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Bullion Dealers: Spin Meisters of the Gold Market

CFA, Senior Managing Director, Co-Portfolio Manager
February 19, 1999

Cast as the perennial bad guy of financial assets, gold faces many protagonists. Low gold prices reassure the bond market that commodity prices remain tame and that no inflationary threat exists. With low interest rates and firm bond prices, lofty equity valuations can be justified. The political world is happy to see gold languish. Its submissiveness imparts an "all is well" hue to the landscape. But gold's worst enemy by far is the bullion dealers. If not for their reign of terror, gold would in all likelihood have broken out of its long downtrend. Purveyors of unrelenting pessimism, their collective voices have affected a generation of thinking in the financial markets at large and among their clientele which includes mining companies, central banks, and hedge funds.

The dealer community consists of a small inner circle of blue chip institutions that control the flow of leased gold into the market place. Less than ten in number, their strong credit ratings qualify them as counter parties for central banks leasing gold. Since this trade originates as a short sale, dealers are predisposed to promote a bearish picture for gold. These institutions have persuaded the gold mining industry that the upside potential of gold is limited. Their message to the miners is: buy price protection from us. It is an absolute necessity to assure continuity of mining operations. Their message to the central bankers is: mobilize your gold for the leasing market so you can earn a return on this stagnant asset.

The success of their campaign is evident in the mindless negative slant of the financial press and attitudes of many leading mining executives. Their small number facilitates obscurity, secrecy and informal cooperation (collusion?) in their efforts to keep a lid on gold prices. While spreading their gloomy message for gold, they have built up a mega short position. Their relentless selling is a major, if not the principal, reason for gold's lackluster performance in recent years. The size of the short interest in gold has been estimated to be from 4000 to 8000 tons, or two to four years of new mine supply.

However, the world according to bullion dealers is beginning to veer out of touch with reality. They contend that there are three major reasons why gold can never mount a sustained rally: central bank or official sector selling, producer forward selling, and world deflation.

For years, the gold market has quaked at the prospect of official sector selling. Rumors or stories of such sales have frequently topped out many gold price rallies. Such rumors, spread by the bullion banks, encourage front running by their hedge fund clients. In truth, central bank selling has dwindled. The outlook is for little or no new supply from this source. Wim Duisenberg, chief of the new ECB, recently issued an emphatic public statement that Europe's vast gold reserves would not be sold. Duisenberg's point of view has been strenuously reinforced by European central bankers in private meetings. The Europeans regard gold as an important reserve asset whose value is of great concern. Unauthorized sales are unlikely and even gold leasing is likely to come under review once it is understood to depress the metal's price. Central bankers regard gold as an important basis of credibility for the new Euro, especially at the grass roots level. Official sector sales, in the succinct view of one knowledgeable observer, just "ain't gonna happen." If anything, official sector buying will become a significant source of demand, particularly in Asia, where gold is a very low percentage of reserves.This recent evolution in official sector attitudes is absent in the pronouncements of bullion dealer spokespeople.

The second most frequently invoked rumor to terrorize the gold market is of producer selling. This threat is as outdated and inaccurate as their central bank spiel. The gold mining industry has not added significantly to forward sales positions in recent years. The industry is already heavily hedged, and producer selling cannot and will not be the incremental source of supply it has been in the past. Based on slowing reserve growth due to reduced capital flows and low gold prices, significant new selling by the industry is unlikely. While gold mining managers are still inclined to sell into the rallies, they do so mostly to replace less favorable hedges on the books, and therefore there is no net increment.

The 1998 Asian meltdown provided a cue for macro hedge fund selling. Short interest rose to extreme levels three times since the Asian meltdown: year end '97, August '98, and January '99. This speculative selling pressure produced a succession of higher lows, suggesting that the worst expectations may have already been discounted. Asian economies now appear to be on the mend. As the Asian recovery becomes more apparent, the macro case for shorting gold and raw materials in general will evaporate. It is hard to ignore the reports of strong demand from traditional gold consuming markets. Preliminary numbers suggest that the fourth quarter of 1998 saw the highest gold consumption on record.

The deficit between mine production plus scrap and demand for gold continues to widen. It is conservatively estimated at 1300-1500 tons for 1999. If net forward sales by producers equal 200-300 tons, a generous assumption, short selling must exceed 1000 tons in order to keep the gold price locked into its downtrend. In other words, the bullion dealers must go out further on their short selling limb to defend their basis risk.

