Happy New Year!

2016
Year of the Fire Sale

Last year, I began with "The dollar is on fire right now… 90.28 at the close!" The dollar has indeed been on fire all year, and is now at 98.69. Gold was just under $1,300 last January, and today it's on sale for only $1,062. So my title for this year, in a way, is already a fait accompli.

But what if you knew the price of gold would probably drop this year to a range it hasn't seen in more than a decade? What would you do? Would you sell all of your gold? Or would you buy more? Would you try to wait for the bottom to buy? Or would you continue buying all the way down?

What if you also knew that at some point during the decline, it would become impossible to find physical gold for sale at that price? What would that mean? How could that be? And would that change your plans?

I don't have a crystal ball, but there is a good argument to be made that the dollar price of gold ($POG) will decline to somewhere between $750 and $350 this year, and that physical will not be available at that price. But before we get into that, please read and understand my disclaimer. It was written years before I even knew what gold was:

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."

What that means, like I said above, is that I don't have a crystal ball, only my Freegold lens. And my opinion is not a prediction, but rather just an opinion of what's likely to happen this year. My confidence in the final outcome (i.e., Freegold) is in no way dependent upon the potential events described in this post. You should therefore (like I have explained many times) think for yourself, and look at my opinion through the lens of your own understanding. I am not a trader, I do not do TA, and I do not do timing. So if you put on a trade and lose, don't come crying to me.

Now, since I don't have a crystal ball, there are a few different things I look at when writing these New Year's posts. Right now, those things are the $POG, the POO (price of oil), the GOR (gold/oil ratio), the GLD inventory trend, the US stock market trend, the dollar, TIC data for official or structural support, and news about foreign currencies switching to a clean float and/or depegging from the dollar. Also, I'm only interested in the long term trends, not the daily fluctuations.

Three years ago, I dubbed 2013 the Year of the Window, and I still like that call. Something happened in 2013, and I characterized it as the opening of a window of opportunity for systemic change. And now, looking back, it looks like support for the system's status quo did indeed end in 2013. Foreign official dollar support stopped dead in its tracks, the $POG fell off a cliff, and GLD's inventory began disappearing faster than a box of donuts at a police convention. I'd say the window clearly opened in 2013, and it's still open today. Here's a rough comparison between January 2013 and today, which looks quite encouraging through my lens:

$POG

In my Countdown to 2013 Open Forum post, I wrote, "The thing is, paper gold is so relatively valueless that it’s no wonder when the price falls. The real wonder is when it rises." And in my Interview post in July of 2012, I wrote:

"Where do I see the $PoG going over the next couple of years? Maybe to $500 or less, but you won't be able to get any physical at that price. I think that today's price of $1,575 is still a fantastic bargain for physical gold."

You may ultimately say I was off by two years, but in that case, please refer back to my disclaimer. This was, in fact, my basic view of the $POG even as far back as 2010, when I wrote:

"So, in conclusion, the price of gold will plummet!

That's right. At some point in the future, after the price of gold rockets upward, it will fall like a box of rocks! And right about that time you'll see more of Robert Prechter on CNBC than you ever thought was possible.

But here's the challenge. When the price of gold falls to $200 per ounce, try to get some physical. I'm sure that Kitco will sell you some from their pooled account. And GLD will be standing ready to sell you a share at $20. But just try to take delivery. I think you'll find it will be impossible at that point.

And that's why you've got to take delivery NOW, at the current "high" price of $1,300. Don't wait for the dip. Oh, yeah, the big dip is definitely coming. A **BIG** "correction." But will there be any physical available? Perhaps at $1,200 if you're lucky. At $200? No way."

The problem is that the sheer scale of the paper gold market dwarfs that of physical, such that there's not even a question as to which one leads the market in terms of pricing, and which one follows. There is nothing illicit about it—in fact it was one of Another's main points that it has simply been good business for the past 30 year or so—but it is a systemic flaw, and it will eventually crash the whole paper gold system.

