John Hathaway
Tocqueville Asset Management L.P.
February 18, 1999
Bullion Dealers: Spin Meisters Of The Gold Market
Cast as the perennial bad guy of financial assets, gold faces many
protagonists. Low gold prices reassure the bond market that
commodity prices remain tame and that no inflationary threat exists.
With low interest rates and firm bond prices, lofty equity
valuations can be justified. The political world is happy to see gold
languish. Its submissiveness imparts an “all is well” hue to the
landscape. But gold's worst enemy by far is the bullion dealers. If not
for their reign of terror, gold would in all likelihood have
broken out of its long downtrend. Purveyors of unrelenting pessimism,
their collective voices have affected a generation of
thinking in the financial markets at large and among their clientele
which includes mining companies, central banks, and hedge
funds.
The dealer community consists of a small inner circle of blue chip
institutions that control the flow of leased gold into the market
place. Less than ten in number, their strong credit ratings qualify them
as counter parties for central banks leasing gold. Since
this trade originates as a short sale, dealers are predisposed to
promote a bearish picture for gold. These institutions have
persuaded the gold mining industry that the upside potential of gold is
limited. Their message to the miners is: buy price
protection from us. It is an absolute necessity to assure continuity of
mining operations. Their message to the central bankers is:
mobilize your gold for the leasing market so you can earn a return on
this stagnant asset.
The success of their campaign is evident in the mindless negative slant
of the financial press and attitudes of many leading mining
executives. Their small number facilitates obscurity, secrecy and
informal cooperation (collusion?) in their efforts to keep a lid
on gold prices. While spreading their gloomy message for gold, they have
built up a mega short position. Their relentless selling
is a major, if not the principal, reason for gold's lackluster
performance in recent years. The size of the short interest in gold has
been estimated to be from 4000 to 8000 tons, or two to four years of new
mine supply.
However, the world according to bullion dealers is beginning to veer out
of touch with reality. They contend that there are three
major reasons why gold can never mount a sustained rally: central bank
or official sector selling, producer forward selling, and
world deflation.
For years, the gold market has quaked at the prospect of official sector
selling. Rumors or stories of such sales have frequently
topped out many gold price rallies. Such rumors, spread by the bullion
banks, encourage front running by their hedge fund
clients. In truth, central bank selling has dwindled. The outlook is for
little or no new supply from this source. Wim Duisenberg,
chief of the new ECB, recently issued an emphatic public statement that
Europe's vast gold reserves would not be sold.
Duisenberg's point of view has been strenuously reinforced by European
central bankers in private meetings. The Europeans
regard gold as an important reserve asset whose value is of great
concern. Unauthorized sales are unlikely and even gold
leasing is likely to come under review once it is understood to depress
the metal's price. Central bankers regard gold as an
important basis of credibility for the new Euro, especially at the grass
roots level. Official sector sales, in the succinct view of
one knowledgeable observer, just “ain't gonna happen.” If anything,
official sector buying will become a significant source of
demand, particularly in Asia, where gold is a very low percentage of
reserves. This recent evolution in official sector attitudes is
absent in the pronouncements of bullion dealer spokespeople.
The second most frequently invoked rumor to terrorize the gold market is
of producer selling. This threat is as outdated and
inaccurate as their central bank spiel. The gold mining industry has not
added significantly to forward sales positions in recent
years. The industry is already heavily hedged, and producer selling
cannot and will not be the incremental source of supply it
has been in the past. Based on slowing reserve growth due to reduced
capital flows and low gold prices, significant new selling
by the industry is unlikely. While gold mining managers are still
inclined to sell into the rallies, they do so mostly to replace less
favorable hedges on the books, and therefore there is no net increment.
The 1998 Asian meltdown provided a cue for macro hedge fund selling.
Short interest rose to extreme levels three times since
the Asian meltdown: year end '97, August '98, and January '99. This
speculative selling pressure produced a succession of
higher lows, suggesting that the worst expectations may have already
been discounted. Asian economies now appear to be on
the mend. As the Asian recovery becomes more apparent, the macro case
for shorting gold and raw materials in general will
evaporate. It is hard to ignore the reports of strong demand from
traditional gold consuming markets. Preliminary numbers
suggest that the fourth quarter of 1998 saw the highest gold consumption
on record.
The deficit between mine production plus scrap and demand for gold
continues to widen. It is conservatively estimated at
1300-1500 tons for 1999. If net forward sales by producers equal 200-300
tons, a generous assumption, short selling must
exceed 1000 tons in order to keep the gold price locked into its
downtrend. In other words, the bullion dealers must go out
further on their short selling limb to defend their basis risk.
The macroeconomic argument for gold has swung to the bullish side. Heavy
monetary and fiscal stimulus is being employed by
world governments to fend off deflation. US money growth (M-2) exceeds
9%, the highest in ten years. Other world
governments are doing their part with interest rate cuts and fiscal
stimulus. Failure of these stimulative measures to thwart
deflation will only lead to more intense application of the same
medicine. A cycle of accelerating stimulus will ignite long
dormant investment demand for gold.
