Part II: Gold Keeps
Rising as Other Commodities Fall
This article appeared in AToL
on November 24, 2010
As the Federal Reserve engages in serial quantitative easing
to release more fiat dollars into the US banking system to enlarge the
supply to try in vain to push on a credit string to revive a gravely
is already weighted down with excess debt and misdirected liquidity,
express purpose of lowering long-term interest rates, gold keeps rising
as other commodities fall because gold is a monetary metal, not just an
industrial commodity. Gold has not increased in value; only the dollar
declined in value as the price of gold rises.
The 28-years-long record high in gold price, at $850 per
troy ounce, set at the London p.m. fix on January 21, 1980, had since been broken several
times in January and
February 2009, hitting a then all-time high of $1,218.25 on December 3, 2009. It was
broken again at
$1,231.41 on August 19, 2010
and again at $1239.50 on August
25, 2010.This reflects the
decline in the value of the fiat dollar in gold of constant value.
The actual inflation-adjusted record high set in 1980 would be $2,387
dollars, or 71% higher than it closed on November 9. Gold is a hedge
weak dollar, not a hedge against inflation.
Gold futures on the COMEX Division of the New York Mercantile
Exchange posted strong gains on Monday, August 16, 2010, as weak
exacerbated investor nervousness about the slow pace of global economic
recovery despite central banks, led by the Federal Reserve, having
interest rates near zero, desperately resorted to quantitative easing
deflation without visible effect. This sparked some safe-haven-driven
for gold on fears of more central bank quantitative easing. The most
gold future contract for December 2010 delivery rose $9.60, or 0.8%, to
at $1,226.2 per troy ounce. Gold reached $1,350 per troy ounce on October 5, 2010. December
delivery reached $1500 per troy ounce on the same day.
The smart money, having already been long on gold for decades
in the context of fiat money released by panicky central banks,
view the price of gold as vulnerable to potential central bank upward
manipulation in the face of general deflation risk in commodity markets
prolonged financial crisis. Investors are poised to push price of gold
$1,500 per troy ounce before 2010 ends.
Gold breached $1,280
per troy ounce for first time in history on Friday, September 17, 2010 and traded at $1350 on October 5, at $1,372
on October 18, 2010, at $1,395.5 on November 5 and topped $1,400 for
time in history on November 8 amid market uncertainty on the outcome of
currency talks in the up-coming G20 summit in Seoul, Korea and renewed
over sovereignty debt in the eurozone.
On November 9, gold
touched an all time high of $1,424 an ounce as the market reacted to
the Fed’s $600
billion QE2 injection into the US
banking system and to World Bank President
Robert Zoellack’s surprise call for including gold in a new currency
based on a
basket of dollars, euros, yen and yuan.
Still, that record gold
price after adjusting for inflation remained below the peak set in the
1980s, which meant gold price still has some climbing to do, or the
the fiat dollar has more to fall, along with other fiat currencies that
their exchange value with the dollar’s value in gold.
analyst David Greely in mid-October raised his 12-month target for gold
$1,650 an ounce from $1,365, saying that the Fed’s monetary easing
keep interest rates low and spur gold purchases.
In the week ending Thursday,
October 7, 2010, gold notched what were then new records
the fiat dollar as bullion made a clean sweep of all other currencies.
its gains against the dollar, bullion’s 2.2% advance versus sterling
list, followed by a 2.0% gain in yen and a 1.5% appreciation against
franc. Gold managed to climb 0.8% in euro.
Bullion is the term used to describe precious metals like
gold, silver and platinum in a bulk form such as bars (ingots), plates
coins. Bullion is used to store valuable metals in an easily measurable
form. The purpose of bullion is to use
precious metals as a store
of value; bullion is typically stamped with a given weight and
gold, 24k gold, etc.) to make it easy to account for.
