Cyprus and Gold

I guess it would not be an understatement to say that this has been a dramatic week. In the space of a couple of days, gold prices have fallen $42. It would not be a further understatement to say that it has probably shaken quite a number of people. If the weak hands were not out before they are probably out now. They could also be making a big mistake.

The trigger for the sudden decline this week seems to have been an article in Emerging Markets that outlined that strategists from Societe Generale, the big French bank, were “considerably more bearish than consensus” on gold. Soc Gen believes that gold prices could fall another 15% this year that could see them fall to $1,375.  Others such as Credit Suisse and Scotia Mocatta have also “piled” on with a negative outlook for gold. Soc Gen, Credit Suisse and Scotia Mocatta are market-making members of the London Bullion Market Association (LBMA). Other members include Barclays Bank, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Merrill Lynch International, Mitsui & Co, and UBS.

When sentiment gets bearish it can get downright “ugly” it seems. Today bearish sentiment for gold is at all-time highs or is it lows. Bearish sentiment for gold stocks is even more so and for the down, down, down TSX Venture Exchange the bearish sentiment seems to have fallen off the charts.

Are they right? Maybe, maybe not. The bearish premise for gold has been that economic conditions have been improving and therefore it could justify an end or at least an easing of the Fed’s money-printing machine; that fiscal stabilization in the US would bring a new era of growth; and, that the US$ has been benefitting from the crisis in Europe and that the US economy would continue to outperform sending the US$ higher and the Euro lower.

It is argumentative as to whether the economy is improving. The Euro zone has 12% headline unemployment. Greece and Spain have 26% unemployment with youth unemployment as high as 60%. Unemployment is growing in Italy as well and 1,000 businesses a month are failing. The Euro zone is mired in recession and countries such as Greece and Spain are in a depression. Even the countries that do have growth such as Germany, the Scandinavian countries and Britain, the growth is anaemic at best or questionable.

Japan’s growth is also anaemic and they are embarking on a more aggressive QE program to tackle deflation. Japan thought there economy was coming out of its deflationary spiral and ended its previous QE programs in 2006 only to see their economy plunge back into a downward spiral following the 2008 financial crash. Japan shocked the markets with an announcement overnight that they were they were going to target the monetary base and double its bond purchasing program over the next two years. The program is unprecedented in its aggressiveness. The Yen fell overnight and the Nikkei Dow stock market closed near its recent highs. 

Many believe that the US’s QE program is meant more to prop up the shaky banking system. The five major banks in the US have over $300 trillion in derivatives alone on their books of which an unknown percentage is underwater. Banks in order to attempt to have some growth and to satisfy demand for yield have been securitizing car loans in much the same way as they did with sub-prime mortgages. Many believe that much of the $1 trillion outstanding in student loans is uncollectable as students struggle to find a decent paying job following graduation if they can find one. Some 10 million homes in the US are in homes where the mortgage is worth more than the house. Housing prices and building have improved but evidence suggests that much of the improvement in housing prices is been driven by speculators not end buyers. Housing starts are bottom bouncing not showing any real improvement and unemployment remains high at 7.7% for the headline number and labour force participation has been falling which helps lower the unemployment rate. 80% of the US population control only 5% of all financial assets. The economy may be improving for some but for most the economy has deteriorated. 

The White House and Congress remain locked in partisan disagreement about the fiscal situation. Thus far all they have done is push the day of reckoning down the road while allowing an increase in the payroll tax and the “sequester” is kicking in with automatic budget cuts.

That the US economy might be somewhat better than the Euro zone and Japan is moot. There is evidence as suggested by Shadow Government Stats www.shadowstats.com that the US has been mired in a recession since 2000 except for a brief respite in 2004. Shadow Stats also show a much higher rate of unemployment and inflation then is being reported. Years of changing the methodology of calculating GDP, unemployment and inflation have ensured that the headline numbers being reported show a better picture that what really exists.

Psychology can sometimes mask the real picture. The result is to create a detachment between what is really going on. Gold is considered to be an alternative currency. What better than to have the US$, the fiat currency, going up and gold, the hard asset currency, going down. The US$ is under attack. Japan wants to push its currency lower in order to revive its competitive position. Japan’s attempt to devalue their currency is causing problems in Asia since many Asian countries are exporters like Japan.

The BRICS (Brazil, Russia, India, China and South Africa) nations are in the process of setting up their own alternative financial system. Last week the BRICS announced that they planned on setting up their own development bank and contingency reserve that would challenge the supremacy of the World Bank and the IMF two US controlled institutions. They also would not be using the US$ the recognized world’s reserve currency. China has been working to set up a Yuan currency zone in Asia and agreements are already in place between China and Russia and between others that no longer use the US$ as the means of trade.

Then there was Cyprus. Cyprus was a game changer as for the first time in the Euro zone depositors found themselves at risk to bail out bank failures. This was not supposed to happen. In the US and the Euro zone following the 2008 financial collapse, it was the taxpayer that bailed out the banks. As the Euro zone banking crisis intensified over the past few years it was once again the taxpayer that bailed out the banks. In the Euro zone that should be more specific as the bailouts were led by Germany. Germany also called for austerity programs. That led to massive unemployment, sharply falling GDP and social unrest across much of the Euro zone particularly in the periphery countries. Britain followed the same template with taxpayer bailouts and austerity programs.