You see, the way it should work is that whenever there's a shortage of the underlying (physical gold), the price should rise until there is no more shortage. In fact, there should never be a shortage (or a glut) because, if the market was responding to physical supply and demand dynamics, price would always make it so. But with paper gold, paper supply and demand has supplanted physical supply and demand and the market has no way to respond to its physical side dynamics. It isn't a big problem when the price is rising, but it's a huge problem when the price declines, especially below the cost of production for new gold.

Also, the vast majority of gold demand is in currency terms, so a relatively-stable currency demand translates into an increase in physical demand in weight terms, exacerbating any physical shortage while the paper price declines, disconnected from the physical side dynamics. I covered why this problem is unique to gold in Fallacies – Paper Gold is just like Paper Anything, and I went into some detail on the overwhelming scale of the paper gold market in my Interview with Vivek Kaul for the Daily News and Analysis (DNA), an English newspaper in India:

Vivek Kaul: The price of gold has been rather flat lately. What are the reasons for the same? Where do you see the price of gold going over the next couple of years?

FOFOA: "The price of gold" is an interesting turn of phrase because I use it often to express "all things goldish" in the gold market. In today's market, "gold" is very loosely defined. What passes for "gold" in the financial market is mostly the paper obligations of counterparties. These include forward sales, futures contracts, swaps, options and unallocated accounts. I often use the abbreviation "$PoG" to refer to the going dollar price for this loose financial "gold".

The LBMA (London Bullion Market Association) recently released a survey of the total daily trading volume of unallocated (paper) gold. That survey revealed a trading flow of such magnitude that it compares to every ounce of gold that has ever been mined in all of history changing hands in just three months, or about 250 times faster than gold miners are actually pulling metal out of the ground. Equally stunning were the net sales during the survey period. The rate at which the banking system created "paper gold" was 11 times faster than real gold was being mined.

VK: What is the point you are trying to make?

F: The point is that gold is being used by the global money market as a hard currency. But it is being treated by the marketplace as both a commodity that gets consumed and also as a fiat currency that can be credited at will. It is neither, and gold's global traders are in for a rude awakening when they find out that ounce-denominated credits will not be exchangeable for a price anywhere near a physical ounce of gold in extremis—ironically failing at the very stage where they were expected to perform.

VK: So what are you predicting?

F: But don't get me wrong. It is not a short squeeze that I am predicting. In a short squeeze, the paper price runs up until it draws out enough real supply to cover all of the paper. But this paper will not be covered by physical gold in the end. It will be cash settled, and it will be cash settled at a price much lower than the price of a real ounce of gold, like a check written by an overstretched counterparty. It is a tough job to make my case for the future of the $PoG in just a few paragraphs. The $PoG will fall and then some short time later we will find that the market has changed out of necessity into a physical-only market at a much higher price. If you were holding paper you will be sad. If you were holding the real thing you'll be very happy.

In Gold as a FOREX Currency, I explained how the use of "gold" as a currency (XAU) in the huge FOREX market explains a large part of the unbelievable volume in the LBMA survey. Following that post, the "other gold writer" mentioned in it emailed the LBMA asking for confirmation of my claims in the post. Here was his email:

"I am conducting some research into the gold market.

I am trying to gain a little more understanding about LMBA turnover.

According to your 2011 survey, average daily trading volume in the London market in this period was 5,400 tonnes, equivalent to US$240.8 billion at the time.

Given that most of this is ‘spot’ gold trading (and it is understated given the lack of full responses from members) and it’s clearly not that much physical changing hands/ownership (more than annual scrap and mine supply trading per day would be impossible, despite the large outstanding stock of gold) can you provide some information as to what accounts for this huge level of trade?

The only thing I can come up with is that it’s related to currency trading. As you probably know, you can trade gold on a computer screen in the same way you can trade global currencies. Its currency code is XAU. I’d imagine XAU/USD long or short is a pretty popular pair trade. Is it this ‘gold as a FX currency trade that accounts for the huge amount of daily spot volume?

Would gold as FX trade be reported to you as part of the survey?

Any info you could provide to clear this up would be much appreciated."

