from the paper (futures or derivatives) market. It’s in the process of happening now, with the MF Global collapse the catalyst for the divergence.

Another factor weighing on the gold price – and this time we mean the physical gold price – is the situation in Europe. The shadow banking system has for many years provided liquidity – US dollar liquidity – to the highly leveraged European banks.

Not anymore.

That’s why the Fed had to drop the price (lower the interest rate) of US dollar liquidity a few months back. But the facility doesn’t seem to be working as there are increasing signs of dollar shortages again.

Perhaps the banks don’t have enough collateral to post with the ECB to get hold of the dollars.

The latest news is that banks (probably borrowing from their central banks) are selling gold to raise US dollars. This raises the question, why don’t central banks accept gold as collateral? Could it be they don’t want to accept the fact it is the hardest currency of all and therefore a threat to their own paper creations?

Check out this list of eligible collateral from the Federal Reserve. Every bit of paper (bar the kind you use to wipe your backside) appears on it. Yet gold doesn’t make the grade.

Funnily enough, in the height of a crisis, gold is conjured up from somewhere (the European commercial banks certainly don’t own any) so it can be sold/swapped/leased for US dollars. That sounds like an asset of last resort to us.

More than likely the new gold currently being sold for US dollars is actually someone else’s gold. The original owners just don’t know it. Like the traditional and shadow banking system, the gold market operates as a fractional reserve market. That is, there are a number of claimants to a single ounce of gold.

It’s just that those claimants don’t know it yet.

The MF Global collapse is the catalyst that will unearth this fraudulent market. And when enough people work out what is going on, gold will free itself from the shackles of the bankers and the paper market and soar considerably higher.

Take this correction for what it is – a correction. So don’t stress. Thank Mr Market and buy more.

Or, if you’re convinced gold and all hard assets will head higher as the fiat paper currency system breaks down, check out Dr Alex Cowie’s top six picks for 2012.
Greg Canavan

for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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smoke collateral, the beginning and the end of the story…..

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