My Oh Why!

It has been a painful few days for those who believe that gold (and silver) are a safe haven from government money-printing machines and the mountain of debt of the Western economies. In the space of two days, gold prices fell just over $200 an ounce (13%) in a frenzy of selling. Silver prices dropped over $4, or 15.6%. The bears were licking their chops. The bulls were licking their wounds.

Why?  There was the flippant answer: gold was in a bubble, gold is a useless barbarous relic. The investment banks came out with their bearish reports. Société Générale was one of the first, then this past week Goldman Sachs advised selling gold. Other investment banks chimed in. There was even a book – Gold Bubble: Profiting from Gold’s Impending Collapse – by Yoni Jacobs.

A story emerged that Cyprus would sell its gold to help pay for its bailout. Cyprus’s gold holdings totalled 13.9 tonnes, or 447,000 troy ounces, with a current market value of about USD 600 million. That would barely make a dent in Cyprus’s bailout needs. The suggestion to sell the gold came from ECB head Mario Draghi, who said that profits from gold sales should be used to cover losses the ECB might sustain from emergency loans to Cypriot commercial banks. In an unprecedented move, depositors’ funds were also to be used to cover some of the losses as a condition of the ECB/IMF loan. This template could be used for future bank bailouts (or in this case a “bail-in”).

The decision to sell the gold was to be made by the Cypriot central bank, which later denied it would do so. The Cyprus parliament has asked the Cypriot central bank to review the request to sell the gold. Irrespective, 13.9 tonnes is barely a week’s demand in China.

The talk of Cyprus selling its gold prompted fears that other countries (Spain, Greece, Portugal, Italy, etc.) would be pressured to sell their gold as well. Under the Washington Agreement of 1999, the European central banks agreed to limit their sales to no more than 400 tonnes annually over a five-year period. In 2012, central banks purchased net 535 tonnes of gold much of it being Asian banks led by China. The European central banks have been consistent in stating that they do not wish to sell their gold holdings.

The trigger to the deluge of selling was the sale on April 12 of at least 400 tonnes (some said 500 tonnes) of gold in the June futures contract. It started with 100 tonnes at the open followed by another 300 tonnes 30 minutes later.

Four hundred tonnes is 12.86 million ounces or 128,600 gold contracts on the COMEX. It has a value of $19.3 billion (or $24 billion if it was 500 tonnes sold) at $1,500/ounce and would require initial margin of at least $760 million and possibly as much as $1 billion. Who would be able to put up that much money in order to execute such a large trade on the COMEX? The order apparently came through the Merrill Lynch trading desk. It was, as one pundit declared, “shock and awe” in the gold market.

The sale was one of “naked shorts”, which means no physical gold was sold. It is highly unusual to drop that much gold on the market at one time. The CFTC is already investigating gold prices to see whether there is manipulation in London by the handful of banks who meet twice a day to set the spot price for physical gold. Following the LIBOR scandal, it probably is not unusual that they would also investigate the setting of gold prices.

It wasn’t physical gold that was sold; it was paper gold. It had the desired effect as it pushed the price down through $1,525, the level that had acted as the low since December 2011 and had been viewed as a line in the sand for the gold market. That immediately triggered scores of stop sells that would have been just below $1,525. The frenzy continued into Monday as further selling came in. The huge selling towards the end of the day was most likely margin calls that would have been triggered by such a substantial drop.

Dr. Paul Craig Roberts, a former US Treasury official, has written that the Federal Reserve is rigging the bullion market in order to protect the value of the US$, which is being threatened by the Fed’s quantitative easing (QE) program. The supply of dollars is growing faster than demand. A fall in the value of the US$ would raise import prices (the US is a net importer with a large trade deficit). It could raise inflation and drive up interest rates and the value of debt-related derivatives. This in turn could put pressure on the “too big to fail” banks.

