Five!

My Candid View – Part 10

"Did you have a "simple yet profound" A-HA moment you wanted to discuss?"

Ah, yes… my aha moment.

Well, FOFOA, it may be an errant aha moment, but here it is:

I had thought that the paper gold market was tethered to the physical market, and, while it is, it is not tethered to it the way that I imagined it was. In posts I had asserted that the paper market needed physical, but not vice versa, I was right, but for the wrong reason. I was thinking that paper gold required physical to meet the occasional allocation requests that came along…from anyone asking for physical. But allocation requests from small fry, (even not so small fry) that aren't met, shall we say, in a timely way, are not of the sort that can leave the paper gold market in ruins.

When you wrote the following to XXX...

"Freegold is a top-down phase transition, IMO. The minute there is not enough physical gold flowing at the top level in which it flows, the phase transition will be complete. It will be instantaneous, and when it happens there will be no going back."

somehow the genuine picture came into view as it was intended to. The paper gold market will collapse when the top level doesn't get allocation, because, when the top level can't get the goods, a revaluation is what will be required in order to get gold in size to flow. But, by definition, the ice dam will be so thick that a massive charge will be required to break that dam up to a degree that will achieve the desired result.

The top tier not getting physical will require something like a Def Con 1 response. The bombers will have to be let loose and the world as we knew it can never be the same again.

The process of getting physical in that size to flow will require something so forceful, so monumental, that the paper market must be, as a part of the proceedings, annihilated. Paper gold will be reduced to ashes on a launch pad that will be propelling physical gold beyond the gravitational pull that holds it in lock step with all the other actual commodities. The moment the top tier cannot source physical, the paper market is a dead man walking because nothing less than paper gold's sacrifice will get gold flowing to the necessary degree. Let me know if I am on target or not.

Hello Edwardo,

Yes, I think you've nailed it! But let me try to walk you through a little more detail (i.e., add a little more resolution and color to your view)…

Have you ever noticed that sometimes your local dealer has a lot of old coins, and then at other times he has mostly (or only) the latest year Eagles and Maples? I have personally dealt with maybe a half dozen different dealers in person, and I have noticed this on a couple different occasions. Remember when I kept mentioning a flow chart while we were Skyping? It looks like a family tree, kind of like this:



In this chart, the "Me" at the top would be the top level where gold trades in the largest volume amongst Giants, CBs, SWFs, and large wholesalers. So the "Me" would be the LBMA (in combination with the assistance of the BIS) and the Mom and Dad would be the largest wholesalers as well as the CBs (because Giants and SWFs generally don't "on sell" their gold purchases. At least that's not their reason for purchasing). The Grandparents would be the lower level wholesalers. The Great Grandparents would be the dealers that you and I know, including thousands of small dealer you will only find at coin shows, and then there would be another level of Great Great Grandparents that would be us "shrimp end users".

When your dealer is mostly stocked with old coins, the gold is flowing right here within our own level. Some other shrimp has sold his gold to a dealer and now you are buying it from a dealer. But if there are more buyers than sellers at the paper price, then the dealer has to go up this flow chart to find sufficient supply. Perhaps the shortage you observed is just localized, confined to your area, but in some other areas there are more sellers than buyers. In that case, the "Grandparent" wholesaler will supply old coins acquired from another locality. If not, he'll have to go higher up the flow chart to the CB's mint, and that's when you'll see mostly new coins at your dealer. The first time I saw this was in early Oct., 2008, but I've noticed it lately as well. One dealer I called who doesn't use wholesalers was completely out of stock (more buyers than sellers), and another one I saw at a coin show last month had only brand new 2013 coins. He had bought them from his wholesaler who received them from the mint.

So that's how the physical market works. It is fractal in that different levels operate basically the same only on different scales. And the physical market uses the reference price from the paper market which means that the various states of flow around the physical market are disconnected from the price-discovery market rather than being an integral part of it.