Per the usual (right now I have a two-month-old question seasoning on Aelred's desk which he said he would get answered for me), it took five months to get an answer out of the LBMA, but get one he did, and here it is:

"Apologies for the delay, but I thought that my colleague had already responded to your questions. The Survey included all forms of gold trading so certainly included gold currency trading which would have contributed to the significant numbers that came out of the Survey. We are in the process of discussing with market participants running more regular surveys. I will keep you posted on developments. I am not sure if you have seen the article that accompanied the results of the 2011 Survey, see below. Once again apologies for the delay in responding to your questions.

http://www.lbma.org.uk/assets/Loco_London_Liquidity_Surveyrv.pdf

Kind regards,
Aelred"

My point is that the overwhelming scale of the paper gold market, which determines the price imputed onto the physical side, is no myth. It has been confirmed by the LBMA, and it is massive. The physical market doesn't stand a chance. Even as physical runs dry, the "$POG" will continue to fall if that's the direction it's heading.

Back in September, Alex Stanczyk's Physical Gold Fund recorded an interview with someone who is senior management at one of the largest Swiss refineries, "one of only 5 global LBMA referees, which takes samples from other refineries around the world and certifies them to produce gold" meeting LBMA standards. He also knows his paper gold derivatives, as he built up his refinery's "precious metals trading, funding, and hedging business." Here's what he had to say about the disconnect between price and the physical side of the market:

Interviewer: "How well does the price today reflect the realities of physical supply and demand you just described?"

Head of Refinery: “The price does not reflect the realities at all. Don’t forget, we have a huge amount of artificial gold or paper gold floating around the market. If you look at the numbers of futures exchanges, there is a lot of metal you can’t even detect because it is within some derivative product, which in the end, you have no clue how much it is and on which side it is.

The other point is that nobody is interested in any physical delivery at the end. These products are all cash settled. People are happy just to use the spot market as a benchmark, and the product itself never ends up in the physical market. This looks dangerous to me. If we were to have a situation where everybody said, “Okay, now I have a long position that expires, so I want the physical,” for sure, the physical would not be around.”

When Kyle Bass helped the University of Texas use its 1.25% share of COMEX open interest to take delivery of more than a third of its deliverable gold back in 2011, he said: "When I talked to the head of deliveries for COMEX/NYMEX, I said, 'What happens if like 4% of the people ask for delivery?' He says, 'Oh Kyle, that never happens. We rarely ever get a 1% delivery.' So I said, 'Well what if it does happen?' And he says, 'Well, price will solve everything.' So I said, 'Thanks, give me the gold.'" And that's the problem with the gold market today—price won't solve a thing, and in this case, it'll make it much worse!

GLD Inventory

The reason I pay attention to GLD's inventory is that GLD is not only unique among gold ETFs, but it's unique among ETFs in general, and even among financial products in general. The reason it's unique is a little beyond the scope of this post (I have written several controversial posts on this topic, two of which are only at the Speakeasy), but the most basic reason is that GLD's inventory is a reflection of the LBMA's remaining reserves, and changes are driven by reserve management, not as a response to investor demand.

The common wisdom among virtually every gold analyst in the world today is that the GLD inventory expands and contracts based on demand for GLD shares. Even those who manage GLD will explain it to you this way if you ask. They'll say, "GLD buys and sells bullion based on an arb that the APs take advantage of. If sellers pound GLD so hard that it trades below spot, the APs will buy GLD shares and redeem them for metal which they will then sell and make the spread between GLD and the spot price. The same works in reverse when GLD trades above spot and the AP arb buys. This is how GLD 'tracks' the metal over time." That's what everyone thinks, and that's what they say, but that's not the way it works, at least not most of the time.

Like I said, I've explained this at length and I'm not going to do it again in this post, but I will give you, not the Cliff's Notes version, but the Cliff's Notes to the Cliff's Notes version. If selling in GLD is so extreme that it is trading far enough below its NAV so as to render a viable arb opportunity, it suffices to buy GLD and sell spot unallocated or XAU/USD. Then you simply wait until the selling pressure in GLD has abated and you square your position. No redemption involved.