For the same week, the dollar’s performance was highlighted
by the following:
Morning gold fixes in London
averaged $1,332, wrapping up the week 3.7% higher at $1,360;
COMEX spot settlements averaged
$1,330, but finished only 2.0% higher at $1,334;
Average daily gold futures volume
fell 3.9% to 142,055 contracts; open interest rose from 4,753 contracts
COMEX gold warehouse stocks
increased by 62,929 ounces (2.0 tonnes) to 10.960 million tonnes;
on that day covered only 17.6% of open interest;
One-year gold lease rates slipped
to 0.26% or 26 basis points (1 bp = 0.01 percent) while three-month
rates held steady at 0.3975%; SPDRGold
fell by 16.2 tonnes (521,935 ounces) to 1,288.5 tonnes.
are shares of a family of exchange-traded funds (ETFs) traded in US and
markets and managed by State Street Global Advisors (SSgA). Informally,
are also known as Spyders or Spiders.
SPDR is a trademark of
Standard and Poor’s Financial Services LLC, a subsidiary of McGraw-Hill
The name SPDR is an acronym for the first member of the
family, the Standard & Poor’s Depositary Receipts (NYSE: SPY),
biggest ETF in the US,
which is designed to track the S&P 500 stock market index.
The risk trade resumed in the week ending October 7, 2010 as
investors favored junior gold mining shares over established producers;
the Market Vectors Junior
Miners ETF(GDXJ)gained 2.8% versus a 1.2% rise in the Market Vectors Gold Miners
the Gold Miners (GDX/GDXJ) Ratio fell from an
average 1.66 the week before to 1.65; the S&P 500 Composite Index’s
correlation to gold producers rose 5 points to 14%; the blue-chip
correlation to bullion climbed 16 points to -3%.
WTI (West Texas Intermediate) crude oil prices rose 2.1% to
close out the sameweek at $81.67 per
barrel; the gold/oil multiple continued to fall, dropping from 16.8x to
TED is an acronym formed from T-Bill and ED
(Eurodollars), the ticker symbol for the Eurodollar futures
contract. The TED spread is the difference
the interest rates on London
loans and short-term US
government debt (T-Bills). Initially, the TED spread was the difference
the interest rates for three-month US Treasuries contracts and the
Eurodollars contract as represented by the London Interbank Offered
However, since the Chicago Mercantile Exchange dropped T-Bill futures
1987 crash, the TED spread is now calculated as the difference between
three-month T-Bill interest rate and three-month Libor.
Futures contracts in general and Treasury bill futures in
particular, are taxed in the US
in a manner that provides individual investors with an opportunity to
taxes on gains and to take full tax deduction of losses. The Internal
Service (IRS) considers all futures contracts to be capital assets.
other capital assets, however, the holding period for long-term gain is
months for futures contracts but only long positions qualify. All gains
losses on short positions are short-term regardless of the holding
asymmetrical treatment of long and short positions gives individual
an opportunity to profit at the expense of the government by taking all
as long-term capital gain at lower tax rates and all losses as
full tax deductions.
One-year TED spreads ending December 31, 2010 (an indicator
of banks’ willingness to lend to each other) averaged 53 bps (basis
points) - a
point higher than the previous week - on lower Treasury yields;
spreads also rose a basis point.
three-month Treasury Bill rates and three-month
Eurodollar deposit rates generally move together - rising in times of
tightness and business cycle expansion and declining with monetary ease
cyclical weakness - the co-movement typically is not exactly equal. The
spread, which reflects the difference between these two interest rates,
offer some attractive trading opportunities to investors/speculators
correctly anticipate such differential movement between the two rates.
Finance rates embedded in COMEX gold futures traded at a 23
bps discount to one-year Treasuries; the discount started to narrow
late-week decline in yields; the one-year gold contango
averaged $10.70 an ounce, but finished the week at only
depicts a pricing
situation in which futures prices get progressively higher as
progressively longer, creating negative spreads as contracts go further
time. The increases reflect carrying costs, including storage,
insurance. It is a term used in the futures market to describe an upward
sloping forward curve (as in the normal yield curve). Such a forward
said to be “in contango” (or
Formally, it is
situation where, and the amount by which, the price of a commodity for
is higher than the spot price, or a far future delivery price
than a nearer future delivery. This is a normal situation for equity
The opposite market condition to contango is known as backwardation.