As I just stated, I did call one dealer last month who had no inventory at all at today's low paper market price. But obviously my personal experience didn't leave the paper gold market in ruins. Another example is that, just today, Jim Rickards tweeted that his dealer (presumably on the east coast) is out of gold. Nickz immediately tweeted back that his dealer (on the west coast, who incidentally is also a wholesaler) has plenty. Then he tweeted that the "supposed tightness" in the physical market is "gold bug fiction"… tweet.

This is the same thing we hear from XXXXXX and XXXX, that if they aren't seeing it in their little corner of the physical market, then it doesn't exist. It therefore must be fiction created by gold bugs to sell their gold bug hype. The problem with that view is that there's no cohesive and coherent narrative to explain their view of plenitude. And it also leaves them with only the consensus view to explain the unusual draining of GLD. All three of them have professed, in no uncertain terms, their rejection of the coat-check room view, but I digress.

The point was that Jim Rickards' tweet didn't leave the paper gold market in ruins either. And as I said, when the flow is tight at our shrimp level, we tend to see more current-year coins directly (or indirectly through large wholesalers) from the mints. The CBs have large reserves of gold, and they regularly send small amounts to the mint which is generally enough to keep the shrimp demand supplied whenever the shrimp level of the physical market fails to supply itself with old coins. And the countries that don't have large reserves, like Canada and Australia, have sufficient flow coming out of their mines which is essentially the same thing as having a large reserve.

So, to some extent, our shrimp-level demand shocks are isolated from the top level supply chain by the CBs and their mints. As long as the paper market is still functioning, any physical shortages we are able to identify at our level will likely be localized and mostly immaterial to the timing of the inevitable collapse. These localized shortages are symptomatic of the overall tightness and the failure of the paper market to keep physical gold flowing properly, but their relevance to the timing will only be known in hindsight. As I said, I saw it happening back in 2008, so their value is not predictive in nature.

But here's the main thing… A properly functioning physical gold market is one in which each level of this flow chart pyramid more or less supplies its own demand, and any differential between supply and demand, meaning the margin of that particular level that must reach up to the next level of volume in order to satisfy demand or unload excess supply, transmits a price signal that makes its way up the pyramid. The transmitted price signal is a premium difference between localities that allows higher-volume arbitrageurs to move the gold to where it needs to go while making a profit from doing so, just like what I wrote above where the "Grandparent" wholesaler will supply old coins acquired from another locality. This is how the gold physically flows from one locale to another, and the higher up the pyramid, the larger the volumes and distances.

That's the way it should work. The more gold that flows at the bottom levels, the less that needs to flow at the top. Yet the top receives—through the dealer network—the aggregated price signals from the various "bottom" locales and so the "top level price" where gold is moving in the largest volumes becomes the reference price used at the bottom. If demand for gold is high in your locality (i.e., your area is running a trade surplus excluding gold), there will be a higher premium locally than elsewhere, and so someone higher up will bring in some physical gold from elsewhere. Simple as that!

Today, however, this natural system isn't even functioning. No gold price signals are transmitted from the lower levels to where the price is discovered because the price is discovered in the paper gold market. The CBs could potentially supply the bottom level for quite a while. So why don't they? Well, it must be much more than just the bottom level that matters, because what we learned from ANOTHER was that they were very worried about this flow as far back as 1979, so they formulated a temporary plan.

They could have run down their reserves by minting small coins forever to keep the shrimp gold bugs satisfied, but apparently there were larger interests who couldn't possibly be satisfied with mint tubes and monster boxes. So they tapped the mines. Annual mining supply in 1985 was 1,500 tonnes. If ANOTHER knew what he was talking about and the CBs were hoping for a 5-fold increase, that means the (temporarily) sustainable flow, as viewed from the top where we cannot see, must be around 7,500 tonnes per year at current ratios (notice I didn't say "prices" because, even though the POG has changed since 1985, the ratios with commodities haven't). With very little basic math, that leaves a huge shortfall pressure on the physical gold market today, in the range of some 100,000+ tonnes of physical that was expected or at least hoped-for (promised to someone?) but never delivered.

