Why Isn’t Gold Higher?

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Published : January 30th, 2013
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( 19 votes, 2.6/5 ) , 5 commentaries
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Category : Editorials





My colleague and erstwhile nemesis Gonzalo Lira posed the question above in a recent essay, and it is indeed a most puzzling one. Given that the world’s central banks — joined most recently by a shockingly reckless Switzerland — are waging all-out economic war by inflating their currencies, shouldn’t gold be soaring,? In fact, prices have continued to meander between $1500 and $1700 since September of 2011, when gold topped out at $1945 after a spectacular run-up from $728 in just three years.

What could have caused the bull market to go lifeless since then, even as more and more countries appear hell-bent on devaluing their currencies to keep their exports competitive? The answer that Lira has offered is novel and engaging, but it did not persuade me, perhaps because the underlying conceit seems forced. For he has likened the current gold market to the one for credit default swaps (CDS) prior to the Great Financial Crash of 2008. Because swaps provided insurance against bond defaults, they rose in value as the crisis mounted. But then, suddenly, they ceased to appreciate, Lira says, because “the markets collectively realized that the counterparties to those CDS contracts might not be able to pay up.” This, Lira asserts, is exactly what is occurring in gold, as paper certificates have come to greatly exceed the supply of ingots held in vaults. The result, he says, is that “the global precious metals markets are essentially a game of musical chairs, with far fewer seats than players—far less gold than gold holders. And market participants collectively know this. Which is why they don’t trust their counterparties. Which is why gold isn’t rising like a shot.

I think there’s a more convincing explanation for why gold isn’t rising, and I will get to it in a moment. But first let me say that my intention is not to assail Lira or his ideas. Even though we had a nasty spat on the Web a couple of years ago over the inflation vs. deflation conundrum, I’ve always found his essays insightful, original and well wrought. Putting aside our differences over whether the inevitable collapse of the financial system will be brought on by hyperinflation or deflation, we probably agree on 90% of the things we write about.

‘Vague’ Insurance

This time, however, his logic would seem to equate apples and oranges. To begin with, the swaps he would compare to gold are a contractual form of insurance against default risks in certain types of financial instruments. As such, it is at least theoretically possible to calculate exactly how much risk is insured, even in a market as large as mortgage securities. Gold, on the other hand, and relative to inflation, offers only a vague kind of insurance. Moreover, unlike swaps, gold does not give its owner a claim on anything.

Lira’s argument might have been more persuasive if he had simply asserted that an effectively unlimited supply of “paper gold” has been absorbing enough demand to suppress the price of physical. But if, as he evidently believes, ruinous inflation, never mind hyperinflation, were immediately in prospect, then we should have expected to see the demand for bullion soar, pushing up paper gold no matter how large the supply.

Physical vs. Paper Gold

Lira lumps paper and physical together to argue that “the current spot price of gold is reflecting market uncertainty as to who has actual gold, and who has worthless paper certificates of gold.” Again, if this were so, then we should have expected uncertainty itself to have spiked the preference of investors for physical over paper, overwhelming carry-traders and other feather merchants playing gold from the short side. And if investors were indeed worried about whether the insurance they hold is properly matched to the endgame, would they be buying the Treasury paper of a country that owes so much more than it will ever be able to repay? In fact, the risk of a U.S. default is the last thing on their minds at the moment, and it will likely remain so until the day when events no one can predict cause creditors or debtors – it will have to be one or the other – to get stiffed.

In the meantime, whither gold? My own theory as to why prices aren’t bounding above $2000 is simply this: the central banks have so far failed to produce any meaningful inflation. The untold trillions worth of stimulus they have shot at this goal have barely kept deflation at bay. Granted, prices for groceries, health care and some other necessities have gone through the roof. But the inflationary impact of all of these things together is inconsequential in comparison to the deflationary down force of a quadrillion dollar financial edifice that remains in a state of incipient collapse.

Hyperinflation Scenario

Under the circumstances, I continue to believe that deflation, rather than hyperinflation, will wreck the global financial system. I did not, by the way, “switch sides” in this argument as Gary North asserted in an essay he wrote for LewRockwell.com. It was when the debate turned unendurably ugly that I was impelled to take a closer look at what some of the hyperinflationists were saying. Peter Schiff, for one. In his scenario – which, along with the running debate at FOFOA blogspot is the most persuasive case for hyperinflation that I’ve come across — a run on the dollar would force the Fed to absorb the entire supply of Treasury paper at auction. An unintended result, says Schiff, is that ostensibly unsupported bond markets such as corporates and municipals would collapse, forcing the Fed to extend open-ended buying to all fixed-income securities.

This would most surely trigger a hyperinflation – would in fact be a hyperinflation. However, this scenario, and virtually every other hyperinflation scenario of which I am aware, envision hyperinflation occurring as a result of political decisions made, Fed actions taken and markets “rescued.” My gut feeling, however, is that the collapse of global markets will be so swift as to preclude intervention, let alone rescue. Pent-up forces will take their course, and the entire financial system will experience an instantaneous collapse for which the May 2010 Flash Crash will seem to have been just a warm-up.

