Gold Bull Market: Next Stop Exchange Failures

by: Tom Luongo

Last week the Hong Kong Mercantile Exchange -HKMex-- closed its doors after just two years of operations. It is likely a casualty of the toxic admixture of new rules governing shadow banking of 'Wealth Management Products" and the massive take down of gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) which resulted in a well-documented rush for physical metal which the exchange could not cover. The defunct exchange will not be delivering on its gold and silver contracts all 200 of them.

With the rate of draw down on the reserves at both the COMEX and the LBMA - not to mention anecdotal reports of failures to deliver by major LBMA banks - it is not much of a stretch at this point to project a time when either there is a commercial signal failure on the COMEX or, more likely, a force majeure event whereby the CME Group (NASDAQ:CME) settles up the contracts in dollars and goes to 100% margin.

This is an end-game scenario that has played out in the minds of many a gold bull, myself included, many times. And, while I have no doubt that those operating the exchanges will do everything imaginable to avoid publicly admitting to either of these events, the laws of economics are immutable and it is the only logical conclusion one can come to given the present course of money management as practiced by both the Federal Reserve and the ECB.

If the speculation at Zerohedge is anywhere close to the truth than HKMex was nothing more than a gold rehypothecation engine that broke with the take down in price, i.e. if the gold on the exchange was being used as collateral for other contracts which stood for delivery, then that is the end of the exchange. HKMex was shut down for liquidity purposes and the latest twist has 3 executives arrested with fake bank documents drawn off of HSBC (HBC) and Standard Chartered Bank, 'worth' nearly $1.2 billion.

With the changes to the banking rules in China, this will greatly affect the copper market, releasing up to 500,000 tons of copper currently being used as collateral for a leasing scheme that is both complicated and previously necessary because of China's insistence on setting all interest rates, not just a benchmark lending rate. Much of this lending and search for yield came from a deposit interest rate that was set well below what the market wanted which drove the creation of these "Wealth Management Products" that SAFE is now trying to rein in. If they can securitize copper to the tune of half a million tons then they can do the same thing with gold, a commodity in perpetual contango, which is necessary for this form of financing.

In short, China is looking to collapse its shadow banking system to a more manageable loan to deposit ratio of 70%. Liberalizing interest rates and letting the market set the deposit rate is a necessary first step.

The takeaway for investors here is that we are seeing, with increasing frequency, an asset class - gold -- that supposedly no one wants is routinely unavailable for delivery and whose price is deviating in certain markets significantly from the quoted price on the COMEX. In Vietnam where the State Bank has been trying to monopolize the gold trade, gold is trading at north of 20% over the futures price. Normally the premiums in Vietnam run 3-7% and have been higher recently with the unwinding of the gold loan market by the SBV but 20% is aberrational. The COMEX is down to less than 8 million ounces and JPMorgan's (NYSE:JPM) vault has been nearly drained as it shuffles registered gold into the eligible pile.

And since the U.S. is exporting more gold than it is producing and investment demand is running very high, I have to ask where all of this gold for export is coming from? Eric Sprott is convinced it is coming from the central banks themselves and he may well be right. But that is not nearly as important to the near-term price of gold as the rate at which the demand is draining the supply.

And if the collateral chains encumbering the measly 200 contracts on the HKMex were broken with the April crash then it is logical to assume that they have broken in other parts of the system as well. This is as good an explanation for the 300 ton draw down off the GLD as any other I've seen so far, because if this market were functioning properly then gold would be flowing into and out of the COMEX and the GLD as it has for the last 8 years.

If the volatility in the gold and silver market has created this kind of havoc for the exchanges and the bullion banks then what is the volatility in the Japanese bond market causing? This extreme volatility is causing the number of repo failures to triple in the last month. One cannot repeatedly be exposed to 6-sigma volatility in opposite directions nightly and not destroy maintenance margin positions up and down the collateral chain.

If we add in a collapse of the JGB market, which is becoming more likely by the day, that will remove the artificial demand for the dollar that has existed since the QE IV announcement in December and the birth of 'Abenomics' and create upward pressure on securitized gold in the futures markets. The 10 year UST/JGB spread has contracted from a high of 1.409% to a low of 1.03% since mid-March (see chart). Moreover, US TIPS yields have risen dramatically this month along with treasury rates.

The takeaway here is that the paper gold markets are still reacting to the changes in the foreign exchange markets in ways that reflect old correlations, i.e. selling Yen means buying dollars which means selling gold. That is why the Yen's debasement has helped mask the effects of QE and helped push securitized gold down when the fundamentals are screaming otherwise. Now that JGB bond yields are rising and the Yen is still falling - a recipe for hyperinflation -- it has added fuel to the physical markets which were already tight after Cyprus. This is what a run on the gold banks looks like. We can expect to see more of this until the scenario reaches a decision point for the COMEX and the LBMA as I described above.

All is not calm in the markets, regardless of what the VIX (NYSEARCA:VXX) currently says. When collateral chains collapse, first there will be a rush to raise liquidity, the beginnings of this we are seeing now with the USDX (NYSEARCA:UUP) up near 84 and the dollar strengthening versus most currencies - except the Yuan. This is analogous to 2008 and the situation after Lehman Bros, except this time the collateral chains that are breaking are not mortgage-backed securities but rather gold-leasing contracts.

Yes, UST rates are rising, but that will only be tolerated for so long. A technical sell-off, which I would put at a weekly close above 3.26% as a preliminary signal, will force the Fed's hand and reveal all of the Fed's talk of ending QE III as nothing more than disinformation. Either it lets yields rise faster or QE will be expanded to hold rates in place. Either way the price of securitized gold will shoot higher like it did during QE I and QE II - as the fundamentals predict it would.

If that yield crisis in either JGBs or USTs does not materialize then the exchanges will be drained of their physical gold at current prices and continue collapsing the gold-leasing collateral chains, creating the need for intervention and dollar settlement - more QE. This only happens if the Bank of Japan holds the Yen in its current range between ¥95 and ¥105.

Either way, physical gold comes out as the winner at these prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.