a view from South Africa:
Daan Joubert
28.02.01
Is the fuse already burning in the gold market?
Please click here for the daily price chart
Introduction
The evidence, from many different quarters, including statistical studies of very strange aberrations in the gold price during US trading hours, that there is something not normal in the global gold market is becoming overwhelming. Anybody who can write off a consistent trading pattern that exceeds 3 times standard deviation as quite normal market behaviour, either does not understand statistics or is blind to any evidence that does not conform to his or her own preconceived ideas.
Anybody who discovers from official records, submitted by the relevant banks, that there was a rapid and very substantial increase in the gold derivatives position of these banks in the quarter that followed the Washington Agreement, and who does not think that there happens to be a link between the announcement of that agreement and the large increase in the banks’ bullion derivatives, surely must place a tremendous premium on the role of coincidence.
And much more. Some are small things that would mean little in isolation. Yet, when all these small things are viewed in the broader perspective supplied by the large things that cannot really fail to attract the attention of the objective observer, the fine detail of the overall picture gets completed.
Recap
Quite some time ago a few articles were written for the iii community to explain what the situation in the gold market was. To recap briefly, during 1994, Central Banks and some financial authorities were becoming concerned about developments in the gold market.
The dollar was losing ground against the Deutschmark and the Yen, on its way to what would be its weakest level ever. The trade accord that was being negotiated between Japan and the US included a clause that they would co-operate to let the dollar firm against the Japanese currency, but was not net finalised.
A fragile dollar could not tolerate a rising gold price and the price of cold had appreciated by over 20% during the latter half of 1993 to briefly exceed and then settle just below the $400 level. Any further increases would spell trouble for the dollar and there was a silent agreement that all concerned parties would collaborate behind the scenes to keep the gold price contained. A continued steep rise above $400 was not desirable at all.
During 1995 the Japan-US trade agreement was signed and the effort to support the dollar was under way. One measure in this campaign was that the Bank of Japan lent out money to Japanese institutions at the then unheard of rate of 0,5%, provided the money was used to buy dollars for investment in the US at 6% or more. This served a dual purpose – weakening the Yen and helping the struggling Japanese banks to make some very needed profits, both on the spread between the rates and as a consequence of the strengthening US dollar, which represented an exchange rate or capital profit.
The Japanese institutions were not alone in this game. Many hedge funds, smelling the opportunity for easy profit, borrowed large amounts of Yen from Japanese banks, mostly at around 1% or so, bought dollars and invested in the US – in US Treasuries, for a 5% profit spread, but surely also in the new bull market on Wall Street.
By early 1996 the Yen had already weakened so much against the dollar that the practice of the Yen Carry, as this was known, had become a little risky. If the rising trend of the dollar should reverse, a firmer Yen would eat into the profits of a new Carry position and soon result in a loss. At the same time, the efforts to keep gold under $400 that had been successful for about 18 months, were showing cracks and the gold price had moved above $400 in early 1996.
The US and other large banks that had acted as middlemen in the Yen carry, had some knowledge of – or even participated in – the program to keep the gold price below $400. They now saw a new golden opportunity ( pun intended!! ) since they knew that Central Banks would lease gold at about 1% of market value, or even less. Two reasons applied why the lease rate was so low – firstly, most banks carried the gold on their books at the cost price of about $42/oz, so that 1% on say $400/oz was a pretty good return on book value. Secondly, the “interest rate” that applies to any currency is largely determined by the soundness of that currency. The less subject to risk or inflation, the lower the rate. And gold has since time immemorial been to most sound currency of all – thus justification for the low rate.
Soon the Gold Carry was in full swing – hedge funds and others would lease gold from the Central banks and sell this into the market. The proceeds would be used to invest in US Treasuries or even on Wall Street and the profitability was enhanced by the fact that as supply increased as a result of the Gold Carry, the gold price retreated below $400 and started a long term bear market.
To cut a long story short, the Gold Carry effectively got out of control and so much gold was leased and sold and disappeared mostly into the jewelry market, from where it could never be reclaimed, that a situation has arisen where it would be catastrophic for the bullion banks and their clients if the price of gold should rise steeply.
Many measures have been employed to postpone such a development. After the 1998 Russian crisis, when the price of gold reacted to the new uncertainties by rising steeply, Switzerland announced out of the blue that they would sell half their gold reserves – a very substantial 1300 tons of gold would come onto the market. Strange, though, that it was not a well-rounded press release that contained all the facts. No; it was just a very brief press statement that half the Swiss gold would be sold for humanitarian purposes.
