The Bank of England Gold Sale... A Blow to Market Sentiment a Green Light for More Bear Speculation?

Executive Summary

• The UK will reduce its gold holdings of 715 tonnes to an ultimate target of 300 tonnes. In the first year, only 125 tonnes are to be involved. In terms of supply, the impact of the sale is minimal.
   
• Because the UK is a major G-7 country, and because there are no readily identifiable special circumstances to rationalize a UK official sale, the BOE announcement of its intention to sell half its gold reserves is likely to have a more adverse impact on gold market psychology than any other official sector sale to date.
   
• The G-7 central banks have been very cognizant that a major G-7 official sale would have an extremely adverse impact on gold market sentiment and the gold price. The UK's unexpected break from this policy stance on the part of the G-7 central banks provides considerable ammunition to perma-bears who contend that a major new generation of central bankers will dispose of their non-yielding gold holdings.
   
• There have been meetings between the major gold producers and central banks. The central banks acknowledged that fears of official sales were depressing the gold price and provided reassurances that they were in fact unfounded. The BOE's decision to sell gold is a major blow to producer confidence and sentiment and will thereby encourage more producer hedging.
   
• On the recent rally in gold, cyclical stocks were exploding to the upside, the price of oil had risen some 80 percent and other commodities were beginning to follow. The US bond market broke support . The XAU broke out above a downtrend line that defined its three-year bear market. Thursday, the price of bullion broke above several key-moving averages. The resultant technical pattern would have attracted substantial buying interest. At this very juncture the BOE dropped its sentiment-destroying bombshell on the gold market.
   
• The BOE's extraordinarily timed and unique announcement has turned suspicions of orchestrated intervention in the gold market into outright conviction. Funds will be emboldened to sell more gold short, since there is now a prevailing conviction that "City Hall" is behind them.
   
• The BOE's sale will increase the propensity of producers to hedge and speculators to sell gold short. The extent of such short selling will depend greatly on the response of the ECB and the Fed. If either were to indicate any tendency to follow the Bank of England's action, gold hedging and short selling would occur of an unprecedented scale. If, on the other hand, they move to decisively disassociate themselves from the BOE's decision, they may reduce its impact. The odds favor positive statements by the ECB.
   
• Rather than the inevitable supply/demand driven rally we expected imminently, the gold market may trade sideways to slightly down into the summer, when the weight of accelerated short sales , BOE auctions and IMF related events is at its likely peak.
   
• The gold market's supply/demand structure is powerfully bullish long term. This will eventually become apparent. The odds are that a sentiment induced sell-off in gold this summer following the BOE announcement will simply constitute a further phase of base building at the end of gold's 19-year bear market.
   

Who Decided to Sell the UK's Gold…
The Treasury or the Bank of England?

In the unabridged version of this report on the proposed gold sale by the United Kingdom, we have referred to the UK Treasury and the Bank of England interchangeably, implying a convergence of views on the issue. Recent statements by a number of individuals, notably Ms. Haruko Fukuda of the World Gold Council, however, imply a possible split between the two bodies and suggest than the Bank may have been reluctant to sanction the proposed sale. Last Thursday, Mr. Terry Smeeton, former head of foreign exchange and gold at the Bank of England, who retired only last year, made the following statement:

"[The gold sale] is not a policy I would have advocated when I was at the bank. I am sad this action has been taken…It's clearly a Treasury decision in which the Bank has had to acquiesce."

Smeeton was also critical of Britain's timing given its vocal support for International Monetary Fund gold sales to help finance debt relief in Sub-Saharan Africa:

"I find it at best ironic that our government, which has tried to seize the moral high ground with regard to the IMF debt issue, then gets in first with its own sales."

Smeeton agreed that BOE sales would hit market sentiment not only because of the supply being offloaded by the BOE, but also because of the Bank's leadership role amongst London's bullion dealing community and other central banks holding gold:

"It's a pretty seminal event this sale, particularly as the market will see the Bank as responsible for it. Where the Bank goes, others tend to follow," adding that the 11 Euro-zone national central banks might now pressure the European Central Bank to allow them to sell gold." "I was reasonably confident up until last week that the ECB was unlikely to allow the participating central banks to sell anything in the near term. That's probably still the case but I think this must bring forward the likelihood of sales. Whereas it appeared that gold was very much on the back burner, in light of this there may be greater pressure from the other central banks to be allowed to do that."(Reuters, 13 May 1999)

Terry Smeeton represents the accumulated wisdom of the Bank of England as regards the gold market. His statements make it clear that the Bank fully understood the damage to market sentiment and the gold price that it would create by such a sale proposal. Smeeton also notes that the UK auction will hurt the sale of the IMF gold, which Gordon Brown, and other Treasury officials, have been promoting so aggressively over the past few months. For these reasons, Smeeton attributes the decision entirely to the UK Treasury and distances the Bank from it.

We regard Terry Smeeton's statement as notable. We are not alone in this regard. Andy Smith knows Terry Smeeton far better than we do, and argues that "last night's Reuters outburst from former head of Bank of England's gold/forex operations, Terry Smeeton, was remarkable for anyone in the market who knows him even in passing."

Terry Smeeton had a long career at the Bank of England. Trusted careerists at major central banks tend to conduct themselves in a manner, which is consistent with the central bank's ongoing positions after their own retirement. We have to view Terry Smeeton's statement as one, which, in all probability, reflects the views of the BOE. The BOE is probably telling us that this was the Treasury's decision, not the Bank's.

In the Sunday Times of London it was reported that the bank of England was in full agreement with the UK Treasury on the proposed gold sale.