The US$ has been under attack. The “BRICS” countries are attempting to set up their own version of the IMF and the World Bank. They would not use the US$. China is attempting to set up a Yuan currency-trading zone in Asia. China and Russia already conduct trade in Yuan and Rubles. Other trade deals are bypassing the US$ as the means of trade. Others including Japan and Australia are joining the new currency zone as they depend heavily on trading with other Asian nations and would not want to be left out.

Following the two days of selling gold, the US$ broke down on April 16 as it fell and closed under the 82 support level on the US$ Index. The question now is whether the US$ Index can find support here and regain previous levels. On April 17 the US$ did bounce back on weakness in the Eurozone and rising unemployment in Great Britain. Thus far, at least, the 82 support appears to be holding.

There are potential supply problems for gold. A couple of weeks ago the Netherlands’ largest bank, ABN Amro, defaulted on contracts with its customers for delivery of gold. They were instead paid in Euros:http://www.examiner.com/article/largest-dutch-bank-defaults-on-physical-gold-deliveries-to-customers. ABN Amro customers thought they owned a risk-free physical asset (gold). In fact, they owned an IOU from ABN Amro.

Coin dealers and others continue to report robust demand. The Perth Mint in Australia said that following the sharp drop in prices, its business doubled from the previous week. Long lines have been reported in India and China to buy physical gold, in either jewellery form or coins for investment.

The US Mint has reported strong sales of gold coins following the two-day plunge. Some US states concerned about the policies of the Fed have made gold legal currency. Others are considering doing the same.http://www.bloomberg.com/news/2013-04-08/trust-in-gold-not-bernanke-as-u-s-states-promote-bullion.html.

Premiums to purchase gold and silver coins have widened. A quick check at Silver Gold Bull shows that a one-ounce Cdn Gold Maple Leaf is offered at $150 over spot and a one-ounce Cdn Silver Maple Leaf is offered at $6 over spot. Prior to the collapse the spreads were $100 and $2.50 respectively.

Some central banks view the price drop as an opportunity to add to their gold reserves, according to an interview with the head of the Central Bank of Sri Lanka. The Central Bank of South Korea has reiterated that building gold reserves is part of a long-term strategy for its foreign reserves. As noted earlier, central banks were net purchasers of 535 tonnes of gold in 2012. Central banks are by nature long term planners and are not known to suddenly change strategies in mid-stream. The Bank of China has been slowly selling off US Treasuries in order to diversify its foreign exchange holdings including purchases of gold. Russia has stated its nervousness with western currencies and has been a major purchaser of gold over the past few years to shore up the Ruble.

Every year gold demand has exceeded annual mine supply. The chart below compares production and demand and shows the annual deficits, up to 2011. It was a similar picture in 2012 as the trend continued. The deficit is made up with recycled gold. Mine supply has been growing over the past few years after falling in the early part of the millennium. Following years of falling gold prices in the 1990s. many mines had stopped production because costs exceeded what they could get for their gold. With the recent sharp drop in gold prices, could that happen again?
                                Source: www.sharelynx.com

Anything is possible, and the recent drop in prices could make a number of mines only marginally profitable. The all-in cost of producing gold generally ranges between $850 to $1,250 an ounce, depending upon the capex involved in bringing a project into production.

A decline in the price of gold to $1,300 or even lower could make a number of mines marginal and as a result, there could then be the risk of closures. Mining companies might also be forced to return to hedging, a strategy many used during the 1990’s in order to protect themselves. This in turn would add to the selling of gold although in this case the miners are selling their production forward.

Even as the gold price was rising in the early years of the millennium, mine production actually fell. Closed mines cannot be reopened instantly just because the price is going up. 

Mine location is also important. Political risk is higher in some countries than in others. China is the world’s largest producer, with some 370 tonnes of production in 2012. However, all the production stays in China.