Of course the gold price halted any further increase and fell back sharply. Only then did the Swiss authorities complete the statement by saying they would first have to change the Constitution and probably have to survive a referendum on the issue before one ounce could be sold. Even then the sale would be conducted over 10 years, at 130 tons per year. But, of course, buy then the price of gold was already at new lows. Just to make sure that it stayed there, the CB’s of the Argentine and Australia announced during this period that they, too, had sold much or all their own gold reserves, but had done so many months earlier. In the fragile state of the gold market, this news sent the price even lower.
Similarly, more recently when gold started to show signs of increasing back above $300, the Bank of England also announced they would auction off half of their gold reserves in order to purchase interest bearing instruments to replace the gold. Their announcement did not appear as hurried as that of the Swiss, but it was later discovered that there was no consensus among the parties involved – the Cabinet, Treasury and Ministry of Finance, as to where the proposal originated or at which meeting of which entity it was agreed to implement the proposal. No agenda apparently contains such relevant entries.
The major problem of course is that demand exceeds the natural supply of gold. While it has been possible to feed more gold from Central Banks into the market to satisfy excess demand, the Washington Agreement of 1999 limited the amount of gold that could come out of Europe and also from some other central banks.
The futures market on COMEX has played a major role in keeping the gold price in check, but this too depended on arbitrage to draw gold out of various vaults to match supply with demand. But, obviously, with demand rising even further above supply, the situation could not last indefinitely.
This brings us to the theme of today.
A crunch in the making?
A number of rumours have been circulating recently through the gold market. Among these are:
· A rumour that the countries involved in the Washington Agreement – i.e. the European Central Banks as well as those of Switzerland, Great Britain and the US – are due to come out with announcement that they intend to curtail leasing and or sales even further. It is of course an open question whether the three “non-ECB partners” will join the new agreement. In 1999 they were caught unawares by the ECB agreement that was largely sponsored by Germany, Italy and France, the three European countries with the most gold.
· A vague rumour that some of the purchasers of gold at the recent BoE auction had to wait longer than expected before the gold was made available.
· While the above rumour is at first glance questionable, there is another one that says the BoE has just recently ceased to make gold available for leasing. If true, that would tend to support the other rumour about delayed deliveries.
· The situation with respect to gold futures on the COMEX exchange implies that the traders in futures who are most consistent in anticipating the market correctly are very long of gold futures, which would indicate a rising gold price. The more speculative traders are massively short of gold futures. The overall position is very large, showing strong commitment to both views.
· There are indications of a very large position on COMEX – perhaps as large as $200 million – that could be running into trouble. This should break before April.
Two facts contribute to reinforce the veracity of at least some of these rumours.
The World Gold Council has sent out a circular in which it warned its members of very tight conditions in the gold market and intimations that something could be developing to upset the status quo. It is apparently highly unusual for this to happen.
Secondly, lease rates for gold have spiked steeply over the past few weeks, accelerating towards the end of last week. Normally, lease rates, just like future premiums in general, are lowest for the near months, rising as the time of the contract increases. Now, for the first time in a year or more, the lease rate for gold for 1 and 2 months are substantially more than for longer terms.
This development, known as “backwardation”, is an indication of very tight liquidity in the spot market. For example, in the run-up to the recent northern winter, crude oil was in backwardation since available supplies could not satisfy immediate demand.
Conclusion
It would appear that there are different factors combining to result in a unique situation in the gold market – one where the supply has suddenly become very tight, but at the same time one where there could be very urgent requirements for bullion in order to settle some speculative positions.
If this is true, the gold price could become very volatile at any time during the next few weeks. While the direction of the major trend cannot be stated with certainty, it would appear as if the odds favour a significant rise in the price.
It will be interesting to observe all the goings on – and particularly, if the price of gold should spike, what the effect on AngloGold’s rumoured take-over of Goldfields will be.
It could be very happy times for the gold bulls.
Unfortunately, last weeks developments in the US is likely to have a negative impact on equities. If Greenspan should listen to what his ex-colleague said on Friday, and cuts interest rates this week, between meetings, by 50 basis points, the dollar could well fold completely – with rather widespread effects on the US equity and bond markets.
If Greenspan does nothing, after Wall Street reacted so strongly on Friday to what was almost an assurance that Greenspan will cut rates, the sell-off could be frightening.
A compromise 25 basis points is likely to leave both camps disappointed and probably will trigger both kinds of event simultaneously.
Happy trading!!
Daan Joubert
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