Tuesday, December 15, 2009

THE GOLD MARKET: The Players, Part II

Central Banks are a very special case as a player in the gold market. They will act in secret and try to have as little impact on the market as they can. When they buy they want as low a price as possible and will refrain from buying if the price is too high, in their opinion. Their purchases will be large, spread over years. Recently it was revealed that the Chinese central bank had doubled its gold reserve. That news excited a lot of people (plus the news that China also told its people to buy gold and began holding talks to use a “bag” of currencies for oil purchases). Lost or ignored was the fact that the change had taken six years to implement and that no one could say when China stopped buying. China has recently said that they would not buy when the price was too high. One person I talk to suggested that the recent push to $1200 was due to Chinese buying. An article I found suggested that the Chinese stopped buying at around $920. No one seems to know.

There are rumors that other nations will begin buying gold for their reserves, putting more upward pressure on gold and downward pressure on the dollar. We won’t know if any bank was buying until well after the fact. Certainly, if countries do try to move away from the dollar, gold will play some part in their strategy. Considering their options, among the currencies of the world, there aren’t many realistic choices. But the moves into gold will not be big, on their scale of things, just considering their interest in keeping the dollar as highly valued as they can. It would do them no good to cause the dollar to plummet, in spite of the warnings of some American writers.

If central banks should be buying, it will be very good for the gold bugs. Central bank buying would be a step into bringing gold back into currency support. It would support the gold price, level out the market some.

Another issue is that the gold held by central banks is currently valued at next to nothing, in the $30 range. Someone wrote that the U.S. government could undercut the market by pricing its gold at market. He didn’t explain how that would work. Everyone knows how much gold is held by the central banks. It isn’t a secret. I don’t think that people take the $30 number seriously. No one thinks that there will be sales from the cnetal banks of any considerable proportions. Who cares how they value it? Even at the market price, the number of dollars held by central banks as reserves would still dwarf their gold holdings. The central banks would want the gold market to be stable. I don’t see the problem, at least based upon what I know today.

Let’s move on to the speculators. Speculators are in and out of markets in short bursts. They go where they see opportunities in short-term price swings. They actually help even out the market and provide a valuable service. One good barometer of a person’s understanding of markets and capitalism is how they regard speculators. Speculators often don’t agree with each other. When they do, the market will swing in their direction, at least briefly. If your goal is safety from the depreciation of the dollar, their short-term activity will have little meaning.

The hedge funds have found gold. They have put a lot of money into gold and gold related investments in a very short time. I think that it is possible that it was their activities pushing the gold prices up in the short-term, maybe even this last push. I read comments from one of them who stated that he was concerned about inflation, price inflation I suppose. He didn’t say why he had this concern. There is a problem with the recent entry of hedge funds into the gold markets, I think. These people are marketers, they want to offer products that people will buy, that is, use it as a place to put their money. The hedge fund makes money, at least in part, from just selling the investment. I expect that this is just a new found opportunity to them, like the tech stocks were in the 90’s. I don’t expect them to stay, at least for the duration. If the economy appears to be coming back and significant price inflation doesn’t pop up in the next year, I expect to see the hedge fund pack up and go somewhere else. The fad will be over. The assets in the hedge gold fund will be either liquidated or sold to another investment company. This may happen slowly, in which case the impact will be minor. I mean, they won’t want to announce that they are leaving. It isn’t good marketing. We may have seen the end of the hedge fund impact on the gold price because they may not have access to more money and the price is high, compared to what it was when they first entered the market. That isn’t a prediction, actually. We will just have to wait and see, just as we will with any other element in the gold market.

Recent articles have also found a few mutual funds, generally more aggressive stock funds, are also investing in bullion and etfs. As far as the safety-oriented person is concerned, their presence, commitment, and understanding of this market should be regarded as just as the hedge funds.