The G20 and the Bank for International Settlements (BIS) have put in motion bail-ins so that the taxpayer is no longer on the hook. It will be the depositors. Britain and the US already have an agreement in place since 2010. On pages, 144-145 of the recent budget tabled by Finance Minister Flaherty the government has proposed to implement a “bail-in” regime for systemically important banks. The bullet goes on to say the “bank can be recapitalized and returned to viability through the very rapid conversion of certain bank liabilities into regulatory capital. This will reduce the risk for taxpayers.”

The proposal in the Canadian Federal budget has caused considerable controversy such that the government was forced to issue a disclaimer that depositor’s funds were not at risk and that CDIC still protected depositors up to $100,000. They also tried to suggest that the bank’s capital would be at risk and other assets sold to cover losses. That the banks’ capital would be at risk in a systemic collapse is a given. The question is how will it be recapitalized? Up until Cyprus it was the taxpayer that bailed out the bank. Not any more, it seems. All of this emanates from the G20 and the BIS. Europe, Britain and the US already seem to have put in place the ability to go after depositor’s funds. Cyprus was the first test. There could be more in the event of further bank collapses. 

In Cyprus, the large depositors are paying the price potentially losing some 60% of their funds. It seems that the small depositors would be protected but the large depositors may see a considerable loss in the event of another systemic banking crisis along the lines of 2008. That event cannot be ruled out as most of the world’s banks are undercapitalized and many especially in Europe and even the large money centre banks in the US are derisively referred to as “zombie banks”.

Against this background, it seems surprising that gold prices would be falling. One would think they should, if anything, be going up. Sure, there is evidence that the ETFs such as the SPDR Gold Trust (GLD-NYSE) have been losing assets. On the other side there is evidence to suggest that physical demand is quite high. Spreads for both physical gold and silver over spot remain firm. Both the US Mint and the Royal Canadian Mint have had difficulty keeping up with demand. At one point, the US Mint actually suspended sales of “silver eagles”. Yet the price of silver was falling sharply over the past two days along with gold. Demand in the Mid-East and Asia remains strong as does evidence of central bank buying. It was reported that Turkey’s gold imports hit an 8-month high in March and silver imports in March were 31% higher than the previous month.

What all this suggests is that there is growing disconnect between paper gold as represented by futures, options and ETFs such as the GLD and the physical gold market. Not noticed is that the open interest in the gold COT as reported by the CFTC has been falling. It was especially the case in last week’s COT report. Since the Cyprus crisis broke a couple of weeks ago, open interest on the COT has fallen roughly 10%. Falling open interest suggests that the recent decline is corrective and not the start of a new trend to the downside.

There are those that believe that this week’s action in gold and silver is manipulation. In an interview with former Assistant of the US Treasury, Dr. Paul Craig Roberts he intimated that the current action is an orchestrated move by the Fed against gold and silver in order to protect the exchange rate of the US$. The US is creating $1 trillion a year in new US$ per year through QE. The US monetary base continues to grow and the Fed’s balance sheet has expanded to over $3 trillion. Given that over $1 trillion of the Fed’s balance sheet is largely mortgage backed securities (MBS) purchased from the banks there is little likelihood that the Fed would be able to unload the portfolio.

The world, however, is trying to move away from the US$. Witness the moves by China and the BRICS as noted above. All of the current moves are designed to gain time for the financing of the US deficit and to keep interest rates at effectively 0%. The moves by the G20 and the BIS in setting up the capability to seize bank deposits is the means to continue to finance the banks and ultimately the US deficit. Where Canada stands in all of this is a mystery but according to Flaherty’s budget, the wheels have been set in motion for the same thing in Canada.

The long-term chart of gold shows that gold remains in a long term uptrend. Gold has slipped under the 18-month moving average for only the second time since the uptrend got underway in 2001. The other time was during the 2008 financial crash. Note the series of triangular patterns that were formed during the uptrend. The current triangular pattern is one of the largest thus far signifying that this is an important consolidation. If gold were to break under the lows of December 2011 a decline towards the uptrend line currently near $1,375 to $1,400 could get under way. Soc Gen’s forecast would be fulfilled.

On the other hand, the risks remain high. Geopolitical risks are in North Korea, Iran, Syria, the Israeli/Palestine conflict and the conflict between China and Japan over the islands in the South China Sea. With the collapse of the offshore banking centre in Cyprus focus could shift to other offshore banking centres in Luxemburg and Slovenia in the EU and even to the Cayman Islands in the Caribbean. There are risks of a major default in Italy and Argentina. Nervous bank depositors in Spain and Greece and elsewhere could get nervous and start a bank run. Russia has expressed its displeasure to Germany about the seizure of Russian deposits in Cypriot banks. Could Russia somehow retaliate? Not likely and if they do they will bide their time. Russia has been active in the gold market over the past few years as its central bank continues to shore up the Ruble with gold purchases. The program could be accelerated and that in turn would create further demand for physical gold.

The sentiment towards gold is extremely bearish. The drop over the past two days has caught many off guard. On the other hand there is some evidence being suggested that this drop has been orchestrated. The COT is suggesting that this is corrective only. There is evidence of strong physical demand whereas the drop in price is coming from the paper gold market. As long as the December 2012 lows near $1,525 holds a reversal could soon get underway.

 

copyright 2013 All Rights Reserved David Chapman

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