The junior gold explorers and miners are in a deep depression. Their stocks have fallen to levels where some are trading below their cash holdings. With the malaise in the market (the TSX Venture Exchange (CDNX) is down 74% from its 2007 highs and 62% from its 2011 highs), companies are having difficulty raising funds to continue exploration programs. It is estimated that upwards of half of the junior exploration miners have run out of cash and as a result they just stop their drill programs and move to the sidelines. This means there is no new supply being found and that could translate into lower production later, as other mines mature.

A sharp drop in exploration eventually translates into fewer discoveries. Fewer discoveries translates into lower supply in later years. Even at that, the gold deposits being found today are of lower grade and lower size then what has been found in the past.

Even new mines are having problems. Recently Barrick Gold (ABX-TSX) announced the postponement of the Pascua Lama mine in Chile. It was to be one of the largest in the world but it is now tied up in litigation over ownership as Barrick appears not to have clear title. The mine’s reserves are 18 million ounces of gold and over 700 million ounces of silver. This is a potential large source of production that could be off the market for some time.

Last week there was a reported “landslide” at the giant Kennecott copper mine in Utah. Kennecott is the largest copper mine in the world. It has also produced 400,000 ounces of gold and three million ounces of silver as by-products of copper mining. It is unknown when the mine will come back on stream. While the size is not that large for gold and silver, what is significant is that supply has been taken off the market.

The chart below suggests that COMEX gold supplies have fallen almost 25% since late 2010. There are 9.2 million ounces remaining, or 286 metric tonnes. This is why the sale of 400 or 500 tonnes last Friday is so significant. It overwhelms the current supply of the COMEX, even though a short position would have to deliver rather than take delivery. The remaining supplies at the COMEX pale in comparison to the naked short position. There has also been a large drawdown at the JP Morgan Chase Depository Gold Stocks. There the stocks have been cut almost in half since early 2012.

Some have mused that there is something bigger at play, especially given the huge naked short positions put on last Friday. Under normal conditions, those positions would have to be covered prior to the June contract expiration or rolled over into a further-out date contract. They are unlikely to deliver.

But what if the COMEX defaulted prior to the expiration of the June contract? The naked shorts would then be settled in cash, just as the customers of ABN Amro were. This is not to suggest that there is impending default at the COMEX, but some see the huge short position as a possible set-up to a default. Settling the contracts for cash at expiration would be less disruptive to the market than the naked shorts either covering in the market or rolling over.

Source: www.sharelynx.com

So where is gold going? Could it fall further? If it was falling from a distribution top there is potential for it to fall to measured objectives near $1,190 – a further decline of about $150 from the lows this week. As the chart shows, it broke sharply once it busted through what may be the neckline of the topping pattern. Gold has found possible support at the four-year moving average. Note how the four-year MA held the plunge during the 2008 financial crisis.

A line was drawn from the lows of 1999 at $250 to the high of September 2011 at $1,912. A parallel line was drawn up through the 2008 low. Gold prices have also tested down to that potential support trendline.

Other trend lines lie below. The trendline (blue line) up from the 2005 lows through the 2008 low comes in around $1,040. That would fit with the measured move objectives noted above. A slow rising trendline comes up from the 2001 lows, also near $250, through the 2005 lows. This trendline comes in around $700, which fits with Yoni Jacobs gold bubble book.
 
Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

Some veteran gold analysts have noted a possible comparison with the current market and the sharp correction experienced by gold in the mid-1970s. After Richard Nixon took the world off the gold standard in August 1971, gold began to trade freely. It rose steadily from $35 in 1971 to a peak of $190 by December 1974. It then fell into a significant correction and did not bottom until 20 months later in August 1976 at $101.50.

The current market topped in September 2011 at $1,912 (roughly 10 times the 1974 peak) and has now been in a downtrend for 19 months. At the time many were declaring that the gold rise was over, that gold was in a bubble and that it would fall all the way back to $35. Many even declared the commodities bull market over.