The common wisdom is that an AP would need to redeem the GLD shares to get allocated physical which would, according to the myth, er, wisdom, bring a higher price. But GLD is so large that any LBMA bullion bank would gladly take it instead of allocated. So why redeem? In fact, GLD is the same as (and in some cases better than) physical reserves inside the LBMA, so in the end, it is the BBs decision whether to redeem or not. Hence the coat-check room view.

Still not convinced by mere logic? Then try a simple comparison of GLD and SLV. The gold price is down from $1895 on September 5, 2011, to $1062 today. GLD inventory is also down, from 1,232 tonnes to 642 tonnes over the same period. Meanwhile, the silver price is down from $42.71 to $13.93 over the same period, yet SLV's inventory is up, from 314.5 million ounces in 2011 to 320.3 million ounces today. I do understand that this is not a comparison of the relative demand between the underlying and the ETF, but gimme a break if that's gonna be your argument.

Now that we have that settled, the draining of more than half of GLD's massive inventory since the window opened in 2013, tells me that the slack in the flow is quickly disappearing. What that means is the LBMA is quickly running out of reserves. The LBMA manages a dynamic interaction between “inside supply”, “outside supply”, “inside demand” and “outside demand”, as well as the interaction between the physical and paper sides of the market. I wrote about this in My Candid View – Part 9:

"Think about the warehouse as having two sections, or two sides. On one side they simply offer the service of storing your gold for a fee. That’s where all of the allocated gold sits. On the other side they store gold that they bought, mostly from the mines, while collecting the fee from the speculators playing in the futures market. They buy up any slack in the flow and sell futures at a higher price keeping the difference as the storage fee, rather than collecting a fee directly from the owner of the gold.

That way, you can think about the “draining” of the warehouse as all of the gold either a.) leaving the warehouse or b.) being slid over to the other side where it’s all allocated to specific customers.

Some might be going East or Mid East, but I doubt it’s as much as people think. At least probably not as much LBMA LGD bars. Remember, there’s still some flow of new gold coming in, so that would go to supply “outside of the LBMA demand” before LBMA bars would be shipped. Some might be going to Switzerland to be melted and recast into kilo bars which are very popular in the East. Bron and Warren speculated that this is why it seemed like more “four nine” bars were being redeemed from GLD than the lower purity bars. Kilo bars are all “four nines” whereas London Good Delivery bar specs do not require that much purity. So if they were going to melt them to make kilo bars, the lower purity LGD bars would require additional refining i.e., additional cost.

But I'm not so sure about that explanation. Today more gold is being refined to .9999 anyway, so the "newer bars on top" might tend to be higher purity and, like I said, the "new" flow should be going to fill that "outside demand" before they move a single LGD bar. Remember also that XXXXX said HSBC was requesting gold shot from the refinery's scrap recycling. That would likely go toward the "outside the LBMA flow".

I think that there's probably enough "inside LBMA demand" to prevent too many LGD bars from exiting the system. So I think that a lot of the movement we see is probably just location swaps within the LBMA system. Think about the tight flow being asymmetrical amongst both individual bullion banks and locations. Gold coming in doesn't necessarily match the demand for gold going out in terms of which BBs are taking in versus which BBs are putting out, and the locations where the gold is being demanded.

So, netting out the entire LBMA system in aggregate, I tend to think that there's probably not as much "physically leaving the warehouse" as most people think. Basically just the entire new inflow is "leaving" while the bars already inside are being shuffled around to match allocation requests. I'm sure there are some LGD bars leaving the LBMA and heading east or being melted down, but probably not too many IMO."

I wrote that back in 2013. Two years later, and now we have some evidence that a lot of those bars did in fact leave the LBMA and get melted down. From the interview with the head of the Swiss refinery mentioned above:

Interviewer: Over the last couple of years, has this meant that you actually had to melt down and re-refine a whole lot of 400-ounce bars for China? If you have, I’d like to know where the bars come from.

Head of Refinery: The bars are coming from what you could call “the market.” Looking back, there were all these ETF liquidations, and the ETFs were holding bars in the form of 400-ounce bars. At that time a lot of the physical liquidity maintained in the London gold market was actually in 400-ounce large bars. The final customers were not interested in 400-ounce bars, so it was one of our jobs to take these bars, melt them down, refine them up to the 999.9 standard, and cast them into kilo bars.