Think about that for a minute. Hmmm… How did FOFOA come up with that number? Hmmm… Is it meant to be sensationalistic hyperbole or a very conservative back-of-the-envelope calculation? Hmmm…

It's conservative.

So just think about how long the CBs could prolong the status quo ratios with their mere 30,000 tonnes if that was their goal. It's not their goal, so you can stop thinking now. ;D

The point is that the "marginal drain" from all levels combined has reached the very top of the pyramid and is now draining its reserves. This is not the way the physical gold market should work. The CBs announced in 1999 that they would no longer support this constricted flow under the current market structure. Today, as the CBs are increasing their physical gold reserves in aggregate, they are once again telegraphing the message that there is no support for the status quo from the CBs, even as they continue to mint shrimp coins due to tradition.

So once those reserves at the top are gone, what happens?

"The top tier not getting physical will require something like a Def Con 1 response. The bombers will have to be let loose and the world as we knew it can never be the same again."

Yes. But do you see how the Def Con 1 response has a lot of moving parts and detailed resolution? We can't know exactly what has transpired at the top, except for what ANOTHER alluded to. But just imagine that 100,000+ tonnes of promised or at least expected gold (that's marginal-flow-gold, not global-stock-gold, so a simple doubling of the price would never suffice) never flowed. Once the top stops supplying the top as well as all lower levels, what would it take to get physical moving again for those that apparently mattered even as far back as 1979?

Remember, at that top level you have a variety of different players, but they generally fall into two types. I would categorize the two types as "savers" and "dealers". The "savers" include the CBs, SWFs, Giants and oil producers, and the "dealers" are the bullion banks and the largest wholesalers—the "arbs" that will move gold in volume from the lower premium zones to the higher premium zones for profit. These dealers don't care about the price. They don't own the gold, they only move it for profit. The top-level "savers", on the other hand, do own the gold and do care about the price. But most importantly, they have no reason to sell any gold, and every reason to buy more.

These are the CBs who can print, the sovereign wealth funds that are tasked with spending surplus currency and the Super-Producers who, until they stop producing, have no reason to sell any gold. And there's no level above this top level for the top level dealers (the bullion banks) to reach up to for more supply. When the top-level dealer supply runs out, the only place to go for more supply is to the demand side, to those who want more and have no reason to sell what they already have.

Can you see the dilemma? The price of gold will still be the paper price, but the flow will have completely stopped at the top level. It will be a de facto failure of the paper gold market and a new price separate from the paper gold market will be required to get it moving again. It will be like gridlock in a big city. The lights keep changing from green to red to green again but nothing moves. The system has failed, and only a revaluation can get it moving again. My gridlock is your ice dam.

At a high-enough price (in real terms, meaning a revaluation), those with gold *IN SIZE* who have no reason to sell any and simply want to buy more will only have to sell a small percentage of their "savings" to unlock the gridlock (melt the ice) and get it all moving again which will, in short order, allow them to resume "saving" once again. But gridlocks don't just unlock themselves, so someone will have to act first. And here's where it gets interesting.

What is the price that will unlock the gridlock at the top level, convincing those who have no reason to sell and every reason to buy more to sell? Who can act first, and what would that action necessarily entail? Here's what I think. The first to act would have to not only understand what is happening, but also be willing and able to sell or buy any amount of gold. This eliminates the Giants, SWFs and oil states because, even though they have plenty of gold, they don't have the printing press the way the CBs do. And that's why I think the CBs will be the first to act, probably under the auspices of the BIS.

In order to break the gridlock, they will have to announce a very high spread, a bid price and an ask price, either of which can be voluntarily accepted by the other top "savers", the Giants, SWFs and oil states, or "arbed" by the top "dealers". It would look something like this: "We will buy any amount of your gold that you are willing to sell at a price of $55,000 per ounce, and we will sell you any amount of gold that you would like to buy at a price of $56,000 per ounce." How's that for a Def Con 1 response?

