Seeking Alpha
Research analyst, CFA, portfolio strategy, gold
Profile| Send Message|
( followers)  

After every market crash the pitchforks and torches come out as angry investors look for someone to blame. This last correction is no exception:

As the dust continues to settle after the gold rout, market participants and scribes are still trying to come up with a rationale for the drama. Some of the commonly cited reasons include:

  • India's recent decision to increase its gold import tax to 6% from 3%.
  • Reports Cyprus would be forced to sell gold to pay for part of its "bail-in." (On Wednesday, Cyprus' finance minister Haris Georgiades confirmed his government has committed to sell about 400 million of 'excess' gold reserves.)
  • Bitcoin's collapse, on the theory many of the same investors were long both 'alternative' currencies.
  • China's weak GDP report, which prompted a broad flight from commodities, including copper and energy as well as gold.
  • Selling begets selling: A lot of 'hot money' has poured into gold in recent years and speculators were quick to rush for the exits when prices started to falter. To be sure, gold's sharp decline is a reminder that momentum is a double-edged sword.

To that list I would add that the sell-off started on the Friday before tax day and reached a peak on April 15, and may have been partly due to people selling their gold to pay their taxes. Let's not forget that gold had been weakening long before last Friday. So there are many places to lay blame for the SPDR Gold Trust's (NYSEARCA:GLD)/gold's correction, but the least convincing argument I've heard is that central banks are causing the collapse of gold. In the above-linked article that theory is discussed.

But such explanations miss the forest for the trees, according to Chris Powell, co-founder of the Gold Anti-Trust Action Committee (GATA). The organization's goal is to 'expose, oppose, and litigate against collusion to control the price and supply of gold and related financial instruments,' according to its Web site ... According to Powell, global central banks flooded the futures markets in London and New York with sell orders to prevent a short squeeze that was developing. He claims a similar operation occurred in March 1999 when the Bank of England announced plans to auction 58% of its gold.

One of the problems I have with this theory is that it can't be proven, and the person making the claim admits that there is no evidence supporting the claim:

By his own admission, Powell 'can't prove' his theories but the folks at GATA believe them with religious fervor. Among other documents, he pointed me to a 'secret IMF' report from 1999 that purportedly reveals such machinations.

The problem is -- and why these claims are so difficult to debunk -- that they can't be disproved. It is like saying the sun is made of cheddar cheese. No one will ever be able to visit the sun to prove me wrong.

Part of the beauty of GATA's theories is they cannot be disproven; academics call this an 'unfalslifiable theory.'

While the article does a good job debunking this theory using facts:

But I will note a few facts on the other side of this argument:

-- Although the New York Fed's vault is the repository for gold owned by other central banks and the U.S. Treasury, the Fed doesn't own any gold. 'None of the gold stored in the vault belongs to the New York Fed or the Federal Reserve System,' according to its Website.

The 'gold certificates' listed on the Fed's balance sheet are a 'historic accounting' from when the Fed used to own gold, according to a spokesman. 'The Fed doesn't own gold' and is not involved in buying or selling on behalf of other central banks, he said. 'Other reserve banks hold gold, you could ask them.'

-- The Washington Agreement, signed during the IMF meeting, was designed to limit annual gold sales by central banks to prevent a repeat of the 1999 sell-off incited by the BOE, as noted above. The agreement was last renewed in 2009 and remains in force, compelling central banks to limit annual gold sales to 400 tonnes. 'They live by that,' says Mark Dow, a former IMF staff economist turned hedge fund manager and blogger, who doesn't believe the 'big conspiratorial plot' explanation for gold's recent washout.

I will use a different tactic to debunk this myth: common sense. First, if you were the largest holder of gold would you want to trigger a sell-off? What benefit do central banks get from losing money? Especially when central banks reached a 50-year peak of gold buying in 2012? If anything, I would think it is far more likely that the sell-off was triggered by individual investors selling their gold in fear that the Cyprus central bank may be forced to sell their gold, instead of voluntary selling by central banks.

Second, just why do central banks own gold? They hold gold to implement their monetary policy. A fall in gold price complicates this situation. Imagine a situation where a nation desires to increase their money supply by $13,788. At the current price of gold of $1,378.80, the central bank would spend $13,788 out of cash and buy 10 oz of gold. The central bank's cash would decrease by $13,788, and the central bank's gold assets increase by $13,788. Basically, the central bank simply converts an illiquid asset gold into a liquid asset cash. No longer is some individual holding gold in their basement; they are holding cash in their wallets.

That situation works absolutely fine -- as long as gold keeps going higher. The problem is, when gold falls in value, the central bank no longer has the necessary assets to bring the money back out of circulation. In the above example the money supply is increased by $13,788 and that increase is backed by 10 oz of gold. If gold drops to $700, the central bank would only have $7,000 in gold to sell, but has $13,788 in circulation.

There is no way for the central bank to effectively implement their monetary policy. The central bank can always put money into circulation -- they can even print money if needed -- but to bring that currency back out of circulation, they have to give an individual something in exchange for the currency they hold in their wallets. Without the gold, they have no way to bring the currency back out of circulation. In reality, they do have ways like increasing the reserve requirements of banks and increasing the interest rate paid on deposits at the Fed, but those aren't the normal operations of the central bank, and would be considered "complications" as far as this article is concerned. The point being, falling gold prices aren't beneficial to central banks. They may have work arounds, but I'm pretty sure they would choose to avoid using them if possible.

In conclusion, people invested in GLD should not put much faith in the theory that central banks caused the recent sell-off in gold. In my opinion, that makes no sense whatsoever. The real risk to GLD holders isn't past central bank selling, but future central bank selling. The example I used above demonstrates that there is an incentive for central banks to sell gold if it keeps falling. The more gold falls, the lower the value of their gold assets backing existing currency, the more difficult implementing monetary policy becomes.

It is to the advantage of the central bank that holds gold to sell it and buy something stable like a government bond or U.S. dollar, and if gold keeps falling that is most likely what they will do. That is what I view as the real risk to gold with regard to central bank selling, future, not past selling. So while the critic referenced above may be proven right in the future about central banks pressuring gold, I find his claim that they are responsible for the current situation totally unconvincing.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Central Banks Are An Unlikely Cause Of The Crash In Gold