The macroeconomic argument for gold has swung to the bullish side. Heavy monetary and fiscal stimulus is being employed by world governments to fend off deflation. US money growth (M-2) exceeds 9%, the highest in ten years. Other world governments are doing their part with interest rate cuts and fiscal stimulus. Failure of these stimulative measures to thwart deflation will only lead to more intense application of the same medicine. A cycle of accelerating stimulus will ignite long dormant investment demand for gold.

The world has changed dramatically from the days when shorting gold was a good idea. Nonetheless, this does not stop the dealers from rumor peddling to promote business. One producer hedger observed that when such rumors appear at the top of a gold rally, it is impossible to get a straight story. It is not improbable that such selling represents proprietary trades by dealers defending their short positions.

If so, their position is on shaky grounds. The depressed gold price means almost no producers are reporting profits. The high quality leasing business has already been exploited. Financially strong producers, that cared to, have been selling forward for many years. What's left, for the most part, are the companies with weaker reserve positions and balance sheets. Hedge business placed on the books over the last year is the weak link that will break easily in a sustained gold rally. The basis risk for much of this short interest book is probably in the high 290's or low 300's.

There is circumstantial evidence that gold lending has evolved into a successor to the failed yen carry trade. Bullion dealers have enjoyed bang up profits over the last few years. A gold carry trade would seem like a rational line extension of their lucrative business. Low interest gold loans could fund long positions in the treasury market. Based on their trail of success, it would not be hard for them to recruit fresh capital from within the firm or outside.

One mining CFO observed that there is a kind of inverse euphoria rampant in the gold market that the gold price will never rise. Call writing and short selling are guaranteed ways to make money. Bearish sentiment has become increasingly cocky, overconfident and reckless. Such attitudes could well be founded on a perception of official sector policy towards the metal price. Increasingly lax credit terms reflect this sentiment. There has been a flood of gold mobilized by central banks in the last six to nine months. Over eighty central banks are now lending their gold. Lease rates have plummeted, terms have lengthened, and margin requirements relaxed. As credits have become weaker, more complicated derivative structures and higher fees have proliferated. A mining CEO professed to having been hounded in recent months by dealers promoting ever more lax credit terms. The sub prime lending business is alive and well in the bullion market. Just as internet investors were piling in at the top, there is an overcrowding of capital in this dubious trade, a precursor to a market turning point.

You can be sure this will come to an explosive end. The gold market is more wrong-footed than before its huge 1993 rally. At least the yen was a liquid currency that could be bought to cover shorts, even if there was a substantial loss to cover. The gold that is being borrowed from central banks is being sold into the physical market where it is being consumed as jewelry. It is no longer in liquid, deliverable form. Gold loans will not be as easy to repay as the borrowed yen. The shorts are facing an epic squeeze. Once the markets realize that the selling pressure has been artificial and the self-fulfilling, bearish axe grinding of a small group of institutions with their own agenda, there will be a swift re-evaluation of the market fundamentals. It could be quite some time before gold trades below the basis risk of the short positions.

Bullion dealers must assume that plenty of fresh central bank gold will be available if the price rises. This could be a dangerous assumption. The unanimity of negative opinion on the yen was followed by a huge short squeeze. The sentiment on gold is similar. If the price rises sharply, central banks will be reluctant to mobilize more gold for lease. Under such a scenario, the finances of the bullion dealers could be jeopardized. Lease rates are low because there is a huge supply of gold available for lease. The central banks have been coaxed (duped?) into the gold lending scheme by the relentless dealer pessimism. A strong gold price rally would dissipate negative psychology. Lease rates would spike as central banks ask for their gold back. Most of the banks have lent their gold against the credit of the bullion dealers and don't appear to appreciate the risk that they could actually lose the gold.

We are among the many gold investors who anticipated such upheavals as the Asia meltdown, LTCM, and Brazil, that remain disappointed by gold's indifference. It is quite apparent that gold has been held in check by the artificial constraints we have described. As these constraints become better understood, the short position that they are built upon on will come under speculative attack.

Our investment case for gold goes well beyond a short squeeze, but the catalyst for a breakout could well be just that. We expect investment demand to materialize in conjunction with the inevitable deflation of the stock market and dollar bubbles.

Gold is a David and Goliath story. Written off by the financial establishment and pinned down by the reign of terror we have described, all expectations are negative. Strong underlying fundamentals are ignored. Defenses against a breakout are flimsy and overrated. Gold today is an opportunity to take a low risk position that the financial markets are in the late stages of a blow off. At the very least, it provides insurance against such an event. We are looking forward to an imminent reversal in gold's status as an outcast among financial assets.

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management ( Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

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