Gold report

Structural shift in gold, money markets

Introduction

April is traditionally a quiet time in the gold market, but not this year. Suddenly, the gold market time bomb appears to be on a short fuse.

May, 2006/May, 2007. What is the difference between the last run to $700 and this one?

When you contemplate the gold price nearing $700, the first question that comes to mind is whether or not the price is for real. In other words, what is behind the recent strength in the gold market? The second question is whether or not the price is sustainable. After all, we've been here before, my fellow goldmeisters, and from here we took quite a tumble just a little over a year ago -- back to the $570 level. The short answer is "that was then and this is now." The facts of economic life on the planet line up much differently in May, 2007 than they did in May, 2006.

The most profound change has been the wholesale run from the dollar led by Japan, China and various oil exporters. In December, 2004 Japan held $690 billion in U.S. long and short term bonds. By December, 2006, not only had the net Japanese position failed to increase, it had actually declined to $627 billion. Recently, China publicly joined Japan in shunning U.S. debt paper and so have several of the oil exporting states. Though this troubling change of direction has been de-emphasized by the mainstream financial media, it has not been ignored by the foreign exchange and gold markets. It explains the $2 pound; the $1.35 euro and the near $700 gold price.

Altogether, the IMF recently reported that 80% of the annual U.S. fiscal deficit is now financed by foreign sources. Common sense begs the question "Who is going to fill the gaping hole left by the exit of America's top creditors?" A prime candidate, and perhaps the only candidate, is the U.S. Federal Reserve itself with its magical ability to manufacture money. It will write the check for whatever Treasuries are not taken up by the marketplace. The federal government, with two wars on the table and a third brewing, will cash that check. However, it will not be without a major cost in the form of ramping inflation, and perhaps, if things get dicey enough, inflation in the extreme.

When considering what is different between last May and now, and whether or not the gold rally can be sustained, the withdrawal of Japan, China and several oil exporting states from the Treasuries market, looms large. This amounts to a structural shift so profound that few really understand the full implications. The economists, politicians and Wall Street pundits who always believed that the dollar quid pro quo would go on forever are now suddenly forced with the prospect of its complete and imminent collapse. Whereas the run to $730 last May came as a final speculative blow off before the correction, this run to $700 looks more like the beginning of new leg up fueled by a fundamental break down in the operating international quid pro quo.

A rumor that Goldman Sachs is short 1000 tonnes. What does it mean for gold investors?

When Dennis Gartman, who publishes one of Wall Street's most widely circulated insider newsletters, passed along the rumor that Goldman Sachs' is sitting on a one thousand tonne gold short position, he reignited long-held suspicions in the gold market. Gartman also linked the short position to the 1999 Bank of England's gold sales intimating that Goldman influenced that decision to sell over half its reserve. What's more, given the copycat behavior of the financial engineers these days, if Goldman has a problem, it is likely that other bullion banks do as well. Thus Goldman's problem could be the tip of a massive iceberg.

This tells us that in the future investors might be competing not only with each other for available physical gold, they could very well be competing with well-connected bullion banking institutions that have the inside track on gold supplies. Since the long term trends indicate a steady decline in mine production and official sector sales (the two largest sources of gold), covering shorts of this size could create an explosive mix.

So what does this mean for now and would-be gold investors?

Though such a brew could be a major positive for the gold price, there is a darker side to the story. At some point down the road, private investors could be squeezed out of the physical gold market by a pack of hungry bullion banks. If you do not own gold, or do not own enough, you run some serious risks by waiting. First, it is likely you will pay more later simply because the gold price will continue rising in response to the shortcovering. Second, there could come a breaking point where the premium on physical gold items goes through the roof. Last, you might find yourself unable to locate gold at all as the free supply dwindles to nothing.

For those who consider such thinking farfetched, keep in mind that in the late 1990s premiums on pre-1933 European coins shot up aggressively in response to the Asian contagion and ramp-up to year 2000. Relatively common items like the British sovereigns and Swiss 20 franc gold coins sold at premiums of 30% over the gold price and more. The gold market is relatively small compared to the high-volume stock and bond markets. The number of gold brokers nationwide is probably equal to those housed at two or three nice-sized Merrill Lynch offices. The gold business in terms of manpower, item availability and infrastructure is simply ill-equipped for what might happen to it if even a minor gold panic should develop.

Why Gordon Brown's calls for IMF gold sales have become a reliable indicator of an up trend

Recently, with gold pressing $700, Britain's Chancellor of the Exchequer Gordon Brown, on cue, renewed his push for International Monetary Fund gold sales. There was a time when Brown's antics were cause for alarm in the gold market, but no more. As it turns out, one of the more reliable indicators of an impending spike in the gold price is Gordon Brown pressuring the IMF to sell its gold.

Just prior to the Bank of England sales in 1999, Brown pressured the IMF to sell a portion of its gold. When that sale failed to materialize, he prevailed upon the Bank of England to sell instead. Gold hit a bottom shortly thereafter at $280 and then sharply rallied to $450 per ounce, the beginning thrust of the current bull market. Then again in 2005, Brown was knocking on the IMF's door trying to persuade it to sell, and again he was turned back. Gold, which had been stalled in the low-$400s, promptly found new life this time rising to over $700 per ounce -- the second leg in the bull market.

Brown's latest attempt to persuade the IMF to sell gold suggests that the bullion banks are still having difficulty finding physical gold, and if that is the case, they are likely to bid up the price to meet whatever obligations are on the table. If the past is an indicator, Gordon Brown's new call for IMF gold sales might be predicting another explosive move upward.

Note I: The real problem for the bullion banks could be that global gold depositors, including central banks and private parties, have become very skittish about the dollar, probably for the reasons outlined in this issue's opening article. They would probably feel more comfortable with their gold in hand, or at least in an allocated account. Thus, they are asking, in essence, to have their gold deposits returned. If Gordon Brown were successful in bringing some gold liquidity into the picture via IMF sales, it might salve frayed nerves, but it will do little more than buy time.

Note II : We should all keep in mind that IMF gold sales require approval by the U.S. Congress. Both U.S. political parties -- each for their own reasons -- are opposed to any action that might depress the gold price.

Note III: The London Times (Rupert Murdoch owned) has decided to make an issue out of the Bank of England gold sales pushed by Gordon Brown. Those sales, if you will recall, occurred at the bottom of the gold market in 1999. The method of sale -- by auction -- insured that the liquidation price would be ridiculously low. Thus far, the British government has lost billions on the sale due to gold's sharp price increase -- an embarrassment for Brown and the Office of the Exchequer ever since. Now the Times is turning up the heat and so is the British Parliament which has called Brown to testify on the matter. It would like to know what Brown and the British government were really up to with those sales. Maybe, just maybe, this time around we will finally get to the bottom of the whole affair. Brown will replace Tony Blair soon as British prime minister.

Note IV: The Times article linked below (a recent USAGOLD NewsGroup must read presentation) not only makes the case for gold as a national asset; it makes the case for gold as a personal asset. The Times, as it points out in the article, is pushing to receive Bank of England and Exchequer meeting minutes from the 1999 gold fiasco, and they've been stonewalled. The obvious question is "Why?"

Gordon Brown's Blunder - London Times - 4/15/07