Why gold prices don't reflect fundamentals - Phillips Part 3
Gold markets are inefficient, unreflective of fundamentals & understate the metal's market value, writes Julian Phillips.
Posted: Thursday , 10 Oct 2013
It may be in the reader’s mind that somehow all gold markets come together at some point and an exact representation of demand and supply is given by the gold price. The reality is that most markets are entirely separate from each other and reflect the buying and selling in that individual market only.
These markets are only joined by the ‘arbitrage’ activity, usually only by the professionals in the market –banks mainly—who can both electronically and physically move gold from one market to another.
Arbitrage, or dealing between two markets for instant profits, has always been very profitable. An arbitrageur will often deal in gold and currencies simultaneously, profiting on each ‘book’ throughout a day.
With the world’s richest banks involved in nearly all global financial markets and capable of moving prices to suit themselves, it becomes easy to ensure prices either do or don’t reflect demand and supply. We look into the different markets and how that can happen below. We start with the best known of the U.S. gold financial markets: COMEX.
A fact that is usually overlooked in the media when they comment on COMEX is that transactions. It is only these that could have a direct bearing on the gold price. How?
Ninety-five percent of transactions in the futures and options markets are terminated before they reach the date on which gold has to be delivered. The purpose of this is not simply to make profits (which are the sole purpose of the speculator) but to hedge a physical position. As we discussed in an earlier part of the series, such moves are to protect against the risk gold prices pose to a miner or manufacturer who profits from the business of producing gold products.
But they can be used by a speculating institution, such as Goldman Sachs or J.P. Morgan Chase, who as they did in April, sold around 400 tonnes of gold on COMEX with the full intention of buying the gold back before the contracts matured. Let’s be clear: this was not a gold transaction, but a financial transaction only linked to the gold price. It did not involve the movement of gold, nor did it affect the gold price directly (except through the psychological impact on the gold market itself).
In conjunction with the positions established in the futures and options markets, the banks and their clients sold 100 tonnes of physical gold very quickly so as to swamp the gold market, as the SPDR gold ETF was seeping gold from U.S. gold funds. Since the beginning of the year to May, the U.S. sold around 1,000 tonnes of gold. Together this huge amount of physical gold (in a market whose daily supply of gold is just over 11 tonnes) reaped around $6 billion in speculative profits and knocked back the gold price around $460 an ounce.
Speculators will argue that they are part of the supply/demand equation and they are, but are not part of the big picture of either supply or demand. This is because their short-term positions are always closed out. They are, as we described in the first part of the series, like waves on the seashore going both ways, but not affecting either the tide or the current.
Because they’re part of the highly sophisticated market mechanisms, including high speed computer trading, they can, and freely do, affect prices in the short-term.
But what happened to the gold that was sold out of the U.S.? It went to refineries in Switzerland, in particular, and from there to Asia, never to return. That final move is part of the current and tidal effect of the market.
Just as the massive hedging of the last century we looked at in the second part was ‘de-hedged’, post 2005, to accelerate the rise of the gold price, so will any attempt to buy back the gold into the U.S. impact the gold price and take it higher.
Distribution of Gold, Globally
As unseen, potential manipulator of the gold price lies in the distribution system itself.
You will note how in both China and in India, there are premiums on the gold price of varying sizes. For instance, in India the premium on the gold price has been as high as $40, but it has now dropped to between $5 and $7. In China it has also varied around $15.
The difference between the two nations is that in China, the gov’t wants the Chinese market to import more and more gold, whereas in India the gov’t wants to import less and less gold.
So why are there any premiums at all in China? The bullion banks that supply the Chinese market will no doubt cite the rising demand runs ahead of the volume of supplies they expected to be brought in. This is a weak argument, for any normal supplier carries stock to meet unexpected demand, particularly from a country where they know demand is rising. But for some reason, supplies have usually been less than demand, which has had to wait for new supplies, hence the premium. But this premium is the additional cost of gold over and above the price, which goes into the pockets of the suppliers. This is of course a form of manipulation.
That’s also why it is not surprising that the Chinese authorities have expanded the number of import licenses to include manufacturers importing more than 10 tonnes a year. As these licenses are used, we would expect these premiums to dissipate over time.
It may be that the banks that import bullion to China were delaying or reducing import orders to engineer the premiums that they received, but it would also happen if they wanted to slow the rise of the gold price. What is clear is that the importing banks have a means of manipulating the gold price in the shipping of gold.
Gov’t Price Manipulation
Over in India, the gov’t attacked the importing of gold by raising import duties, initially. Add to this the confusing nature of the actual legislation and Customs at the airports where gold is flown in, halted the release of the gold until they were clear on how the new system of 20% for export and 80% for import would work. Both these gov’t actions slowed imports of gold to almost a halt in August, resulting in 3.5 tonnes of gold imported in August against the usual amount close to 70 tonnes.
The aim of these measures was not to interfere with the price of gold, it was to reduce the Current Account deficit. We know that these measures will only work in the short-term as smuggling will replace the import deficit of gold.
The Indian family expects misgovernment and interference such as this and is happy to ignore it, for in the last century there was a period when gold imports were actually banned. But the gold continued to come in from Dubai and across the long coast of western India. Boats would meet the fast speedboats with silver and exchange it for gold, thus avoiding risks on the Rupee.
The Indian gov’t is fully aware of this, but the advantage of taking such a line is that the official Current Account Deficit will fall while unreported imports of gold avoid adding to the CAD. The CAD will in reality rise still but be off the books. This too is a manipulation of the gold price as pent-up demand adds to the premiums being charged.
Evidence of this was seen in the last couple of weeks when the premium fell from over $40 an ounce of gold to $5 - $7, as Customs released imported gold, to the internal gold market. Now gold imports volumes will jump, restrained only by the need to import 20% of the gold order for re-export. Indian importers are wily enough to export to known buyers who will alter the gold sufficiently so as to send it back to India.
With a superb Monsoon giving the farming community bumper harvests the demand from October onwards will be very strong.
So what’s the Indian government’s next move? We see it as a politically incorrect move on the part of gov’t to interfere with the Indian gold market until after next year’s elections.
Before then, the Indian gov’t may be faced with a reserves crisis as its indebtedness relative to reserves becomes critical. It has already made exploratory moves to see what gold they can ‘harness’ to support the Rupee. But this will prove a very positive for the gold price, but this may have to wait until after the elections.
The point is that gov’ts can act directly to manipulate gold prices inside their country, whether to its detriment or positively.
Additional moves that government’s use are the addition of Value Added Taxes, limitations on the amount to be imported, but most significantly –and one we expect in the near to medium-term—is outright confiscation of gold.
This need not take the form it did in the U.S in 1933. A gov’t can supply gold ‘bonds’ (3 years term, in the case of India is proposed) against the voluntary delivery of gold to its agencies with interest in the form of cash or gold paid to citizens. Then it is simply a matter of extending the term at the government’s option.
Where gold is already sitting in bank deposits, the ‘harnessing’ of gold is easier. We think of how cash and gold deposited in this way becomes unsecured loans (remember Cyprus!). It’s a small step to instruct banks to pass that gold to them ‘for a period’. When a country believes it is in its national interests to take such measures, they will be taken.
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