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As Fed Holds its Ground, Gold's Explosive Rally Signals a Paradigm Shift

November 3, 1999

The plot thickens: Along with currencies and interest rates, central banks add gold to their list of manipulated markets. But even the best laid plans of mice and men can't overpower checks and balances of the marketplace.

They're saying in the gold producing countries that gold has joined the list of august commodities that are manipulated. If one considers the four-month long Bank of England gold fiasco followed by last week's European Central Bank (ECB) announcement, one might have to agree. Yet, investors and the U.S. mainstream media hardly seem to recognize the paradigm shift that has occurred in the marketplace.

And that list of manipulated markets should by no means be limited to commodities such as copper, silver, and oil, where the OPEC countries are commonly known to use their collusive powers to manipulate oil prices. The U.S. Treasury and the G7 countries have also been commonly known to manipulate currency prices, and the U.S. Treasury also in the past two years admitted that there is, in fact, a Plunge Protection Team that exists to manipulate stock prices via the S&P futures market. Incepted during the Reagan years under the guise that a U.S. fund was needed to support the market in the event it crashes, the PPT has been rumored to be abused for political reasons and has been the subject of many stories in the Washington Post this decade. But how long will the global financial and commodity markets allow the powers that be to attempt to engineer their agendas? According to our work, not long.

A look at the dynamics of the gold industry within the context of the ebb and flow of market forces] detailed in our special report, Gold In A Deflationary Economy, sheds some light on the subject. Some are calling the 15 central banks of Europe "Goldpec" in the wake of last week's announcement that the member countries of the European Economic Community will not sell more gold than has already been announced, and that more importantly they will restrict leasing. Central bank selling has been responsible in part for the oversupply of gold on the markets, sending the precious metal to a 20-year low this year at $250 per ounce. But it is the restriction on the gold lease market that is the key to the paradigm shift that has occurred, and it is likely to provide a bullish fundamental background to the gold market for months to come.

Central Bank Realization Costs Gold Producers So, what happened? To start, it seems the central banks finally realized that their feet are hurting after months of shooting themselves in the proverbial foot. After pre-announcing gold sales of over 400 tons last May, the Bank of England then commenced selling part of its gold reserves into the lowest prices in 20 years during its two auctions since May, in the process revaluing the gold reserves of central banks across the world in the exact opposite direction they had wished: down. "Wait a minute," the ECB said, "why are we debasing our own reserves, and why are we making it more difficult for the International Monetary Fund to bail out problem economies?

That the IMF is just about to revalue its reserves is not to be ignored with respect to the timing of the ECB gold announcement. Forbidden by its charter to simply revalue its gold reserves and running into opposition from the gold industry and from the U.S. Congress with respect to selling gold on the open market, the IMF feels forced to revalue its gold reserves through creative accounting measures. As reported in our September issue of The Global Market Strategist, the IMF is just about to sell gold in a paper transaction to distressed economies at current market prices, then buy it back in a transaction that involves no market risk (the buy-back will be at the same price as the sale). By revaluing its reserves, it hopes to elevate its ability to bail out distressed economies. The IMF, then, continues to try to manipulate the global economy by applying band-aid therapy to distressed regions, and it will simply run out of funds without some sort of maneuver to come up with more capital.

Goldpec Announcement: No Favors To Producers

With last week's ECB announcement to limit gold sales, the so-called Goldpec countries did producers no favors. Even though the much-needed rise in the spot price of gold has helped, producers came into last week nicely hedged and enjoying the contango in the lease market necessary to bleed a profit out of an industry that has been locked in the throws of a severe bear market. In the meantime, the cost of production has been plunging the past two years, putting producers in a better position than before sentiment toward gold turned decidedly negative two years ago. They did what they had to do to prosper under conditions that have seen the largest oversupply of gold in years.

