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The Other Bubble

February 22, 2001

Yes, it's Bubble time again, only this time let's look at one which has operated in reverse -- Gold.

The barbarous relic has long been demonized by inflationists of all persuasions who rankle at its ability not only to restrict their ability to counterfeit the claims needed to pay for their social programmes, without explicitly asking taxpayers first, but at the fact that it provides an objective measure of the toll they are exacting on the value of peoples' savings along the way.

Here at the back end of the latest New Era, few of us still operating in financial markets have anything but hoary old tales from our fathers' knees to remind us of the metal's former appeal and significance. Flattering ourselves that we have not only abolished the business cycle, but that we have also slain the dragon of inflation, we tend took look with ennui or amusement on the gold bugs. Our new electronic finance era hardly seems to need a lump of shiny metal any more than it needs cow hides or cowrie shells.

It seems hard to contemplate that one of Ronnie Reagan's first acts as president -- before his administration was hijacked by deficit-spending supply-siders and then tax-and-spend neo-conservatives -- was to convene Congressional hearings on proposals to restore the gold standard in some form. It is forgotten that James Baker, during his disastrous tenure as Treasury Secretary, seriously suggested - a month before the Crash of '87 - that all major currencies be linked to basket of commodities, prominent among them gold, but whose parities were kept secret from the market! It seems hard to believe that in June 1997, then-PM Hashimoto of Japan caused a furor (not to mention a sharp decline in the Greenback's value) when he expressed his frustration with the usual US hectoring of his country's main creditor, saying:-

'Our American friends were paying little attention to maintaining the value of the U.S. dollar as an international key currency, and we were tempted to sell off (bond holdings). In terms of funds, it is true that we have not really made the right choice, shall I say, or advantageous choice. By selling Treasury bonds, we might increase our gold holdings. That is an option we had. Among countries around the world, there are many who hold their foreign currency reserves in the form of U.S. Treasury bonds. As long as they continue to maintain the U.S. government bonds -- even when the U.S. dollar is weakening relatively -- it is because these countries are holding onto these government bonds that the U.S. economy is being maintained. Many people, in fact, don't realize this.'

`I hope the U.S. will engage in efforts and cooperation to maintain exchange stability so that we will not succumb to this temptation to sell off government bonds and switch our foreign reserves to gold.'

(Can you imagine the consternation THAT caused!)

It seems hard to see as anything but quaint Greenspan's wistful musings on the classical gold standard as recently as 1998. For example, in his speech before the SIA in Boca Raton in November of that year, he said:-

'Between our Civil War and World War I when international capital flows were, as they are today, largely uninhibited, that discipline was more or less automatic. Where gold standard rules were tight and liquidity constrained, adverse flows were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences. Imbalances were generally aborted before they got out of hand.'

Greenspan the Academic and Greenspan the global Firefighter are two different animals, however, and just before the Russian crisis erupted and the spiral to the LTCM fiasco was entrained, he was telling a Senate committee that:-

'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.' Not so much a Greenspan Put as a Greenspan Call in the Anti-Bubble, it seems in this case.

There is widespread frustration in Gold mining circles at their commodity's fall from grace. There are those who see Greenspan's remarks as evidence of official collusion in suppressing this price, in concert with the major bullion banks, in order to camouflage the emptiness of the New Paradigm and to disguise the inflationism of the credit bubble era by un-derpinning the Clinton strong dollar policy.

GATA is prominent among these and has been assiduous in pointing out to miners -- especially those in South Africa -- and to US Congressman from the mining States that by selling forward and engaging in aggressive derivative transactions, they are destroying their own industry. Judge for yourself at - be warned, it is polemical!

Of late, this has begun to strike a cord as the realization spreads that selling metal for a financially engineered rate above the costs of production may look good in the short-term, but it allows nothing to defray the depletion of reserves or for re-investment in prospecting. Running a business on a myopic operating cost basis is to squander shareholder value: de-pressing the worth of those shareholder assets by dint of the process itself is to be culpable of bad stewardship.

Moreover, other industry figures have questioned the uncanny ability of the Comex session in NY to snuff out price rises engendered in London and the Far East and one of them, Reginald Howe, has even gone so far as to institute legal proceedings under American anti-trust law which comes before a judge on March 15th . Full details will be found on his site at , especially in the legal complaint itself which has a wealth of fascinating detail as the basis for the allegations.

Few in the market believe the UK Treasury's motives were wholly as explained when it suddenly announced its gold auction programme in May 1999 either, suspicions not helped by the ludicrous assertion in the National Audit Office report which we abstract here:-

'The second UK auction took place on 21 September 1999, shortly before the European central banks' announcement (of the Washington Agreement rationing out central bank gold sales and -- more importantly -- restricting leasing). Within two weeks of the auction the price of gold rose by 25 per cent. We explored with the Treasury whether it would have been possible to postpone the auction until after the announcement. In the Treasury's view to have postponed the planned auction to take advantage of a possible but uncertain strengthening in the market would have created very considerable un-certainty in the gold market with a potential detrimental effect both on the gold price, and on the market's confidence in the fairness of the auction programme, putting at risk the prospect of achieving the policy objectives of the programme. It was also not certain on 21 September that such an announcement would have been made.'