A contango is
normal for a non-perishable commodity which has a cost of carry. Such
include warehousing fees and interest forgone on money tied up,
less revenue from leasing out the commodity, as in gold.
For perishable commodities, price differences between near
and far delivery are not a contango.
Different delivery dates are in effect entirely different commodities
case of perishables, since fresh eggs today will not still be fresh in
months’ time, 90-day treasury bills will have matured, and so on.
The contango should not
exceed the cost of carry, because
producers and consumers can compare the futures contract price against
price plus storage, and choose the better one. Arbitrageurs can sell
buy the other for a theoretically risk-free profit to bring the price
line. In a futures contract, for no arbitrage to be possible, the price
delivery (the forward price) must be the same as the cost (including
of buying and storing the asset. In other words, the rational forward
represents the expected future value of the underlying discounted at
free rate (the “asset with a known future-price”). Thus, for a simple,
non-dividend paying asset, the value of the future/forward, will be
accumulating the present value at a specific time to maturity by the
Investors need to be aware of return-killing factors through
contango. Since contango is a phenomenon when nearby, or front-month,
contract prices are higher than spot prices, that means when expiring
positions held by an exchange trade fund (ETF) such as the United State
Fund (NYSEArca: USO) are rolled over to the next nearby contract,
diminished. That can really add up and cause returns on funds such as
vary significantly from spot oil prices.
If there is a near-term shortage, the price comparison
breaks down and contango may be
reduced or perhaps even reverse altogether into a state called backwardation. In that state, near
prices become higher than far (i.e., future) prices because consumers
have the product sooner rather than later, and because there are few
who can make an arbitrage profit by selling the spot and buying back
future. A market that is steeply backwardated
— i.e., one where there is a very steep premium for material
for immediate delivery — often indicates a perception of a current shortage
in the underlying commodity. Similarly, a market that is deeply in contango may indicate a perception of a
current supply surplus in the commodity.
For example, in 2005 and 2006, a perception of impending
supply shortage put the crude oil market into backwardation.
Traders simultaneously bought oil and sold futures
forward. This led to large numbers of tankers loaded with oil sitting
ports acting as floating warehouses. It was estimated that perhaps a
barrel premium was added to spot price of oil because of this backwardation. If such is the case, the
premium may have ended when global oil storage capacity became
exhausted; the contango would have deepened, as the
lack of storage supply to soak up excess oil supply would have put
pressure on prompt prices.
However, as crude and gasoline prices continued to rise
between 2007 and 2008 to peak at $139 per barrel, this practice became
contentious that in June 2008, the Commodity Futures Trading Commission
the Federal Reserve, and the Securities and Exchange Commission (SEC)
to create task forces to investigate whether this took place.
A crude oil contango
occurred again in January 2009, with arbitrageurs storing millions of
in tankers to profit from the contango.
However, by the summer, that price curve had flattened considerably.
The contango exhibited in crude oil in 2009
explains the discrepancy between the headline spot price increase
$35 and topping $80 in the year) and the various tradable instruments
oil (such as rolled contracts or longer-dated futures contracts)
showing a much
lower price increase. The United States Oil (USO) ETF also failed to
crude oil spot price performance.
BIS Gold Leasing
One reason Bank of International Settlements (BIS) gold-swap
activities incite controversy is because, on the face of it, the BIS -
the central bankers’ central bank - is not supposed to lend
commercial banks. However, via its gold-swap the BIS has clearly found
around this restriction.
BIS Statute Article 21 (a) states:
“The Board shall determine the nature of the operations to
be undertaken by the Bank. The Bank may in particular: (a) buy and sell
coin or bullion for its own account or for the account of central
So essentially the BIS is free to buy and sell to whomever
it wants in connection with its own bullion account: that is to say as
its own market operations.