Here's the key. Which do you think you need to lend credibility to a really high revaluation price, a buyer or a seller? The answer is you need a buyer, and not just any buyer, an unlimited buyer. The physical gridlock requires a physical seller to unlock it, but the revaluation that will make that happen requires an unlimited buyer. So the "first to act" can't just be a willing seller at a high, revalued price, it must also be a willing buyer at that same price and in any quantity offered.

Remember this post from ANOTHER (THOUGHTS!)? This Def Con 1 response would be quite similar to the pre-euro potential oil-bid-for-gold scenario in that post. So I will rewrite a small part of it using simple word replacement to show you how it would work:

"The first few moments after the BIS's proposal to buy gold at the very steep price of $55,000/oz, there would be roars of laughter. One fast thinker after another would think "Hey. I buy some gold from APMEX at $1,300/oz, sell it to the BIS for $55K. Net profit is $55,000-$1,300=$53,700. Easy money."

Everyone at once turns to the shrimp and paper gold markets to buy, markets which promptly shut down. Now no one is laughing. Because everyone realizes that gold is now worth $55,000 per ounce and no one is prepared for that revaluation. Whoever has gold now has 42.3 times the purchasing power in that stockpile. What appeared to be a stupid offer has now become a complete revaluation of all gold stockpiles worldwide vs all currencies worldwide."

The point is that the credible bid alone is enough to shut down the paper markets and stop all shrimp transactions at the old price in their tracks. The top level price is now the reference price used worldwide. The first transactions will be sales to the BIS, but before you know it, cash4gold arbitrageurs all over the world will be buying any and all physical gold offered for, say, $54,000/ounce just to arb that $1,000/oz. spread. Before you know it, the new physical-only market will have emerged worldwide.

So there's your Def Con 1 response to gridlock at the top level in which physical gold flows.

I think the draining we see today at the top via daily GLD inventory updates is just buying enough time to divvy up the few remaining scraps. At some point you're giving away the scraps by buying more time to divvy up the scraps, so where's the point of diminishing returns? Is it now? Is it next week? Who knows? We can only guess at such "hypothetical" choices.

If I'm right about the meaning of the GLD drain, then we're already in that zone where someone is asking, "Now?" "Now?" "Now?" with a loaded pistol aimed at the suffering animal's head. The physical market is no longer functioning properly, nor is it being supported. It is instead like a body in the last stages of starvation, eating its own extremities while hoping for some kind of a merciful reprieve. Each bite out of GLD is like a crazed animal eating its own tail, or arm, or leg. ;D

Sincerely,
FOFOA

Hi FOFOA,

Thank you for that very illuminating added color and detail. The last few paragraphs of your epistle really hammered home the "state of play". The system has become cannibalistic.

The main coin and bullion dealer that I used to go through here in town, a dealer who had been in business in town for many years, closed down a little over a year ago. I never received a very satisfactory answer as to why he closed when he closed other than burnout. Now his nephew operates a shop on a substantially smaller scale, and for many months, whenever I have contacted him to find out what the cheapest premium coins are in stock, the only response I have received is the thin gruel of MLs, GEs and the occasional Kruggerand and 1 ounce bars.

Now for a mini-digression of my own. My sister and her family were visiting us this weekend and I showed her the RT interview. In the last few months, I have finally persuaded her to buy some physical, and, now, after this weekend-where we discussed matters related to the interview- she is acquiring more. Unfortunately, My father is pretty much intractable which is a shame, but C'est la vie.

Edwardo

And finally, here's one last bonus email for you. Unlike the others, this one is not from the last 30 days. I wrote this one back in February, a month and a half before the big gold price crash in April, while the PoG was still barely above $1,600:

Hello FOFOA - I started off this week-end feeling very gloomy. But then your Checkmate Post hit the streets - and boy did that cheer me up!! What a feast! Funnily enough I was going through some older posts again, trying to make sure I understood each and every one of your Catch-22 scenarios. I think I "get" them all now, and the Checkmate Post just put the icing on the cake.

So you "expect it soon" - and if you had to bet on the "what triggers it" question - what do you see as the "most likely" trigger? I'm sure you ponder this often, and I'm also sure you have already selected your most likely or most appealing "favourite". So how would you like to see the game end?