Whatever we might predict about the outcome, one result that seems entirely likely is that banks in the U.S and elsewhere will not open for business the next day. Over the short-run — a few weeks, perhaps — this would be ruinously deflationary, since a hitherto inexhaustible supply of digital money will have become inaccessible via checks, ATMs or charge cards. The fragility of the clearing system that allows such money conduits to function will be tragically obvious by then, as will the distinction between cyber money and the real stuff. And you had better have some of the “real stuff” stashed away in your home, by the way, since, The Morning After, that’s the only kind of money Safeway cashiers and gas station attendants will understand. Nor should you expect them to be up to speed right away on the junk silver you’ve socked away, since, at the retail level, although perhaps not in barter circles, pre-1964 coins are likely to be treated the same as the pot-metal coins that have driven silver dimes, quarters, halfs and dollars into secure storage.

Gold Hoarders, Beware

A couple of caveats for gold hoarders. Don’t count on exchanging gold at $5000 an ounce for something with high intrinsic value, such as farmland. For all we know, supply-chain disruptions could be so severe that you’ll pay a Krugerrand just for a loaf of bread. And while it has always been possible in theory for short-squeeze pressures to push gold well above the $5000 level, this is most unlikely for reasons that Lira’s essay implicitly recognizes. Consider who is short all of that paper gold: carry-traders such as Morgan Stanley, J.P. Morgan, Goldman Sachs and other bullion bankers who have always been able to borrow gold for next to nothing. The likelihood of regulators forcing them to make good on their paper gold obligations can be dismissed in advance as negligible.

Despite the seeming paradox of intrinsically worthless fiat money gaining traction in a post-apocalyptic economy, there will remain the possibility of a hyperinflationary spike. It could happen if, say, the Fed were to attempt a lump-sum pension payment to all government workers. For political reasons, this would have to be matched by similar windfall benefits to private-sector workers in the form of Social Security, welfare payments, unemployment compensation and food stamps. The Catch-22 of this approach is that any benefits in excess of what is needed to keep the economy functioning, if only barely, would touch off an inflationary spiral. Imagine how the world would react if someone in Congress merely mentioned that The Government was going to cover all of the obligations and liabilities of public and private pensions and health plans. If and when that day arrives, I will have no argument with Lira and the hyperinflationists about the likely outcome.



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Rick Ackerman is the editor of Rick’s Picks, a daily trading newsletter and intraday advisory packed with detailed strategies, fresh ideas and plain old horse sense.
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The answer to this question lies in the paragraph " Gold holders,beware"
"Consider who is short all that paper gold'.

Those big players have been making risk free profits on their gold (physical) that they have been borrowing and still holding, at very low rates for years.
When they close those paper short positions on that physical position ( now massive) after they have sorted out all the paper bulls THRU CAPITULATION , they will be left holding gold going ballistic.

This could be soon. Backwardation is occurring more often.

Rate :   3  0Rating :   3
Don't know where to start, so this will have to do.

"The first thing we do is corrupt the language."

Inflation and deflation are monetary events.

There is money and money substitutes. Money substitutes are fiat.

There is physical and there is fiat.

There are commodities and fiat. The commodities can be anything from raw materials to finished goods.

There is supply and demand.

Demand requires a willing buyer with the assets to purchase the item. Otherwise it is just want.

Most of the gold market is in fiat because that is what the buyers demand. The buyer has no intention of taking delivery or paying for storage in an allocated account. The buyers and sellers are buying exposure to the market in the form of fiat and not buying/selling physical gold.

If the primary market is for fiat, the much smaller physical market is caught in the net. On top of this, we tend to forget that a lot of newly mined gold was sold months ago at what might have been a lower price. This most assuredly affects the bid price decisions of larger buyers.

Now what is more probable? Inflation or deflation? Inflation is the current trend. Deflation could only happen by removing gross amounts of money from circulation. Money substitutes are not money anymore than a coupon for a free hot-dog is a hot-dog. Could gross amounts of money be removed? No, but when the majority of folks trust money substitutes, such as entries on a computer, and those substitutes vanish, the effect is the same. We are dealing with perceptions of wealth.

That the buyers walk away (hoard money, etc) and prices fall is NOT deflation. It is readjustment of the supply/demand curve. Prices can move up or down with inflation and deflation, but prices don't inflate or deflate. A commodity does not inflate or deflate unless it is a rubber balloon.
Cash on hand is always good.

PMs are for later when the economic system stabilizes and is allowed to take care of itself.

Silver coins will become a barter item later also.

On these we agree.
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simply... FANTASTIC !
Had a great laugh. If one can not laugh with it it is not the truth.
Have the feeling we are on the same wavelength.
Genial !

One of the flaws in your article is that you leave out the fact that some of the world's central banks are buying PHYSICAL Gold. Early on, in this twelve-year Gold Bull Run, the occasional fall-back in prices were explained away by the fact that Central Banks were selling tons of gold into the market and driving the price down. Now that the Central Banks are buying gold; how can you explain the gold prices STILL going down ?? There HAS to be some missing information here; some kind of overwhelming and powerful entity or group that consistently stays out of the Information Loop. Let's face it: that entity or group is holding down the gold price.
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If central banks are buying gold they will do everything in their power (and today their power is truly, yet unreasonably formidable) to keep the price down. When they finish buying gold then and only then will the price find its true value.
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Latest comment posted for this article
If central banks are buying gold they will do everything in their power (and today their power is truly, yet unreasonably formidable) to keep the price down. When they finish buying gold then and only then will the price find its true value. Read more
dennyc - 1/31/2013 at 8:06 PM GMT
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