According to the World Gold
banks are investment banks that function as wholesale suppliers dealing
large quantities of gold. All bullion banks are members of the London
Central banks have always leased out their gold to bullion
banks to make their assets work for them. This was particularly the
gold prices were stagnant, with little scope for asset appreciation,
forcing central banks to seek revenue for the gold it holds.Central banks would lease their gold to the
bullion banks for a price just less than the going interbank market
rate — or
what they perceived would cover their credit risk by some basis points.
The Bullion banks, to make profit from BIS gold leasing —
and to protect against falling gold prices – acting as market makers,
lease the gold forward at a higher price and invest the proceeds at the
official market rate, hence capturing the so-called implied lease rate
to Libor minus the gold forward rate). These central banks’ own
then be market neutral to gold price volatility, and they could then
profit by a
Gold producers like Ashanti
and Barrick were keen to be on the other side of the central bank gold
to hedge the future sales of their gold production or to help finance
production. They did this by taking advantage of the gold contango
carry trade, much like in the oil market. The cost of
financing and sound credit relationships are critical conditions needed
These conditions (low financial cost and solid credit) disappeared
with the bankruptcy of Lehman on September 15, 2008. As credit risk rose, the
central banks pulled out of the
gold leasing market substantially – since there was no incentive for
lend their gold against rising credit risk. It was also close to
find credit-worthy counterparties.
Central bank withdrawal from the gold leasing market would
have put downward pressure on gold forward rates. However, because
presence was replaced by bids from the private sector (which had higher
costs), the effect pushed gold forwards to rise relative to Libor. The
banks stopped leasing gold when lease rates went below 10 basis points
to cover their credit risk. Meanwhile the reason lease rates went
because investors were lending gold against borrowing dollars through
forward purchases on leverage for forward delivery, pushing up gold
As Libor fell, GoFo (gold forwards) fell but not as much as Libor.
With most investors going long on gold against the dollar,
with more expensive financing costs than the highly rated bullion banks
long in the market and looking for a return via the contango
trade financed with leverage — lease rates ultimately
gold interest rates are lower than fiat dollar interest
rates because gold is safer. This gives a positive figure for the
meaning that forward rates are at a premium to spot. This condition is often referred to as contango.
On very rare occasions when there is a shortage of metal
liquidity for leasing, the cost of borrowing metal may exceed the cost
borrowing dollars.Under such conditions, the forward
differential becomes a negative figure, producing a forward price lower
or at a discount to, the spot price, creating a backwardation.
Market participants borrow money from banks that grant them
leverage facilities at a margin. For a hedge fund, that margin can be
large, up to Libor +200 basis points outright just to leverage a long
position, which is much higher than for a central bank whose credit in
unquestionable. Under such conditions, it makes sense for a central
lend dollars and get the gold as the security. Then all participants in
market are long and the marginal cost to borrow then is much higher
which pushes gold forwards up.
Central bank arbitrage has since appeared to have been
reversed, largely because the amount of gold that is in the system is
the market can profitably finance. From the BIS perspective, gold
rates might have finally become steep enough for it to arbitrage the
Under such conditions, eurozone institutions became simply
matching BIS cash with the gold length that was already in the market
happened to be in need of financing.
A central bank doing a one-year trade on gold would buy gold
for payment on October 31,
at $1200 and sell it back for payment on October 31, 2011 at $1208.88. For one year, the
bank can take the gold and put it in its vault and gets a return of
or 0.74% interest on its dollar investment (8.88/1200 = 0.74% = 1yr
on the LBMA website). This trade is known as cash and carry arbitrage.
banks, with a massive amount of cash and a gold vault, are in the best
to do cash and carry arbitrage.
For example, the yield on long bond climbed 23 basis points,
or 0.23 percentage point, to 3.98%, from 3.75% on October 8, according
BGCantor Market Data. It touched 4.01% on October 20, the most since
The increase was the biggest since a 31-basis point jump for the five
ended Aug. 7, 2009.