The London Exchange is the primary market for gold in the world. Why am I including it in a survey of different elements that participate in this market? There is a claim that the London Market is practicing a form of fractional banking. That is, they are selling more gold than exists in their safe-keeping. They buy and sell London Good Delivery (LGD) bars of a certain weight and fineness. The estimate is that whether measured in weight or dollar amounts the 100% turnover in LGDs is high, weekly by dollars, daily by weight. I am not too worried about this. People participating in the London market are not going to be seeking to ask for delivery of their gold holdings, at least for a while. If the market starts moving that way, the London market management can move to acquire the necessary gold. If the claim of overselling their supply is true it does mean that the market is less volatile than it would be. Prices might be slightly higher, but the market price would move faster one way or the other to attract the necessary supply or demand. If true, it isn’t a major problem because the London market is not acting like the Fed, for example. They are not constantly making new pretend LGDs. The creation of LGDs is contained to a certain level and no more. My view of the people who are yelling “fraud”, if the allegation is true, is that they are correct to the extent that the London market is doing so and not admitting it. But the significance is far less than the allegations would imply. It would be significant if many of the market participants suddenly demanded delivery of the gold they owned. If that happened, I think we would have many other more serious problems to concern us than the short fall of the amount of gold available from the London market.

Similar concerns have been voiced about etfs, that they cannot have the amount of gold in hand to cover their investors. As a practical matter, this claim could be accurate. You would need to look closely at the prospectus to see what is allowed. (I will look soon.) I expect that as money flows in they have given themselves time to acquire the gold. There might also be provision for holding funds for redemptions. Practicalities aside, I expect that you will find that they work to have a 100% gold backed fund.

The final group that I know of that makes up the gold market is those who are looking for safety from the currency of their own country. They expect their currency to buy less and less stuff as time goes on and gold to at least maintain that purchasing power. These people come from all over the globe and have varying degrees of understanding of the economic, political, or personal freedom issues involved. They have varying proportions of their personal assets in gold, and they own the gold in various forms. As with the other elements in this market, I don’t think it is really possible to discern the size of this group in terms of numbers or dollars. It may be growing, but not fast, not as fast as you would expect. It is a group that will be buying primarily. They will be mainly fully invested, as much of their assets as they have decided to place in gold. They will rarely be sitting waiting with cash in hand for a drop in price. They might be as the price continues higher, but I don’t think that the last few days showed any real support from this group.

Of the groups that I have mentioned, the jewelry and industrial users, the central banks, and those seeking safety are the elements who are in the market for the longer-term and will be the primary upward pressure on the dollar price.

The most helpful inference to draw from this listing is that short-term movements in the gold dollar price do not necessarily reflect a market response to the dollar or the U.S. government’s monetary policies in any significant way. Rumors of strengthening of the U.S. economy will send the gold price down. Rumors or actual changes in U.S. interest rates will send the price down. Strengthening in the U.S. dollar, short-term, maybe daily, will send the price down.

However, as long as the U.S. continues to export dollars, keep interest rates low, especially near zero, and encourage bank credit expansion, there will be upward pressure on the dollar. These problems will continue as long as the U.S. government insists on spending more than it possibly take in by taxes. They will continue for as long as the U.S. government insists on trying to provide services that it cannot possibly afford. They will continue into the next decade as long as U.S. politicians refuse to address the coming fiscal impossibility of Social Security and Medicare funding. There is no reason to think at this time that the U.S. dollar will stop sliding. There is reason to fear a higher rate of price rises in the U.S., including much higher oil prices. There are good reasons to expect gold to continue to rise sufficiently to maintain the purchasing power of your assets.
At this point it is not clear if productive assets will perform sufficiently that their profits will exceed the rate of inflation plus taxes and provide an increase in wealth. That depends upon many coming problems. The first one on the horizon is Obama’s medical bill. Will it promise expansive spending? The next very big one within the next year will be the Fed’s ability to soak up all of the excess Fed member bank reserves that now exist (see other posts). Watch the Fed. I will be and talking about it here.

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