During the current blow off in commodities, and particularly in gold, talk is again getting stronger that the gold price is manipulated. That’s a hot topic and something GATA (www.gata.org) has been saying for years. Conspiracy theories often contain some truth. Nevertheless, I would not call it manipulation, but definitely mismanagement.
It is a known fact that central banks as the most powerful organized group in the gold market with holdings of approximately 30,000 t use gold lending as a tool to manage their assets more efficiently. The USA as the biggest holder of gold with approximately 8,000 t has always been in the line of fire regarding the gold manipulation conspiracy. I think that gold lending has nothing to do with more efficient asset management as central banks most likely believe. Many investors who don’t accept gold as an asset class are always coming up with the argument that gold does not pay dividends or interest. It’s kind of a dead investment from a cash flow perspective.
I agree, but does an asset class per se have to pay dividends or interests? No, this is not a must in my opinion. As an example, an investor who puts money into equities is not primarily focused on dividends, he is focused on capital gains. Investing in biotechnology or technology stocks is like investing in gold (or non interest/dividend bearing assets) or do you buy these stocks for their dividends (which very likely will never be paid)? I suppose most central banks think they have to generate interest out of gold. So, they invented gold loans for gold carry trades. Central banks are lending their gold to other market participators (mainly well known investment banks) and get an interest in return (q.v. gold lease rates). After doing so, they believe this has been a good deal and call it efficient asset management and are happy to generate some interests. I call it mismanagement!
With these gold carry trades, central banks are destroying value and trigger many negative effects which they are not fully aware. Central banks also own bonds and stocks – if they want to maximize their returns on stocks, they should allow borrowing & lending transactions which means central banks allow that their stocks are been lend, in return they get a fee.
So what is a lender doing with these stocks? They are used for short selling. Short selling puts pressure on the stock price and if the quantity is big enough leads to a lower share price. In other words, the loss on value because of a lower share price is outnumbering the lending fee. The same effect exists in the gold market but the magnitude and implications are even bigger. Central banks are supporting artificially lower gold prices with lending transactions and help to suppress the market value of gold.
Gold carry trades are a big business and one that was very lucrative especially when gold was in its bear market. Remember, central banks think they have to manage their gold assets and therefore allow lending and get some interests – the counterparty was selling the gold and invested the sales revenues into other asset classes. As long as the price of gold didn’t rise, the strategy worked out perfectly. The so called gold carry trades were used very likely to buy US treasuries and gain the interest difference between the gold lease rate and the treasury interest.
This is working as long as gold (which the gold carry trader is short) is not rising or the US treasury bonds are not collapsing. Since these trades have been done for many years and it has been tolerated by central banks which also had an interest since these trades were supportive for treasuries and consequently supportive for the US dollar. Gold was the ‘perpetuum mobile’ for investment banks and central banks. I guess most investment banks involved in these trades never hedged their positions and they are very likely short physical gold since it has been sold in the physical market. So what’s going to happen if central banks are calling back their gold? Short squeeze on the physical market will be the result. Since we learnt in the sub prime crisis that the financial community is very good in creating highly complex products with huge leverage and which are not understood by anybody (including the creators).
It is therefore very likely that the lent gold has been used partially as underlying for highly complex derivates and structured products. These products are leveraged which means that the underlying physical amount of gold is not fully covered by the issuer. It’s the same as with loans – banks don’t have to cover their loans fully with net equity.
The trigger to activate this time bomb is coming from two sides: if central banks want to have their gold back or if the holder of the paper long position in gold is asking for physical delivery. That would be bad news for the issuers of such paper gold products since they very likely don’t have the gold available. Central banks know about this situation and will not call for their gold.
So how can this problem be solved? Only unwinding of leveraged paper gold positions will help, either in buying physical gold or in reducing the paper gold positions. But reducing the paper gold positions is something the end buyer decides who is long and not the bank which is short.
So what happens if the paper gold positions are not been sold but even increase? In this scenario, the seller of the paper gold (bank/broker, etc.) has to buy gold back physically to solve this unbalance. This of course has the potential to trigger a short squeeze in the physical gold market and kick the price of gold up dramatically.
It is also a known fact that the gold market is in a supply shortage for years (peak gold already happened in 2001!) and only central bank selling is balancing the market out. So what happens to the gold price if central banks from the emerging regions become net buyer?
As you can see in the following table, countries such as China, Japan, Russia or India which have a significant portion of their currency reserves invested in US dollar paper assets (e.g. bonds from Freddie Mac (FRE) or Fannie Mae (FNM) and similar ‘smart’ investment ideas), are holding very little gold.
If you compare these holdings with countries such as the USA, Germany, France, Italy or Switzerland, then you can imagine what kind of gigantic backlog demand is in the workings for these emerging countries with their global currency overinvestment and gold underinvestment.
It’s also important to recognize that a ramp up of the current gold reserves to 10% of central bank reserves in China, Japan, Russia and India would require a purchase of approximately 9,300 tons of gold or the entire gold production for the next 4 years.
In general, central banks would be wise to add up on real assets to hedge their paper exposure, I’m not only speaking about the US dollar - I’m speaking about a shift of power and a major devaluation of the current ‘global currencies’: US dollar, pound, euro, etc. Higher economic growth in the emerging countries lead by Brazil, China or India compared to the developed countries will appreciate currencies such as the Yuan Renminbi or the Indian Rupee, etc.
This economic shift will make goods traded in one of the global currencies cheaper and on the other hand assets denominated in US dollars, pounds, or euros less attractive to hold. Since gold is traded in US dollars, it gets cheaper (converted into one of the emerging countries currencies) and since most of these emerging countries - especially China - are sitting on huge amounts of US dollar, they are most willingly to protect their assets from devaluation. The ultimate store of value is gold. So far the gold market is mainly focused on the euro/dollar exchange rate which is positively correlated to gold – if the US dollar rises, gold falls et vice versa. I expect that gold will soon be influenced by this global macro shift towards the emerging countries in a positive way. The correlation between these emerging currencies against the developed currencies will be strongly positive for gold.
So what does this mean for our central banks? Since they manage our gold reserves, I’d be happy if they make sure that our gold is still around or at least they can get it back. So far our central banks have shown little understanding of gold as unique asset class and underlying of all the paper money in the system. Remember the Bank of England or the Swiss National Bank have sold lots of their reserves only some years ago virtually on the bottom at approximately $300 or lower. This is a complete lack of understanding the fundamentals of financial stability and unfortunately it’s done by the central banks which are required by law to obtain monetary stability and contain inflation. They did an incredible poor job, M3 has skyrocket and inflation is at highs not seen for many years. Instead of backing up the paper assets with real assets, they even decreased the ratio between real assets (gold) vs. paper assets (FIAT currencies or inflated bonds, stocks and real estate).
The natural hedge against inflation and a global currency devaluation is a long position in gold, either physically or by listed ETFs such as the SPDR Gold Shares (NYSE: GLD). Be smarter than our central banks, buy gold and stay long!
Disclosure: The author is fund manager for a mining & metals fund. The author’s view reflects explicitly his personal opinion.
