The Physical Gold Market , from weak to strong.

The Physical Gold Market – From the Weak to the Strong

By Greg Canavan • May 18th, 2012 • Related Articles • Filed Under

We left off yesterday wondering why the market had turned on goldrecently - the supposed "safe haven" metal. But we woke up this morning and saw things had turned again...gold surged 2% overnight as the US markets sank around 1.5%.

No doubt this type of price action will confound many investors...especially those who sold in a panic in the last few weeks. The recent sell-off amongst the gold stocks is up there with 2008 for severity.

In a clear example of how the emotional decisions of investors send price diverging from value, gold stocks have plummeted while theAussie dollar gold price, which, along with production, determines revenue, is only slightly lower.

The gold price certainly does move in mysterious ways. Today our task is to try and work out why. To do so, we need to look into the mysterious world of the London gold market.

This won't be easy reading. Sometimes you have to look under the hood to work out what the real problem is. If you're not a mechanic, looking under the hood can be daunting. But stick with us, because this could be one of the more important Daily Reckonings we've written for some time.

Trading Physical Gold With Paper

London is supposedly the home of physical gold trading. But as you'll see, most of the trading that takes place is actually a form of 'paper' gold.

Contrary to what most people think, the gold market is not a small market at all. According to the World Gold Council (WGC), in terms of size it is only behind the US and Japanese debt markets.

The WGC reckons all the gold ever mined is around 170,000 tonnes...or about 6 billion ounces. Of that amount, they estimate that 60,400 tonnes (2.13 billion ounces) represent private investment and official sector holdings. At US$1,600 an ounce, that's a market size of US$3.4 trillion.

That's hardly chump change.

The gold market is massive. It may no longer be officially recognised as money, but gold clearly still plays a hugely important role in the international financial system.

You can see this in other stats too. According to the London Bullion Market Association (LBMA), over the past 12 months average daily turnover in the gold market was 21.2 million ounces. If we adjust this for annualised turnover, an incredible 5.6 billion ounces of gold changed hands last year.

Or did it?

5.6 billion ounces is more than twice the size of the estimated gold investment market, which is 2.13 billion ounces. We didn't sell any of our gold in the last year, and we're sure many others didn't either. So this turnover is clearly not all physical gold. Most of it is paper gold, which is often referred to as 'unallocated' gold.

Unallocated gold is basically gold you think you own but really don't. The bank, or counterparty, promises to get your gold if you want to convert it to allocated, but in the meantime your gold is 'in the system'...more than likely with a number of different claims to it.

Now, here's where things begin to get interesting.

The GOFO and the Gold Market

Although the London bullion market predominantly trades paper gold, it needs some physical to give the appearance that the market is a solid one.

In times of market stress, there are two conflicting forces pulling on the gold market. When liquidity tightens (as it is now) financial assets fall in price. Because the gold market is dominated by paper gold trading, including many highly leveraged players, selling prevails and the gold price falls.

But in reality, physical gold becomes even more valuable in times of crisis. How can this be, you ask?

To explain, we need to look at what is called the Gold Forward Offered Rate - the GOFO. GOFO is the rate of interest you pay if you swap your gold (short term) for US dollars. Alternatively, it is the rate of interest you receive for lending US dollars against gold.

Lately, the GOFO rate has been falling. This indicates a few things. Firstly, it tells us that gold's value as security for a US dollar loan has increased. If a bank needs to get US dollars in a hurry (as often happens in a liquidity crisis) then using gold as collateral (security) is the cheapest way to do this. Currently, the GOFO rate is 0.3% for a term of one month, the lowest level since February 2011.

Just as a government bond rises in price as its yield falls, so should the price of gold rise as its implied yield (via GOFO) falls. But this doesn't happen in the gold market.

In fact, it's the opposite. That's because in times of a liquidity crisis or deflationary scare you have leveraged paper gold holders selling, while at the same time increasing fear leads unallocated gold 'owners' to request taking ownership of their gold...and moving it out of the 'system', or out of the London bullion market.

So how do these two contradictory forces play out? Well, let's have a look at two recent periods in the history of the gold market. One that kicked the gold bull market off in September 1999 and the other that looked like ending it in November 2008.

In both these periods the GOFO rate fell below zero. This almost never happens. A negative GOFO rate says banks will pay you to swap US dollars for gold. It suggests they are desperate to get their hands on gold...physical gold.

In late September 1999 the GOFO rate fell to an unprecedented -4%. Look what happened to the price at that point. It exploded higher in a matter of days. The gold market needed a higher price to entice some gold back into the system.

Source: StockCharts

Now let's look at November 2008. On November 20, 21 and 24 the one-month GOFO rate went negative, meaning physical gold was again in high demand in the bullion banking system.

If you look at the chart on those days you'll see that the gold price bottomed right at this time. The stress in the market was so great that a higher price was guaranteed.

After hitting a low of around US$700, gold surged to over US$900 dollars in a matter of months. Paradoxically, the demand for physical gold (within the bullion banking system) seems greatest when the selling of paper gold (which sets the price) is heaviest.

Source: StockCharts

Riding The Gold Bull Market

That's why this long bull market in gold is so relentless. As the global financial system continues to decay, physical gold flees the 'system'. Rising prices are necessary to bring some of that gold back into the system. This is necessary to keep the US dollar based monetary arrangement going.

If gold wasn't such a crucial part of global finance, it wouldn't be such a huge market. Gold is crucial...regardless of what Warren Buffett or Ben Bernanke say.

The day when physical gold leaves the banking system - for good - is the day when the paper dollar based system dies. The GOFO rate could give us important clues as to when that will happen. As in the past, the gold 'price' may fall at the same time.

But at that point, the value of physical gold will be many multiples of the current price. We wouldn't be surprised to see trading halted and gold repriced much, much higher over the course of a weekend. As it has done throughout history, gold will preserve your wealth. But you must focus on value, not price if you want it to do so.

Holding on Tight to Physical Gold

This current pullback in the gold price has not been as severe as past episodes. The GOFO rate did not go negative. But it is suggesting that physical gold is increasingly in demand. The credit worthiness of the whole system is now coming into question.

Physical gold, the only asset without counterparty risk, increases in value at such a time...regardless of what theprice tells you. With gold rising today, it's a sign the 'system' needs a higher price to entice more real bullion into the market.

This is a process that moves gold from the weak hands to the strong. So if you're thinking of selling your gold...be strong. Think about what you're swapping it for. You're going short on 6,000 years of history and long on a 41 year paper and credit based experiment.

As a footnote to this theory about how the gold market actually works, we want to say we are a student of the gold market, not a teacher. Years of reading and study haven't changed that...and we're always willing to learn more.

And finally...we haven't mentioned anything about manipulation being the reason behind the gold price fall. We think governments certainly attempt to control the price of gold (as they do with all currencies). In fact, the US government funded the Exchange Stabilisation Fund with the proceeds from its confiscation of gold from the public in 1934.

But the presence of such a huge paper gold market means that at certain times (liquidity crises) gold will sell off with all financial assets. As we've tried to explain though, a very low gold price is not in a government's interest because physical gold would leave the system and end the paper money game.

So governments simply try to control gold's rise, making sure it doesn't throw off too much of a red alert signal. For the gold price to genuinely fall, we need to see a rise in REAL interest rates. In a world buckling under the weight of debt at all levels, that is just not going to happen.

Regards,

Greg Canavan
for The Daily Reckoning Australia