Cheers - XXXXXX

Hello XXXXXX,

I think the biggest threat to the system right now is price volatility. That is, prices of real things changing too quickly in either direction. Prices are where the rubber meets the road, where the monetary plane intersects the physical plane. And I view gold as the linchpin that ultimately holds the two planes together.

I think the "most likely trigger" is the price of gold falling too fast, simply because I can imagine that happening at any moment, with little or no warning. It could easily be accompanied by (and driven by) a general market collapse like we had in September of 2008, or it could happen on its own for lack of support from either of the two legs. By looking at the gradually falling price around Snapshot days, I am simply taking note of the apparent lack of levitation we've seen in the past, which could mean that official support has ended if it was ever present in the first place.

Of course technical support levels still come into play even if the bull run has ended, so I think it is most likely to be accompanied with some sort of a general market decline. If there's a general market crash that punches gold downward through some of those technical support levels, there may be nothing below to stop the fall. That's when the paper price separates from the physical price IMO.

So will it happen this year? What are the odds that we make it through the rest of the year without a "dramatic correction" in the markets?

If the bull run continues, a rising price is also a threat because the general price level of commodities (real things) is correlated with gold during a bull run. The USG's spending habit is another place where the rubber meets the road because the USG's addiction is in real terms but its spending is in nominal terms. If "gold" goes to Jim Sinclair's $3,500 and oil follows it up north of $200/bbl, that means some real "cost push" price inflation as Jim likes to say.

Take a look at the US national debt during the last decade's bull run. It was at about $6T when the bull run started. Today it's over $16T. I don't care about the absolute level of the debt (what I call the stock), I'm only interested in the nominal rate of deficit spending (the flow), which, because it is in real terms, must accelerate with inflation. In other words, if the price of oil doubles, so does the rate of USG deficit spending, and these days that will mean the rate of QE.

I believe this will have a feedback effect on commodity prices as the USG refuses to cut its rate of deficit intake in real terms which would otherwise be the natural response to a jump in prices. I think that part of the reason we made it through the last decade's bull run was that China, while running a trade surplus, absorbed (sterilized) a large part of the USG's accelerating dollar output. But as has been observed, that mostly ended a year and a half ago, about the same time as the bull run in paper gold peaked.

So once again we have two legs of support which could explain the last decade. Somehow the flow of physical gold was managed while the acceleration in the USG's rate of dollar output was absorbed by a net-producer. And now we find ourselves stuck between a rock and a hard place. The rock being a falling gold price and the hard place being a continued bull run.

While the feedback effect on commodity prices is merely an academic exercise to us now, I think that in reality it could happen a lot faster than you can imagine.

So there you have it. My "most likely trigger" is a falling gold price which leads to the separation of paper from physical. And my "back up trigger" is a rising gold price which leads to impending hyperinflation. Both ultimately cause the other to happen in short order, but which comes first remains a question.

Remarkably, the bull run has stalled out for a year and a half now, along with oil, silver and just about everything else. So it seems we have reached a new plateau of stability. Or not. And if not, just imagine the pressure that has been building during this so called "consolidation phase". What if we bust out of this slump to the upside like July and August of 2011? Do you think it will stick? Do you think the bull run can continue to $3,500? I don't.

Do you think the general markets can continue their upward trend without a sudden and dramatic correction at some point? I don't. Do you think that official support for paper gold as well as the paper gold bull run has ended? Looking at the evidence, I think it's possible. Remember, we had Paulson and Soros selling in December along with my bellwether ringing followed by a chorus of others. Today we hear talk of technical levels of support. So what? They have those in bear markets too. Do you think the East has lost its taste for physical? Do you think the East is instead prepared to soak up the USG's accelerating rate of dollar output indefinitely? I don't. Do you think it has already ended? I think that QE is the proof that it has.