Interviewer: Were a whole lot of these bars coming from London?

Head of Refinery: Regarding the ETF liquidations, this gold had to go somewhere, and that was all converted.

Notice that the head of the refinery takes the position that the GLD drain was supply-push rather than demand-pull driven when he says, “this gold had to go somewhere.” Like I said, this view is simply wrong, yet it’s what virtually every gold analyst in the world thinks.

My first post on this topic from back in January, 2011 is titled Who is Draining GLD. There are many more and there was much debate in the comments, but the bottom line is that the GLD inventory today tells me that physical reserves inside the LBMA are extremely tight, and that could become a big problem in 2016 if I'm right that this is the year of the big, last chance fire sale. You can follow GLD inventory developments here, here, or at the Speakeasy.

Support

In 2013, "Foreign Official" ownership of US Treasury Bills, Bonds and Notes peaked at $4.1T, the same level it stands today. It never even hit $4.2T in between. That's called a plateau, and that's why I said foreign official dollar support stopped dead in its tracks during the Year of the Window. Also in 2013, China's holdings peaked at $1.31T. Today they are $1.25T. Japan hit $1.18T in 2013, and today they are lower at $1.15T. Can you see the trend?

From Bloomberg just three days ago:

“It’s an early warning sign that you’re starting to see a decline in demand for Treasuries" more broadly, said David Keeble, the New York-based head of fixed-income strategy at Credit Agricole SA. “2016 is a hand-off year to the private-sector buyer. Foreign central banks are stalwarts. Private-sector buyers can change with the wind.”

This is what I have been saying about the foreign private sector for a couple of years now, ever since year-over-year structural support turned negative in February of 2014.

"The plunge was stopped because the public sector stepped in, but what the European CBs learned from that experience was the difference in motivations between the public and private sectors. The private sector is very simply motivated by profit, while the public sector is motivated by its desire for exchange rate stability. They learned that, without their structural support (supplementing private sector demand for an overvalued currency via the dirty float), the private sector (the market) will not support a currency if such support turns unprofitable, regardless of the fact that it would collapse the whole system.

[…]

Structural support has clearly ended, and as FOA said, "this is more than enough to end the dollar's timeline." Europe is obvious, China is no longer dependent upon its exchange rate with the dollar, and total foreign official holdings of Treasury debt (the gold standard of structural support for decades) are flat for the last year and a half, not to mention that China itself is flat for the last year. The foreign public sector in aggregate has let go, and now it's all up to the foreign private sector.

The problem is, we're still putting out about $40B in new dollars that need to be bought up by someone in the foreign sector each month. The foreign private sector loves dollars, but not that much. We know this because the status quo of the last few decades included the foreign public sector supplementing the foreign private sector's demand for dollars by a significant percent.

How long do you think the foreign private sector can continue absorbing $40B new dollars a month? Remember, the private sector is driven only by profit, and without the supplemental public sector maintaining the status quo of dollar profitability, demand could turn on a dime. All I can say is hold on to your hat next time there's any kind of a shakeout in the dollar markets, and thank goodness there are no major geopolitical crises at the moment that could potentially precipitate a financial crisis. Enjoy the calm while it lasts, because Freegold is unfolding right before our very eyes, if you just know where to look!"
–From Dirty Float on 8/3/14

_____

"So, without "official support" stepping in at the margin whenever the private sector drops the ball, all that's left is "willy-nilly" support which is the fickle, profit-driven foreign private sector "hot money" that has the tendency to turn on a dime and the ever-present ability to panic.

Back in April, I pointed out that year-over-year structural support had turned negative in February. It didn't stay negative, but that's not the point. The first YOY negativity marked a whole year of being "flat" or established the plateau. It didn't even necessarily mean selling. Debt matures, and if you don't roll it over or buy more, your holdings will decline automatically over time."
–From a comment on 8/24/14

_____

"The dollar, on the other hand, feels the same exact upward pressure even though its economy is living on food stamps and has been in deficit for 40 straight years. That's the curse of the reserve currency! The curse is that your situation, your status quo, is based on others buying your currency as reserves and investments, and that includes the foreign private sector which does so based purely on the profit motive.

