Why Gold Has an Interesting Tale to Tell

If at first you don’t succeed, try and try again. That’s probably what Japanese Prime Minister Shinzo Abe is thinking right now on the news that Japan’s economy grew much less than expected in the second quarter. The expectation was that nominal economic growth would come in at an annual rate of 3.6%. Instead, the economy expanded by just 2.6%.

That’s quite a difference. Perhaps everyone is getting a little too excited by ‘Abenomics’, the revolutionary economic policy that basically involves Japan printing its way to prosperity. Or perhaps this is just how a formerly lumbering economy warms up. A few numbers below expectation and then, wham! an inflationary explosion of economic growth.

One thing is for sure, it certainly won’t deter Japan’s policymakers from continuing on their current course. It’s inflate, or fall into a deflationary trap. Fire or ice.

It’s also a case of try and try again for the gold bulls. The gold price spiked higher overnight following a good session in Asian trade yesterday. Silver did even better, rising nearly 4% in US dollar terms during the US trading session.

The move saw gold rise above its 50-day moving average, which is an important technical level watched by traders. Actually, traders pushed the price of gold up through the 50-day moving average in the Asian session so the overnight rise was probably the result of a lot of traders covering (buying back) their short positions.

So what does the rising gold price tell us?

It may suggest that the deflationary scare brought about by the recent ‘taper talk’ (the Fed’s threat to end quantitative easing) is coming to an end. That is, the Fed won’t taper. Or they will scale back in such a miserly way that no one will really notice anything.

The other way of looking at it is that gold is simply exhausted to the downside. The gold ‘price’ is really the price of ‘paper’ gold. That is, futures contracts traded in the US and spot unallocated gold traded in London. These trades (especially trade in London) dwarf the amount of gold in existence. We’ll give you some stats on that in a moment.

Over the past few months, as gold broke down through long term support at around US$1,525, speculators piled in on the short side, hoping to make money from the falling gold ‘price’. They certainly did that, making substantial paper profits along the way.

But any paper market needs a physical market to support its structure. Think of it like a regular banking system. Banks have ‘reserves’ that support the expansion of credit. The reserves form the base and credit expands on top of the base (provided there is demand for credit).

In the same way, the bullion banking system has physical reserves that support the paper gold market. The bullion banks created paper gold to cope with rising demand for gold, which was in turn brought about by (stick with us here) an explosion in government debt. The chart below clearly shows that explosion:

paper reserves
To ensure the physical gold price didn’t explode too (which would have busted the US dollar based international financial system) the banks created gold derivatives — ‘paper gold’ — to satisfy demand.

Such a system worked well for many years. The rise in paper gold kept gold bulls happy and the dollar system functioning well.

But the recent price plunge is causing a few problems. When the paper price of gold began its precipitous decline, it sparked an increase in physical demand and a squeeze on supply via reduced mine output and less scrap metal available for recycling.

This had the effect of drawing gold out of the bullion banking ‘system’. Gold continued to flow to India, China and into private hands in small denominations.

Yesterday, the China Gold Association reported that China consumed 706.36 tonnes of gold in the first six months of the year, up 54% on the first half of 2012.

India’s imports will be less than last year due to import restrictions imposed by the government. In a move that can only make sense to bureaucrats, India is trying to halt the inflow of gold to boost its currency and reduce its trade deficit.

All this will do is encourage smuggling. Gold imports will continue, they just won’t register as official imports.

So this increase in physical demand, to locations outside the western bullion banking system, is putting quite a strain on the market. As evidence of this, the gold forward offered rate (GOFO) which is the basically the interest rate charged to borrow US dollars using gold as collateral, is negative out to three months (and recently six months). It’s been this way for an unprecedented five weeks.

Gold holders are obviously not being paid to lend their gold for dollars short term (which is what the negative rate implies) but the interest rate structure suggests something very weird is going on.

The LBMA (London Bullion Market Association) says a very low GOFO suggests tightness in the physical market. This is probably true but the London market is mostly a paper market. Recent clearing statistics from the LBMA highlight this.

Check this out…

In June, the daily average of cleared gold trades was 29 million ounces (keep in mind that trading volumes are much more than cleared trades). Annualised, that’s 300,000 tonnes of gold cleared, which is twice as much as there is gold in existence!

So it’s mostly unallocated ‘spot’ gold trading going on. Very little physical trading and clearing takes place relative to overall activity. These volumes dwarf those happening on the Comex, which is the US futures exchange. But London gets little publicity because it’s an ‘over-the-counter’ (OTC) market where trading takes place between two parties directly, not via an exchange where everyone can see what’s going on.

This tells us that a small amount of physical gold reserves support an enormous paper market. Can the system hold together? What happens if it doesn’t? We’ll have a crack at answering those questions tomorrow. There’ll be something there for the bulls and the bears.

Before we sign off for today, here’s another reason to believe that the gold price is a product of the paper trading going on in London, and has nothing to do with physical demand. From the LBMA press release that accompanied its June clearing data:

‘The average price of gold in June fell 5% to $1,342 an ounce, nearly 21% below the year high of $1,693.75 recorded on the 2nd January. In contrast, demand for gold has increased by 39% since January, buoyed by strong physical demand particularly from China and India which has more than offset sales by ETF funds in the western economies.’

Zero interest rates and unfettered market control by central banks make for an upside down world. When paper weighs down the paperweight, you know something is not right.


Greg Canavan+
for The Markets and Money Australia


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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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