Gold
Gold is no longer a side story to the markets; it is the story for the economy and markets. The gap down consolidation I was expecting last week was $7 and lasted one day. This is a strong indication that the market is being driven by investors rather than traders but that even the traders want a bigger upside profit before beginning to trade. That bodes very well for gold's continued upside potential. But, if it runs too fast, called hitting a parabolic, the worlds central banks would certainly have to step in to cap the increase. The situation is similar in respect to the fed bail out of Long Term Capital Management in 1998. LTCM had all of its interest rate derivatives on one side of the market, betting world wide rates would fall along with the 10 year treasury yield. They didn't and LTCM posted paper losses of 1 trillion dollars and the bottom of the market, was forced out of business and forced the fed to step in to create the liquidity required by the counter parties to meet the margin requirements and take the LTCM trades over. The gold carry market is essentially the same play. The gold carry traders are all on one side of the market, assuming falling gold prices and falling interest rates. Two thirds of the gold carry market is represented by JP Morgan. As gold prices continue to rise a new bail out will almost certainly come to pass. In other words there is a dangerous situation building in the gold market for the economy.
As gold carry traders move to cover they will have to liquidate their treasuries, which will drive treasury yields up and force gold prices higher. This could cause a short squeeze to build in gold prices, sending them on a parabolic rise. This would also be an aberrant event and probably not adequately considered by the Black-Scholes model. That is important because it was the model used by the partners at LTCM to predict interest rates around the world. What the model did not take into account was the potential for their to be an economic or market shock. In 1998, Russia defaulted on its debt which caused a cascading race for cover, a flight to safety, out of equity AND bonds all over the world and into US treasuries. This meant that interest rates / bond yields all around the world rose while rates / yields in the US fell. The exact opposite of what Black-Scholes predicted would occur.
Now, here's the problem. The creators of Black-Scholes, Roberton Merton and Myron Scholes won the 1997 Nobel Prize in economics for their creation of the Black-Scholes model. And it is a great model and excellent for teaching the relationships of economic events around the world to one another. BUT, it does not and can not take into account shock events. As a matter of fact it assumes that economic shocks causing markets to not conform to their model are few and accepted as a risk.
Because of this, the use of the Black-Scholes model by hedge funds has grown dramatically since 1998. An apparent belief that Russia was the lightening strike, or exception to the rule, that validated the Black-Scholes model and that the risk of another shock was thus low seems to have swept hedge fund managers and traders. Even hedge fund managers move in herds; it's a part of human nature.
So, what does this mean for today. Remember, the Black-Scholes model stipulates that as US treasury yields move so do others around the world. If the 10 year treasury yield is increasing everyone else's should to and vice versa. The exact opposite however occurred in 1998 following the Russian debacle and the same may be getting ready to happen now; only in reverse. In 1998 US treasury yields fell as the rest the worlds yields increased.
Today, the reversal of the gold carry trades will cause companies like JP Morgan Chase to have to liquidate their treasury holdings to cover their gold shorts by buying it back and delivering it to the central banks from which they borrowed it. This not only would cause gold prices to rise and 10 year treasury yields to increase but would be happening at the same time the dollar is beginning to weaken from record highs. As this occurs and money leaves the US it is probable that European long term treasury yields will fall even as US treasury yields rise. The exact opposite of what occurred in 1998 but with the same results. European and US bond yields moving in opposite directions is the exact opposite of what the Black-Scholes model stipulates should happen. And there are a lot more interest rate derivatives trades based on this model today than there were in 1998.
So, gold carry trade covering could cascade into interest rate derivative exposure and then into the resulting credit derivatives. And from their into the economy, etc.
So, what to do? It may not be avoidable.
If the central banks get together through the Basel Accord and agree to lease more gold in an attempt to suppress gold prices the result will probably be the exact opposite. In other words, the central banks would be acknowledging the gold manipulation by intervening; something they have denied for almost 3 decades. Free market money doesn't like regulation but is allergic to manipulated markets. It's like trying to play poker with a cheater. Once you know he's there either he goes or you go. In this case the attempt to suppress gold prices would probably cause even more money to leave the "free" markets and paper assets in a flight to safety in hard assets, gold, silver, platinum, etc.
This will be a continuing to story.
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excerpts:
"I expect to see a $25 up day for gold one day, largely due to someone getting skewered by their hedge book, either the bank that extended it or the mining company."
"Physical gold is illiquid relative to short covering demand. This will take gold a lot higher, unless the central banks step in, which I expect them to do when the gold market gets really disorderly, like gapping $10-$20 a day or more."
Hathaway sees Wall Street clean-up crews at work, frantic in their efforts to erase the gold derivatives. "There are all kinds of crazy, exotic deals made in the past that will come to light -- exploding puts, knock-in calls, etc., which had high fees originally but are now viewed as toxic waste by the dealers who sold them."
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Nothing has changed with Hecla from last week last month or even last year. |
