Gold: A Pot Worth Watching

January 8, 1999

Basic economics teaches that manipulating a commodity price must lead to distortions in supply and demand. Price supports create oversupply; price ceilings create shortages. While this lesson has been learned through the years in too many cases to mention, it appears that world central banks and finance ministries are attempting the impossible once again, this time with gold. They are screwing the lid tight on gold prices at $300 per oz. At the same time, they are firing up the burners with a volatile brew of anti-deflationary policies. An explosion in the gold price is inevitable.

 

Recent months have contained much news about coordinated rate cuts around the world. ISI Group counts 59 central bank easings since October 1st. Money supply growth, especially in the US, has been accelerating to levels not seen in eleven years. Bailouts for LTCM, Brazil, Japanese banks and many others still unpublicized redeem bad investments and recycle money back into the system. The goal is reflation. Commodity prices must be resuscitated and swooning economies stimulated.

If these policies start to work, the early evidence should be a rising gold price. However, gold prices are being suppressed to help "paint the tape" for the financial markets. Gold price management has been practiced for many years, but the hand and intent of government policy has become more evident as global deflation turns unmanageable. Gold, once a passive indicator of market conditions, is now perceived as a threat to financial market stability.

World central banks are suppressing the gold price, not through outright sales, but via gold leasing activities. Financial ministers held a series of emergency meetings in late September and early October to address the crisis in world financial markets. On or about October 1st, when world credit markets were traumatized by widening quality spreads and panic, gold lease rates plummeted indicating expansive terms and ample credit. Such largesse was totally out of keeping with the bleak mood in the financial world. It belies clear intent to unleash a flood of gold via lease at a time when financial market confidence was in its most precarious state. One can only conclude that as part of a series of steps to restore market confidence, massive quantities of gold were supplied to stifle any incipient gold rally.

For the purpose of market manipulation, lending is more attractive than outright sale because such transactions go unreported and are harder to detect. Reserve positions remain unchanged, unlike outright sales. Nobody knows the size, location, or cost basis of borrowed gold positions on a global basis.

In a revealing glimpse of this policy, Alan Greenspan stated on July 30, 1998, in testimony before the Senate Committee on Agriculture, Nutrition, and Forestry regarding the Commodity.

Exchange Act and OTC Derivatives: "Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise" (emphasis ours). Although the context might be odd, Greenspan refers to generic central bank treatment of gold as a matter of fact, almost common knowledge. If this sort of signal is given publicly, it is not hard to imagine that even stronger indications of this stance are being given to bullion dealers directly.

Bullion dealers are typically also government bond dealers. A breakout of gold above $300 would be deadly for their historically high inventories of government bonds, not to mention the impact of higher interest rates on equity valuations. The combination of a little guidance from the Treasury Department as to the gold price ceiling and the commonality of interests as to bond prices seems sufficient to create a virtual scheme to keep the gold price from breaking out. Our view is inferred from price behavior, circumstance, and Greenspan's statement. To be effective, price manipulation of this sort is best kept ambiguous and informal, as in foreign exchange intervention. This strategy has Treasury Secretary Bob Rubin's signature written all over it.

For bullion dealers, borrowing gold from Central Banks seems like a riskless proposition. Attractive fee and interest income can be earned by the bullion dealers without any fear that they will have to pay back the borrowed gold at prices higher than their borrowing cost. As the borrowed gold must eventually be repaid, bullion dealers have a predisposition to emphasize the bearish case for gold. Mining companies have been willing, but unwitting, accomplices. Heavily influenced by the dire forecasts of bullion dealers, they have readily participated in various kinds of forward sale practices which accelerate supply and depress the market. Accelerated supply from forward selling has been an essential cause of depressed gold share valuations. What has been set in motion by central bank "guidance" on gold, is a self perpetuating daisy chain which tames gold prices, but in which few of the participants appear to grasp the overall picture.

