The Chaos of Central Bank Gold

May 22, 1999

The gold market continues to be depressed. The commodity has been unable to even touch the $300 mark for over six months now. At its current $273 price, it is near the $269 low of almost the past two decades. Gold bugs throughout must admit that the commodity has a tough fight on its hands. Ever hear of the phrase, "never fight the Fed" when participating in U.S. asset markets? Well, gold not only has to fight the Fed, but also has fights against other central banks, the IMF, and hedge funds. Eventually though, the market will prevail and discipline all of its participants.

For years now, the gold market has been depressed by continued short selling made not only possible, but profitable, by central bank market manipulation. While manipulation is a strong word, it is the truth. It is the central banks that lend gold, often at less than 1%, knowing that it will be sold into the market and will drive the commodity's price lower. It is the central banks and national governments that openly propose and talk about the selling of gold, however likely the scenario, as the Bank of England, Bank of Switzerland, and the Clinton Administration have. These same parties ensure that the price of gold does not skyrocket upward although annual production supply is short of annual demand. Instead of recommending that LDCs (lesser developed countries) and nations with weak currencies defend their currencies with strong economic policies leading to manageable growth levels or through informal pegging to hard assets such as gold, central banks do the opposite – they support an IMF proposal to sell gold so that proceeds may be given to countries for debt relief, when the debt forgiveness or rescheduling would be the wiser decision. In fact, the IMF proposal has already hurt these export-dependent nations that the IMF seeks to assist since its jawboning of gold has reduced the profit margins of LDC exported gold. Furthermore, instead of allowing market forces to discipline market participants, central banks (the New York Federal Reserve in particular) intervene and bail out highly leveraged market participants (Long-Term Capital Management) to ensure that a shock of increased demand does not spark what could be massive amounts of short covering. If I may ask, exactly who was on the other side of that off-market transaction? If I may also ask, why are shocks to the market allowed to the downside but not to the upside?

Given this type of central bank gold market manipulation, may this not be the a major reason that the Bank of England has recently proposed the selling of 415 tons of gold, equivalent to over half of its gold reserves? The current global gold short interest is speculated at near 8,000 tons and much of this has been made possible by central bank lending of gold reserves. If the Bank of England is one of these central bank lenders of gold, might not the Bank be actually bailing out a short seller with its proposal? It would not be unreasonable to think that this central bank has leased a large quantity of gold since it has frequently made negative comments towards gold to ensure that a depressed gold price allows its gold lease to continue. Allow me to hypothesize that the Bank has lent 415 tons of gold to a single short seller that now wants out of the market but can only close its position over many months and at the current gold price. If this were to be true, the Bank of England would have little choice but to account for it gold having been sold. Hence, the Bank chooses to convert its gold status from "leased" to "sold" in an incremental fashion with physical gold never hitting the market (since it already did when it was short sold). This would be an easy decision for the Bank since the other alternative may have been to kiss its money good-bye if the short seller were to get caught with a skyrocketing gold price with no money to close the position.

If this hypothesis were to be true, it may be part of a new trend that is beginning where central banks throughout the world realize that short sellers must be relieved of their positions. Moreover, if this realization has been made, then it is reasonable to believe that central banks are now wise enough to ensure that the price of gold does not skyrocket. These major lenders thus use two tools at their disposal – lending of gold to short sellers and verbal attacks on the gold market. Could this not be why gold seems to be unable to break resistance at the $290 to $300 level?

However, as a result of central bank and others manipulating the gold market, the market's supply and demand fundamentals have been put into a situation of chaos. The following supply and demand chart depicts what is occurring in the market.

Currently, the gold market exists in a forced disequilibrium. Specifically, the manipulation of the market has imposed an implicit price ceiling of sorts that now ranges in the $290 to $300 range, represented by the manipulated price, Pm. Hence, the equilibrium, E*, is not allowed to occur from the natural supply, S*, and current demand, D1. Instead, because, as Alan Greenspan stated last summer that, "the price of gold cannot rise as long as central banks stand ready to lend gold," the supply curve is manipulated, represented by Sm. The resulting supply and demand at Pm would result in a shortage, the difference between the quantity, Qm, demanded at the manipulated price, and Qp, supplied by mining production, and the shortage would occur if not for the gold leased by the central banks to be short sold. Unfortunately, this state of disequilibrium can exist only temporarily.

Currently, the long-standing bearishness of the gold market has reduced gold demand to its minimum and shifts the demand curve, D1, as far left as it seems likely to go. Eventually, gold demand will pick up, possibly due to Y2K fears, and the demand curve will shift to D2. However, just as the problems of gold's physical delivery wrecked the gold standard monetary system, the inability to make physical delivery of gold demanded will terminate this forced disequilibrium. Specifically, the quantity of gold demanded will exceed that quantity which central banks possess or will lend to be physically delivered, Qcb, and the aforementioned shortage will result. At this point, the price of gold will rise dramatically, and many or all lenders of gold will demand the return of their gold. Consequently, at that point, the manipulated gold supply cannot exist and must be adjusted to reflect a situation where all gold demanded at a particular price can be physically delivered. The supply curve will thus change to rotate at point X, and likely exist somewhere between the semi-inelastic supply, Ssc, resulting from short covering, and the natural supply, S*. However, since the natural supply quantities cannot be delivered in the short-term since production is sticky, gold must still be leased into the market, or the supply curve be inelastic above Pm. The resulting price of the short covering will be between Psc-min and Psc-max, depending upon the new supply curve. Still, just as the manipulated gold price, Pm, could not exist forever, the short covering price, Psc, will exist temporarily and gold mining companies will increase production until the natural supply is produced and natural equilibrium is reached.

Only after this process is complete will all market participants, including central banks, learn to "never fight the market."

Ryan Tanaka

May 22, 1999

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