If there is a credible rumor that the Fed is planning to further extend
its “Quantitative Easing”, how would you expect the monetary metals to react?
Typically, the gold price would rise and the silver price would rise even
more.The question is why.
Traders read the headlines and they know how the price “should” react to
such news, and they begin buying. For a while, the prophecy fulfills itself.
But then what happens next? It may take an hour or a month, but sooner or
later some of the new buyers begin to sell. What can be bought on speculation
using leverage must eventually be sold.Traders who buy gold and silver
futures think of their “profits” measured in dollars. They cannot profit from
the rising gold price until they sell. So, sooner or later, they must sell.
Alternatively, if the price goes down, they must sell because they are
incurring losses at a multiple of the price drop due to their use of
leverage.
Nearly all buyers of futures are speculators. They could be called “naked
longs” because they have neither the intent nor the means to take delivery.
Their predictable behavior when a particular contract heads into expiry has a
characteristic behavior. One can see this in the gold and silver bases.
One way to debunk
the “naked short seller” conspiracy theory is to watch the basis heading into
First Notice Day. Naked longs must sell the expiring contract, and if they
wish to remain long the metal, they must buy another farther-out contract.
Right now, for example, we are in the late stages of “rolling” from the March
silver contract to May (there were about 80,000 contracts open a month ago,
and now about 30K).
Anyway, getting back to the topic, speculators are frequently driving up
the price by buying news and rumors and almost as often driving down the
price. In the short run, they can have an enormous impact on the price. But
in the long run, they have almost none.
There are an estimated seven billion people on Earth. Most of them don’t
read about the US stock market, the press releases from the Governor of the
Bank of England, or the latest politics surrounding the appointment of a new
head at the Bank of Japan. They don’t know how the price is supposed to move
when earnings estimates for the S&P 500 are raised or lowered.
They are doing one of two things with physical metal. They are either
slowly hoarding it, as the only safe store of wealth they can understand. Or
they are performing arbitrage, each with his notion of the “right price”.
When metal is priced lower than their threshold, these latter folks buy. When
the price rises above, they sell. Most of them, of course, don’t even look at
the price measured in dollars. They are using another currency, such as
rupees.
The actions of the hoarders will sooner enough cause the final descent
into permanent gold backwardation. But don’t count your paper
“profits” just yet. This is not a time when gold owners get “rich”. Sure, the
gold will have a high value indeed, though it may be worth your life to show
anyone that you have it as occurred throughout history.
Permanent gold backwardation—the withdrawal of the gold bid on the
dollar—will lead to bad times. Certainly, government policies are causing the
capital base that supports our society to be hollowed out. If it can no
longer support us, if the debt-based currencies no longer work, and if
industries such as food distribution seize up due to lack of credit, then
even the best case is pretty bleak.
For now, the actions of the arbitragers drive the price. Gold and silver
are totally unlike any other commodities. Both metals have a stocks to
flows ratio that is extraordinarily high. Stocks to flows is
total global inventories divided by annual mine production. For gold and
silver, this number is in the many decades. For other commodities, it’s
measured in months.
All of this inventory is potential supply at the right price. If the price
rises above the threshold set by a large number of owners, then metal comes
into the market. If the price falls below this threshold (or the threshold
ratchets up) then metal is taken out of the market.
The speculators can drive the price quite far in either direction, in the short
term. But it is the hoarders and arbitrageurs who drive the price in the long
term. A century ago, gold was worth about $20 an ounce. Now it is worth about
$1600. This is another way of saying that the dollar has gone down to 1/80th
its value. This trend is not going to end soon (or indeed end at all). But it
does not move in a straight line, as these past few years have proven once
again.
Wouldn’t it be nice to have an indicator that can help one determine
whether hoarders and arbitrageurs are driving the price at the moment, or if
it’s just the speculators again? This is precisely what the basis shows
(among other things). In other words, are you buying your physical gold or
silver into a speculative move (bad), or are your purchases part of fundamentals-driven
move (good)?
Monetary Metals is now publishing graphs of the basis for gold and silver
along with our commentary. Click here to view the Last Contango Basis
Report (free registration required).