It was, however, from that low that the real rise in gold got underway and by January 1980 gold prices reached a high of $875, a 760% rise from the 1976 lows. The catalyst? Negative real interest rates, rising inflation and a falling US$. Today the market has negative real interest rates, possible deflation and a US$ under attack.
 
Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

this. Was it because they saw an opening to break the stop sells in the market under $1,525 or was it a deliberate attempt to shake confidence in the gold market? It raises questions as to whether there might be a problem at the COMEX itself.

On the other side, it could be interesting to see what Russia and China do. Both have been major buyers of gold to shore up their foreign reserves and because of their concern with the US$ as the world’s reserve currency. Overall, there are more questions then there are answers.

There are now signs that the US stock market is poised to break down. Interestingly in 2007 and 2008, gold broke down before the stock market broke down. Critics say that the gold price only goes up in times of inflation. But it also goes up in times of deflation. The 1930s was an excellent example as Roosevelt raised the price of gold from $20.60 an ounce to $35, a 70% increase in 1934. The hike followed his confiscation of bullion and was done to support the US$ and combat deflation. It should be noted that during that time, while the Dow Jones Industrials was falling 89% from 1929 to 1932, Homestake Mining (today Barrick Gold) rose 55% in the same period, and by 1936 was up 500% from its late 1929 levels.

So what’s next? Even as gold maintains its fundamentals, there has been technical damage, which could take a few months to repair. The market may not have made its final low given, potential objectives down to $1,190 or even lower.  If that does occur, the suspicion is that it would probably occur quickly as has been seen over the past few days. The question is who can gain the upper hand – speculators or investors?

A large number of longs are underwater in the futures markets or have been forced out through stops or margin calls. Those in the physical gold market are unlikely to do anything. Those in the physical market tend to be in this for the long run, and given that the fundamentals remain as strong as ever they would not nor should they be shaken out by this rapid drop. 

As to those fundamentals: the Fed, the BOJ, the BOE and the ECB are not going to end their QE programs any time soon. The programs are propping up the bankrupt banking system. The Fed may talk about easing up on QE but the reality is they cannot, as the “too big to fail” banks are still burdened with toxic assets that they cannot sell. The Fed’s QE program is mopping up some of those assets and the Fed’s balance sheet is probably going to grow by another trillion dollars this year. If the Fed pulled its QE program the stock market would fall and interest rates could rise. The US Treasury cannot afford to have interest rates rise as it could send their $16.8 trillion of debt into a downward spiral. The interest payments alone would “eat up” a much larger part of the US federal budget.

Gold rose over the past 12 years not because it was in a speculative bubble as some would declare but because it was a reaction to the deteriorating fundamentals of the western economies. Debt in the US, the Eurozone and Japan has increased sharply over the past dozen years and there are few if any signs that this will abate. Efforts have been made by the central banks to debase their currencies. In 2001, US$1000 would have bought roughly 3.3 ounces of gold at $300. Today despite the fall over the past week, US$1000 would only buy 0.7 ounces of gold at $1,400.

US government debt has grown from $10 trillion at the time of the financial collapse of 2008 to $16.8 trillion today. The US monetary base has grown from roughly $900 billion when Lehman Brothers collapsed in September 2008 to over $2.9 trillion today. The Fed is purchasing $85 billion a month in government and mortgage securities. The monetary base has grown roughly $100 billion a month since the start of 2013. The rise in the price of gold has a close correlation to the rise of debt and the monetary base over the past 12 years.

It is a concern as to who was behind the huge sell order on Friday. Was it speculators (i.e. Hedge funds) or a central bank (i.e. the Fed)?  And there remains a mystery as to why they would do Then over the following months, the two seesawed. When gold fell stocks rose and when stocks fell gold rose.  By the time the stock market made its final low in March 2009 gold was already well on its way back to its pre-crash highs. Could gold be signaling a looming plunge in the stock market? Phase two of the 2008 financial crash may soon be getting under way.

 

copyright 2013 All Rights Reserved David Chapman

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