The world has changed dramatically from the days when shorting gold was
a good idea. Nonetheless, this does not stop the
dealers from rumor peddling to promote business. One producer hedger
observed that when such rumors appear at the top of
a gold rally, it is impossible to get a straight story. It is not
improbable that such selling represents proprietary trades by dealers
defending their short positions.
If so, their position is on shaky grounds. The depressed gold price
means almost no producers are reporting profits. The high
quality leasing business has already been exploited. Financially strong
producers, that cared to, have been selling forward for
many years. What's left, for the most part, are the companies with
weaker reserve positions and balance sheets. Hedge
business placed on the books over the last year is the weak link that
will break easily in a sustained gold rally. The basis risk for
much of this short interest book is probably in the high 290's or low
300's.
There is circumstantial evidence that gold lending has evolved into a
successor to the failed yen carry trade. Bullion dealers have
enjoyed bang up profits over the last few years. A gold carry trade
would seem like a rational line extension of their lucrative
business. Low interest gold loans could fund long positions in the
treasury market. Based on their trail of success, it would not
be hard for them to recruit fresh capital from within the firm or
outside.
One mining CFO observed that there is a kind of inverse euphoria rampant
in the gold market that the gold price will never rise.
Call writing and short selling are guaranteed ways to make money.
Bearish sentiment has become increasingly cocky,
overconfident and reckless. Such attitudes could well be founded on a
perception of official sector policy towards the metal
price. Increasingly lax credit terms reflect this sentiment. There has
been a flood of gold mobilized by central banks in the last
six to nine months. Over eighty central banks are now lending their
gold. Lease rates have plummeted, terms have lengthened,
and margin requirements relaxed. As credits have become weaker, more
complicated derivative structures and higher fees have
proliferated. A mining CEO professed to having been hounded in recent
months by dealers promoting ever more lax credit
terms. The sub prime lending business is alive and well in the bullion
market. Just as internet investors were piling in at the top,
there is an overcrowding of capital in this dubious trade, a precursor
to a market turning point.
You can be sure this will come to an explosive end. The gold market is
more wrong-footed than before its huge 1993 rally. At
least the yen was a liquid currency that could be bought to cover
shorts, even if there was a substantial loss to cover. The gold
that is being borrowed from central banks is being sold into the
physical market where it is being consumed as jewelry. It is no
longer in liquid, deliverable form. Gold loans will not be as easy to
repay as the borrowed yen. The shorts are facing an epic
squeeze. Once the markets realize that the selling pressure has been
artificial and the self-fulfilling, bearish axe grinding of a
small group of institutions with their own agenda, there will be a swift
re-evaluation of the market fundamentals. It could be
quite some time before gold trades below the basis risk of the short
positions.
Bullion dealers must assume that plenty of fresh central bank gold will
be available if the price rises. This could be a dangerous
assumption. The unanimity of negative opinion on the yen was followed by
a huge short squeeze. The sentiment on gold is
similar. If the price rises sharply, central banks will be reluctant to
mobilize more gold for lease. Under such a scenario, the
finances of the bullion dealers could be jeopardized. Lease rates are
low because there is a huge supply of gold available for
lease. The central banks have been coaxed (duped?) into the gold lending
scheme by the relentless dealer pessimism. A strong
gold price rally would dissipate negative psychology. Lease rates would
spike as central banks ask for their gold back. Most of
the banks have lent their gold against the credit of the bullion dealers
and don't appear to appreciate the risk that they could
actually lose the gold.
We are among the many gold investors who anticipated such upheavals as
the Asia meltdown, LTCM, and Brazil, that remain
disappointed by gold's indifference. It is quite apparent that gold has
been held in check by the artificial constraints we have
described. As these constraints become better understood, the short
position that they are built upon on will come under
speculative attack.
Our investment case for gold goes well beyond a short squeeze, but the
catalyst for a breakout could well be just that. We
expect investment demand to materialize in conjunction with the
inevitable deflation of the stock market and dollar bubbles.
Gold is a David and Goliath story. Written off by the financial
establishment and pinned down by the reign of terror we have
described, all expectations are negative. Strong underlying fundamentals
are ignored. Defenses against a breakout are flimsy
and overrated. Gold today is an opportunity to take a low risk position
that the financial markets are in the late stages of a blow
off. At the very least, it provides insurance against such an event. We
are looking forward to an imminent reversal in gold's
status as an outcast among financial assets.
John Hathaway
Mr. Hathaway is a Senior Portfolio Manager at Tocqueville Asset
Management L.P. and portfolio manager of The Tocqueville
Gold Fund.
This commentary is not an advertisement or solicitation to subscribe to
the Tocqueville Gold Fund, which may only be made by
prospectus. To receive a free prospectus, which contains more
information on sales charges, management fees, and other
expenses, call (800) 697-FUND (3863). Read it carefully before you
invest or send money.
|