So when I say soon, what I really mean is "overdue". Like the Big One. I use this only as an example of what overdue means. These "Big One" earthquakes have a certain historical geographical frequency of, say, 70 years. So once the 70 years has passed, we could say the next one is overdue. In the case of Freegold it's not about the historical frequency. It's about all of the identifiable elements being in place. Seems to me they are now in place, so that's what I mean by "soon". Unlike most people (apparently), I don't view the more time that passes as a sign that it's farther away than we thought. That someone has figured out a new and better way to delay the inevitable. Instead, I view each day that passes as another day the Big One didn't hit even though it's already overdue.

It's one thing to explain how we made it through the last 10 years. It's something entirely different to have a gut feeling (based on what??) that it can be repeated, even as we see clear evidence that the European gold sales have ended, QE has begun (meaning not enough net producers mopping up the dollar sewage) and paper gold languishing 16% below its high from 18 months ago. I mean, seriously, anything other than "soon" would be a disservice to everyone. I don't think the actual date of Freegold exists, even with theoretically perfect (godlike) knowledge it doesn't exist. What exists is a probability wave in which "soon" has the highest probability at present.

Sincerely,
FOFOA

We are, today, at the very conclusion of a fiat architecture that is straining to cope with our changing world… Trained from birth, as all Western thinkers are, to read everything economic in dollar system terms; we, too, are all straining to understand the seemingly unexplainable dynamics that surround us today.

Western governments, the public and several schools of economic thought are attempting to define and explain what extent these changes will have within our financial and economic world. Most are all striving to see this as the next plateau of dollar integration, carrying us onto the next level; looking always higher for what this next level will bring in social, financial and lifestyle enhancements…

What if the last decade's efforts to prolong dollar use, both internally and worldwide, have inflated its worth to such an extent that it's now vastly overvalued? Asking more; what if the architects of a competing currency system and the major players that helped guide its internal construction, all took a hand in promoting the dollar's extended life, its overvaluation and its use; so as to buy time for this great transition in our money world?

The actual debt machine that built much of America's lifestyle is now going into reverse as it destroys its own currency; one built upon a stable debt system with locked down gold prices…

To compete in the new architecture of a Euro System currency, unrestrained trading of gold will (and has) advance its dollar and Euro price significantly…

This not only has "everything to do with a gold bull market", it has everything to do with a changing world financial architecture. And I have to admit: if you hated our last one, you will no doubt hate this new one, too. However, everyone that is positioned in physical gold will carry this storm in fantastic shape. This is because the ECB has no intentions of backing their currency with gold and every intention of using gold as a "free trading" financial reserve. None of the other metals will play a part in this.
-FOA

I (we) expect none of you to consider anything said here as credible. Everything is given as I understand it. If you came with a notion that I am someone who sees the future, grab the children and run far away. For these Thoughts, and my ongoing commentary, are meant to impact exactly as the "gentleman" said they would. People hear them, and whether believed or not, the words leave a mark. A mental mark on the trail, if you will. And later, after the world turns, our little "stacks of rocks" will be easier to understand next time you are passing this way. In fact, your ability to find your own way will forever be enhanced for having seen this path in a different light.
-FOA


Moneyness

FOA: My friend, our message and our position is that we are in one of the most exciting times of all the history of gold! We have seen that during times with the most radical transitions, the majority are usually defending the wrong asset. This unfortunate situation need not impact everyone today. If better judgment is the result of a full understanding, then some who read here will be exposed to tools that could help them avoid the mistakes of our Western hard money majority.

For Western Gold Bugs today, their culture, their system and their recent knowledge is all ensconced within the last 30 years of paper wealth. Yet they are using a hard money defense, written by masters preceding our modern era. They struggle to use that logic out of context, as it is thought to apply to this gold market today. These two precedents are leading them to reflect their gold values in some form other than physical ownership in possession. This mistaken detour from gold's true purpose will once again prove, by reality, the value of owning real gold.

Standing aside this group is the Physical Gold Advocate. For them, for us, these times will contain the greatest gain in real wealth ever seen. For those who are falling behind, gold is still within your grasp.

TrailGuide

From Moneyness, here's How It Ends:



What is Freegold?