3.875 percent security due end of August 2040 dropped 4 3/32, or $40.94
$1,000 face amount, to 98 5/32.
The London Bullion Market Association (LBMA) was established
in 1987 to represent the interests of the participants in the wholesale
The LBMA comprises: 10 market making members who quote
prices for buying and selling gold (and silver) throughout each working
8.00 am until 5.00 pm (See also: LBMA Market Makers) 44 ordinary
covering a wide range of banks, trading companies, assayers and
and security companies 24 international associates; a category of
that was introduced during 2000.
The LBMA works with The Financial Services Authority (FSA), which
the major market participants, who operate under the London Code of
Customs & Excise on tax policy, such as Value Added Tax
The LBMA Maintains the London Good Delivery List for gold and silver
its Physical Committee
The LBMA organizes an annual Precious Metals conference. The inaugural
took place in Dubai in
2000, a second LBMA conference was held in Istanbul
in May 2001, with a third one following in June 2002 in San
Francisco. A fourth Precious Metals conference
in Shanghai in 2003.
The long Treasury bond maintained an average 3.71% yield on
October 16. 2010, but weakening rates at the short end steepened the
curve 2 bps to 0.358%. The euro gained 2.0% vs. the US dollar,
week at $1.3945 after averaging $1.3759.
Daily reads of the one-year monetary inflation rate averaged
0.0% the week of October 15 compared to -0.9% the previous week. At the
16 rate, the real return on three-month Treasury bills was 6 bps.
Central bank activity to moderate general deflation in
commodities is to buy gold (to inject money into the economy) not to
(to withdraw money). Deflationary pressures in commodities will push
banks to buy gold to help achieve inflation targeting.
Not All Fiat
Currencies Are Equal and None is as Good as Gold
There is not much wrong with fiat currencies in the modern monetary
world. It is the product of sophisticated civilization and complex
technology. The problem is the domination by one fiat currency over all
in a world order of sovereign states as the fiat dollar does. Gold as a
monetary instrument has the same problem, plus a deflationary bias,
all nations are blessed with gold mines.
How then do other governments stop the issuer of the dollar
from flooding world financial markets with dollarswith no quid pro quo from other
That, unfortunately, is very difficult to accomplish. One way is to
multi-currency monetary regime. However, that can end up being a very
cumbersome system as the economic fundamentals of the world’s nations
different.Besides, the financial elites
of the world’s major economies have all been hooked by dollar since the
WWII. The US
economy would have to crash sharply before the dollar will be replaced.
there is no alternative currency that can readily replace the dollar.
While the US
economy is going through a very tough test since mid 2007, there is no
suggest that it would collapse in the near future. Neither do US voters
that international trade under dollar hegemony is also hurting US
exporting their jobs and keeping their wages low. However, workers in
are still misled by policy makers that the culprit for US
unemployment is China,
rather than the dysfunction of the neoliberal deregulated trade and
globalization. The radical left and the radical right in G7 capitalist
democracies would have to unite against the neo-liberals who put the
this economic mess, and fight only after the neo-liberals are defeated
ousted from control of governments.
In a way, by having the bulk of the world’s foreign exchange reserves
denominated in dollars, the US
is shooting itself also in the foot. As non-dollar currencies
central banks suffer a loss in value in their dollar foreign reserves
of their own currency. This is one reason why most central banks oppose
appreciation of their currencies, except perhaps the European Central
which has a strategy focusing on a strong euro to finance euroland
Events since the Plaza Accord (pushing down the dollar) in
1985 and Louvre Accord (pushing up the dollar) in 1987, within 2 years,
shown that it would be futile for governments to waste scarce financial
resources intervening in foreign exchange markets, as the Bank of
discovered in 1992, but only after making George Soros rich and
sad record of Japan’s
economy in the last two decades has shown that fiscal deficit financing
stimulate the economy can be neutralized by monetary intervention to
external trade competitiveness.