Granted, higher spot prices are better for the industry, but no one knew the European central banks were meeting at all, let alone ready to issue a communiqué which stated that they would limit future gold sales. Worse yet, they decided to limit leasing, which will in turn make it more difficult to borrow gold for strategies either used by producers or by speculators such as hedge funds. It is that effect on the gold lease market that is doing the most damage, and that will change the gold game forever since lease rates are likely to be too high to make the strategies producers and hedge funds employed the past two years profitable.

And, in turn, that brings us back to the Federal Reserve Board's decision this week to leave Fed-controlled U.S. interest rates unchanged. Without implying that the paradigm shift that has just taken place in the gold market figured directly into the FOMC's decision to leave rates unchanged, it takes little observation in the gold industry to realize that the game that producers and hedgers have been playing the past couple of years to forward sell gold and borrow at current lease rates is over. Hedge funds have been selling gold short by borrowing gold at current lease rates, then using the proceeds to buy U.S. Treasuries and enjoy high interest rates and a strong dollar.

Of course, that strategy only works as long as contango exists as long as returns from Treasuries exceed the cost of borrowing the gold to sell short. It also works only as long as the gold one has sold short is not rising in value, contributing to losses on short positions, and as long as U.S. Treasuries are not declining too much. In actuality, two of those three factors were already beginning to pressure the market recently, but declining gold prices and low lease rates made the Gold Carry Play profitable anyway. Now, though, the industry is scrambling to cover shorts in gold and to unwind positions, and word throughout the industry is that the global short position in gold is enormous: between 2,000 and 8,000 tons (difficult to estimate). Many are still waiting to cover shorts, not yet throwing in the towel or realizing that the lease game and its associated strategies is over.

That puts hedge funds once again on the wrong side of yet another carry play. Like Orange County in 1994 and like those involved in the Yen Carry Play in 1997, those now scrambling to unwind gold carry strategies are in actuality scrambling to survive the death of a game that abruptly ended one day. Not that gold producers should be categorized in the same way as speculators, for the producers use forward selling and the lease market to assist in selling their product, and the lease market serves a good purpose in facilitating gold production. Hedge funds, however, jumped on the profitable strategy, but like all strategies, once the game is over, it ends in a crash. In this case, the crash is in the gold lease market, and it involves a crash up in gold prices. The two are affecting both speculators and producers together since the central banks moved indiscriminately to restrict leasing, speculators and bona-fide hedgers included.

So, is Greenspan and company watching the hedge funds again? You bet. We anticipate that many horror stories will soon emerge, some of them perhaps big news. Do we have another Long Term Capital problem on our hands like last year? No way to tell the game is still on and the trade is still scrambling to cover shorts. But you can bet that Greenspan and company, despite feeling the need to maintain a tightening bias to send the U.S. stock market a continued message that it is still watching, is eyeing those involved in the widely-popular gold strategies, and is watching gold prices. If prices continue to move up, hedge funds may again be in trouble.

And in the least, one need only to look back at the past three quarters of 1999 and the great changes that have, in fact, been occurring globally, to see just how important a paradigm shift in the gold market is at this time. It directly follows a shift in the crude oil market, which bottomed last December at $10 per barrel and soared to $25 in only nine months, and the shift in the stock market speculative bubble, where sectors such as the Internet sector peaked at extreme valuation levels amidst a highly speculative background and high margin speculation last April and plunged 60% in only a few months. Our Money Flow indicator shows just how serious stock market selling is behind the mask of the popular benchmark, Dow Jones Industrial Average. This is all occurring just three months ahead of Y2K, and during a time when political and economic instability in Indonesia, Latin America, Russia, and other important places is serving to keep an air of instability about the global economy.

Again, the global financial markets have come to the brink, and what happens in the coming weeks will be highly important.

Daniel L. Ascani
President and Director of Research
Global Market Strategists, Inc. ™

The melting point of gold is 1337.33 K (1064.18 °C, 1947.52 °F).
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