…The Bank defended the sale decision, and insisted that it had agreed with the Treasury on the policy. "This is exactly the way the gold sales were done in the seventies by the IMF," said a spokesman. "We think the markets work best where they have full information."

It is our assessment that Terry Smeeton reflects the real thinking of the Bank of England and that, once the decision was made, the Bank has had to publicly accept the Treasury's position. We understand that the Bank may not only have been forced to acquiesce to the Treasury's decision; it may have been taken by surprise. We understand that, in their public hearing on this issue, the Bank appeared to be unprepared for the questions that were raised.

There is a remarkable degree of controversy and fevered speculation in the wake of the recent decision to sell half the UK's gold reserves. Most extreme has been the following rumor repeated Friday by the widely read Gartman letter:

"There is a rumor sweeping through the markets concerning Mr. Gavyn Davies, one of Goldman Sachs European economists[Ed. Note: at this point, for the sake of transparency, we must note that Goldman Sachs is a long standing and revered client of The Gartman Letter in New York, London, Hong Kong, and Tokyo, on the international equities, metals and foreign exchange desks; thus reporting a rumor concerning Goldman is a bit more difficult than would be the norm, in all honesty. None the less, the rumor is being given such wide dissemination that we've no choice but to report it here] and a close friend and economic advisor of Prime Minister Tony Blair and Chancellor of the Exchequer, Gordon Brown. The rumor suggests that it was Mr. Davies who urged Mr. Blair and Mr. Brown to prevail upon the Bank of England to reduce its gold reserves. The rumor further posits that Goldman Sachs is short 1000 tonnes of gold for future delivery. We are, of course, not privy to Goldman's gold trading position…The rumor, true or not…is becoming more and more widely debated by gold market participants."

We too have heard this rumor from several, apparently unconnected parties. Their ultimate source appears to be one or more high ranking persons in the UK political establishment. We have no material information to contribute, but make the following comments.

First, Goldman Sachs knows the gold market as well as anyone. They presumably have been successful gold traders in their firm's proprietary trading accounts. The firm is noted as well for its strict internal risk controls. Goldman knows that a 1000 tonne short position cannot be readily managed. They conducted a seminar on gold last week, which, we understand, was rather upbeat. We cannot imagine that Goldman was, or is, short 1000 tonnes of gold for its own account.

Second, it is possible that Goldman has a 1000 tonne bullion banking book. In other words, they might have 1000 tonnes of deposits and swaps with 1000 tonnes of gold loans to producers, fabricators, funds, etc. If this is so, it is still a surprise to us. As we have discussed repeatedly in the past, we estimate that there are 37 deposit and swap taking bullion bankers with aggregate gold deposits and swaps of 8500 tonnes from official and quasi-official institutions and from private individuals. We thought Goldman was a second-tier player in this market, holding a deposit and swap position in the range of 300 tonnes. If they have a deposit and swap position of 1000 tonnes, the total volume of borrowed gold outstanding is probably considerably higher than our year-end 1998 estimate of 8500 tonnes.

In any case, if Goldman has a very large 1000 tonne gold swap and deposit position largely offset by gold loans to clients, Goldman would have no obvious reason to encourage the Bank of England to sell its gold. Also, several producers as well as several institutions who attended the recent Goldman Sachs' seminar have reported that Goldman was in fact very surprised by the Bank of England announcement, as reflected by their gold analysts' immediate downgrading of the gold stocks following last Friday's announcement.

Therefore, the rumor about Goldman Sachs makes very little sense on the surface. Nevertheless, the gold market has been hit with extraordinarily large supplies on rallies in recent months, presumably from flows of borrowed gold. Goldman has been reported as a featured seller on all of these rallies, and has been known to warn its major gold producing clients on each successive rise that the gold price would not rally significantly, thereby encouraging them to sell more gold forward.

Recent statements on this subject by the largest gold producers provide some support to such rumors. We quote three such statements. First, Kevin Williams from Anglogold. "There are those others who will question the timing even more aggressively than I am. Why, when the [gold] market looks robust and looks as if it has the bad new built into it does [Bank of England Governor] Eddy George choose this time to drop this news in the market?"

Second, Chris Thompson, Chairman of Gold Fields of South Africa.

"There are parts of this conspiracy theory that I am sure are not true," said Chris Thompson, chairman of Gold Fields, one of South Africa's biggest gold companies. But he said that there was a large amount of circumstantial evidence that investment banks were involved in a plot.

Third, John Wilson, President and CEO of Placer Dome.

John Wilson, president and chief executive of Canadian gold group Placer Dome, avoids words such as conspiracy, but believes malign forces are depressing world gold prices, writes Gillian O'Connor. "I find it difficult to believe, given what (Alan) Greenspan said in the middle of last year, concerning the central banks intention to maintain a low gold price, that there is not some concerted action going on between central banks to hold inflation down through hold down the price of gold," Mr. Wilson says. (Financial Times 5/18/99)

The gold producers quoted above are typically very cautious and conservative. It is not like them to make public statements alluding to an "intention" to manipulate the gold price that cannot be proven. It is our guess that they have heard rumors similar to those now circulating in the markets from sources they consider credible enough to embolden them to make such public statements.

There is no question but that these rumors would have very little credence if the UK Treasury or the Bank had been able to come up with a more convincing rationale for the proposed sale and its curious timing. Neither has been able to do thus far. If there is anything at all to these now widespread rumors, it may suggest that someone in the gold market may be very vulnerable in some way to a strong rally in the gold price. Taken in conjunction with the very perplexing and controversial nature of the action of the UK Treasury, it therefore remains possible that there is a grain of truth to rumors such as this one now circulating through the gold market.