Another reason exchange rate instability may increase in the
near term is that the euro-dollar exchange rate will be of less concern
ECB than it was to its component national central banks because the
the eurozone as a whole will be more closed and inward looking than the
individual members’ economies. The euro zone’s openness rate (measured
ratio of trade in goods and services to GDP) is about 14%, compared
Now if two economies are linked by floating exchange rates, free trade
cross-border capital flows, the one with a high rate of inflation will
exchange rate of its currency fall. However, a fall in its currency
increase the cost of its imports thus adding to its inflation rate. In
addition, the further rise in inflation rate will push up domestic
rates further. However, a rise in domestic interest rates will stop or
fall of its currency and attract more fund inflows to buy its goods and
or even “hot money” to try to profit from carry trade. It also
increases its export,
which reduces the supply of goods and assets in the domestic market,
up domestic prices, while not pushing down the price of imports as
exporter would raise prices to compensate for exchange rate changes.
inflation/deflation balance will then depend on the trade balance
exports and imports. This had been given by the ECB as the logic of
euro interest rates to fight inflation in the eurozone.
However, this effect does not work for the US
because of dollar hegemony, which enables to the US
to run a persistently recurring trade deficit with moderate inflation
That is why the monetary policies and open market measures of the ECB
and the Fed
are constantly out of sync. US exports tend to have a large component
imported parts, as high as 80% in many sectors, thus clouding the
export and import. The US
is now mainly a re-export economy at best, with most of the profit
coming from financial
advantages derived from dollar hegemony. A similar dilemma exists in US
The availability of financial derivatives further complicates the
because both interest rates and foreign exchange rates can be hedged,
and distorting the fundamental relations between interest rates,
and inflation. The recurring global financial crises in last decades
manifestations of this distortion.
The theory of market equilibrium asserts that market tends to reach
equilibrium as it approaches efficiency, which is defined as the speed
with which equilibrium, is reached.
Yet equilibrium is an abstract concept like infinity, a
conceptual end state that has no definitive form or reality. Yet the
complex because not only the relationship of market elements is poorly
or even un-definable, but also the very instruments designed to enhance
efficiency tend to create wide volatility and instability in the
a “natural” equilibrium state has a time dimension and can in fact be
as the actual state of the fluctuating market at any one moment in
equilibrium then exists in markets only to move to the next equilibrium
With 24-hour trading, the notion of a milestone moment of
equilibrium is problematic. Quarterly settlements also complicate the
the very financial instruments created to enhance market efficiency
“natural” equilibrium state make the equilibrium elusive. Such
mainly designed to manage risk generated by both broad market movements
momentary disequilibrium. Structured finance mainly involves unbundling
financial risks in global markets for buyers who will pay the highest
specific protection. Because users of these instruments look for
payoffs through unbundling of risk, the systemic cost of managing such
maximized. Traders begin to seek market volatility as profit
thus neutralizing the stabilization effect of hedging. Volatility is in
derived from synthetic equilibrium.
This dis-aggregation of risk renders the notion of unified market
equilibrium an elusive state. The unbundled risks are marketed to those
the biggest appetite for such risks for high compensatory returns. Thus
equilibrium is no longer merely a large pool of turbulent transactions
unified surface. It is in fact a pool of transactions with many
levels of interconnected undercurrents, each serving highly
Equilibrium is this case becomes a highly complex notion,
making the prospect of externalities highly uncertain and the impact
serious. That very uncertainty caused the demised of Long Term Capital
Management in 1998 when it lost $4.6 billion on leverage of 250:1 in
four months following the Russian sovereign bond default.
Interest swaps, for example, are not single-purpose
transactions for managing interest rate risks. They can be structured
inflation risk hedges, or foreign exchange risk hedges, or any number
financial needs or protection. They can even be profit-seeking moves
carry trade. In addition, the impact is not limited to the two
since each party usually hedge again with a third counterparty. The
of risk results in an under-pricing of unit risk that makes hedging
risks a contributing factor in systemic risk. A further irony is that
objective to insure against volatility risk by covering the market
increases systemic risk of illiquidity.