A crucial effect of this scheme is that gold has been demonetized, reduced to pure commodity status, in the framework of orthodox financial market thinking. This represents a victory of sorts for the financial establishment which has historically been embarrassed by flare ups in gold prices. Unfortunately for these interests, this new perception of gold does not play well at the grass roots level. For example, it would be difficult to convince many Asians, in the aftermath of the devastation of their financial markets, that gold does not have monetary characteristics. The same could be said in light of the record sales of US gold coins this year, or in the continuing strong demand throughout the world despite soft economic conditions. There are times, and this is one of them, when the divergence between the common sense of hundreds of millions of consumers and what passes for advanced financial thinking, should be heeded.

There are four ways this scheme could self destruct:

  1. The borrowed gold disappears once it has been sold into the physical markets. It ends up as jewelry in China, India, other parts of Asia, and the rest of the world. If central banks demand repayment, something they might do if their perceptions of risk in this market change, the supply available for repayment has diminished. As with other unsupervised or unregulated markets, no one has a comprehensive view of the size of long and short positions. It is safe to say, though, that because the downside of gold has been a one way street, there is very likely a large imbalance on the short side.
  2. Anti-deflation policies might start to work. Asia might recover. The markets will anticipate this before a bureaucratic price fixing scheme can react.
  3. Economic and financial market conditions could worsen. Even more extreme anti-deflation measures would be imperative. A collapse of confidence in the dollar, the financial markets and intermediaries would awaken investment demand for gold.
  4. Official sector demand could rise. Most recently, commentary in China advocated increased exposure to gold at the expense of the dollar. There are also rumblings that Asian nations may soon band together to form their version of the IMF, except that the gold backing may be much more significant.

The clear and common goal of the post-October 1st policy shift is to repeal the disinflationary forces underpinning the multi-decade bull market in financial assets. While disinflation was friendly, deflation is frightening. Unfortunately, to travel in the opposite direction implies a return towards inflation and high interest rates, not a welcome thought in light of the $5.3 trillion national debt. While the implicit goal of this policy shift is to raise the level of commodity prices, gold is not invited to the party. A rise in the price of gold at this time would be very inconvenient. It would look bad for the reeling world financial markets, add difficulties for the imminent launch of the EMU and would certainly be unwelcome against the backdrop of the tottering Clinton Administration. Instead, while the right foot floors the accelerator, the left hand disengages the speedometer.

The new European Monetary Unit (EMU) launch January 1999, presents a special complicating factor. As of 1999, the US dollar will no longer enjoy monopoly status as the world's reserve currency. At a time when the Fed is aggressively easing, the cumulative US trade deficit exceeds 20% of GDP.

The US economy is highly vulnerable to dollar weakness. As the first alternative reserve currency to appear in nearly 50 years, the EMU will tend to create an excess supply of dollars. This will place enormous pressure on the Fed to pursue inflationary policies such as pegging short term interest rates below market levels. The conditions are right for psychology towards the dollar to change and the availability of an alternative could be the catalyst for drastic dollar weakness.

Much higher gold prices would undoubtedly accompany higher borrowing costs for world governments. Certainly, given the emerging market financial crisis, a rising gold price would help undermine financial market confidence. As Euroland tries to launch a new currency, misbehavior by gold would be most unwelcome.

Official sector treatment of gold appears to be a concerted attempt to avoid the downside consequences of reflation. It is a subtle attempt to control the mood and thought process of the financial markets. An overt approach to accomplish the same goal would quickly fail. The all important effect is to delay the ultimate market reaction by sending false signals to all participants. Gold prices will go far higher, and financial market assets will slump further and longer. Gold price intervention may have gone beyond the point of no return in the sense that the short interest has become so large that it cannot be unwound in an orderly way. Instead, participants are compelled to reinforce the defense of the $300 ceiling with additional borrowings, to prevent the considerable financial peril many financial institutions would face in a short squeeze.

Disappointed gold investors, who accurately forecast this year's financial market instability, have been fighting City Hall. Despite the failure of gold to move higher, the ultimate upside payoff will be more rewarding as short positions, taken on the perception these arrangements will last indefinitely, will be impossible to cover. Timing the breakout will be next to impossible. Positions will have to be in place well in advance of what is sure to be a cataclysmic event. Gold under $300 is a pot worth watching as it grows into an increasingly tempting speculative target.

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 (www.tocqueville.com). 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.  

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.