So they would have us accept that cancelling an auction in a sellers' market would have had a detrimental impact! Come on, fellas, you'll have to do better than that. Granted, there is a nugget (sorry!) of truth in the last assertion, but only be-cause it seems to have been a fait accompli by the ECB!

Yet another strand can be found at where James Turk adduces facts which might point to the role of the US Treasury's Exchange Stabilization Fund in the process (you remember, the one which was used for extra-congressional intervention in the Tequila Crisis).

Without giving the plot away, let us just say that Mr G and the BIS cabal loom large in the intrigues outlined on these sites.

In recent weeks, the Gold Doomsayers have had a new set of events on which to focus, to snuff out what had seemed to be a promising rally of just the sort one would expect when the Dollar wobbled and US stocks plunged amid concerns of stagflation.

Firstly, there was the devastating earthquake in the Gujarat region of India, main import route to the fabled Hindu wedding market. Next came No 4 producer Harmony Gold's bullion-bank imposed purchase of 1 million Oz of put options to 'safeguard' needed project finance at a strike which would have equated to around $256/oz (a remarkably high delta to start with, it would appear?)

Now we have persistent rumours that 50% hedged AngloGold is circling around GoldFields -- South Africa's next most important enterprise and one which has not only now fully eschewed hedging 'strategies', but which accounts for around one-fifth of the world's uncommitted reserves at a much lower balance sheet valuation than any of its large competitors. If Anglo, legacy of the Rhodes Empire, acquires it -- or, indeed, Barrick (Canadian giant sometimes sneeringly referred to as a metal hedge-fund) -- the obvious worry is that another huge block of derivative-related sales would be in prospect.

However, the World Gold Council has just reported that physical demand hit a record last quarter, taking the total to around 3,300 tonnes for the second year running. With newly-mined supply having peaked out at 2,500 tonnes a few years back, scrap recycling and CB sales are evidently needed to make up the difference. Some estimate the cumulative shortfall at as much as 10,000 tonnes to date. Gold below $260/oz is not exactly guaranteed to bring many new re-sources on stream to address this!

Moreover, look at the bullion banks and their derivative positions. Official figures for US commercial banks (so neglecting the active Bulge Bracket brokers, as well as a certain large German entity active in this field) have grown from $31 billion notional in 1995 to $86.6 billion last September. Given that the increase has been disproportionate in longer maturities, risk has gone up even more. Guesstimating average maturities at 6-months, 3 years and 7 years in each of the recorded buckets, we see that exposure has gone from $46.8 billion year-dollars to $216.2 in the 5-1/2 years of the Anti-Bubble.

Since gold prices have declined to 20-year lows in nominal terms and to their lowest since before the Smithsonian Accord failed in 1973 in real terms, the tonnage this represents is truly phenomenal.

On a straight revaluation, we are up to 10,000 tonnes -- four years' global mine output. Taking 1995 as the mark to market and valuing quarterly increments at then-prevailing spot prices, we still reach 8,150 tonnes.

As this has built up, the physical market has fallen into decline, further testimony to the scale of the unnatural nature of the derivative explosion. LBMA trading volumes have plummeted from a daily average $13.3 billion in March 1997 (37.9 mio oz) to $5.5 bio (25.4 mio oz ) by December 2000.

This combination means that whereas it would have taken a week (4.5 trading days) to have turned over US banks' derivative positions (fully 82% of which were at Chase, JPM and Citi alone last time around), it now would take over three weeks (15.3 days).

In the shorter term, the gold lease rate has hit highs not seen since Y2k (a sure sign of forward sales) while COT non-commercial shorts on Comex are at their greatest since last July 1999 (6.2 mio oz or 199 tones equivalent) -- ie pre-Washington Accord.

Having spiked briefly last week below the $254.50 level where the European banks launched their counter-attack (and right about at Harmony's strike price), Gold has tried to bounce. Buyers with a $250 stop could attempt to ease in, adding if we regain $263, and more on a break of $270.

The hedgers and their bankers, with or without official help, may just head this off again, making it nothing more than a trading rally to the YTD highs at $275. However, the imbalances here are such that Gold represents the ultimate high gamma put on the USD and a failure of the Fed's Great Monetary Inflation of the last six years. This will be especially the case if AUD and ZAR strengthen relatively when the Big Dollar wanes, choking off opportunistic producer sales. The beauty with Gold, of course, is that even the BOJ can't be bullied into printing it to forestall this. As a kicker, you might be treated to the spectacle of the Fed, the BIS and Fat Larry being subpoenaed to the March court case to add to the fun. With a new administration which might have a different agenda to the Clinton-Rubin axis, it might even happen. Where gold might go if even a partial discovery process makes the headlines, heaven alone knows.

Gold weighs 19.3 times as much as an equal volume of water.
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