[…]

My general thesis is that, whenever the dollar's exchange rate is rising, the net inflow is coming primarily from the foreign (profit-driven) private sector, and when the dollar's exchange rate is declining is when I'd expect to see foreign CBs begin intervening in their foreign exchange markets.

[…]

Central bank foreign exchange interventions generally act in opposition to normal, profit-driven payment flows, and therefore have a different motivation than the private sector. On one side, we have normal, profit-driven, private sector payment flows—both in the here-and-now ongoing trade of goods and services, and in the financial plane of debt, equity and their many derivatives—driving exchange rates, and then on the other side we have central bank foreign exchange interventions occasionally pushing back against the private sector.

[…]

I think the clean float, as I imagine it operating in Freegold, is basically already here, and now it's just the foreign private sector piling into the dollar bomb shelter, global stagnation and its vicious circle… that are supporting the dollar and the entire $IMFS. I don't think it has been here for a long time, but maybe for the past year or so.

The dollar strength over the past year has forced many foreign CBs that were already predisposed to a clean float to take the idea quite seriously."
–From Clean Float on 5/10/15

Here's some more from the Bloomberg article:

"Foreign central banks have reduced Treasuries every month this year through October, by a combined $179 billion, on pace for the biggest annual decline in data going back to 1978. Tempering that, foreign private buyers have added $161 billion.

"Foreigners are half the Treasury market," said Jim Bianco, founder of Bianco Research LLC in Chicago. "If we’ve lost one of the biggest buyers -- it doesn’t matter if it’s at auctions or if it’s secondary trading -- if we lose them that will be very problematic."

What we learned from Another and FOA was that the foreign public sector (mainly the European CBs) made a decision to support the dollar in this way right around 1979. The purpose was to keep the international monetary system going until the launch of the euro. Following that launch, it appears that China picked up the baton and ran with it, like big, centrally-managed giant, following in the footsteps of the BIS.

Today it looks like that "structural support" is gone, and that's why I keep an eye on the TIC data. But again, I'm only interested in the long term trend, not short term movements. In the short run, data can move in either direction for any number of reasons, some of which you'd never even consider or imagine. So only the long term trend is really reliable, and the TIC data is only a proxy for, or representative of, what's happening in a much bigger picture.

Hugo Salinas Price published a post on Dec. 18 noting the lack of data on his Bloomberg terminal for World International Reserve Assets Excluding Gold, beginning on Dec. 11th. This was curious, he said, because "International Reserves have been contracting since August 2014 and up to November 27, 2015, had diminished by $752 billion dollars… this contraction was unprecedented, since we have data going back to 1948, and never, ever, has there been a sustained contraction in the total of Central Bank International Reserves since the creation of the present international monetary system in 1944, at Bretton Woods."

That is, of course, not only dollars, but it is mostly dollars, and again, it's an indication of something that's happening in a bigger picture. In this next Bloomberg screen, you can see whose reserves have declined the most:

Not shown on that screen are Saudi Arabia, with a -12.1% YOY change in reserves (excluding gold), Russia with -15.2%, and Azerbaijan with -50.7%.

Floating and Depegging

"There is no week like the Christmas-shortened week to give bad news to the markets, and it looks like the breaking of another currency peg will almost go unnoticed: Azerbaijan just abandoned its currency's peg to the U.S. dollar, sending the manat 48% down vs. the greenback.

The move, the second such measure to be taken by a Caspian oil producer after Kazakhstan scrapped the trading band for the tenge back in August, has intensified speculation about whether the world's biggest oil exporter Saudi Arabia will end up being forced to abandon its own currency peg vs. the dollar.

Azerbaijan's reasons for abandoning the currency peg were a desire to preserve its foreign exchange reserves -- which were being eroded by the need to sell U.S. dollars just to keep the exchange rate stable…"

That's from an article titled If Saudi Arabia Abandons Its Currency Peg, Investors Should Worry. The rising dollar and declining $POO (dollar price of oil) is leading many of these countries to depeg and free float their currencies, but, almost ironically, that very act of depegging contributes to an even higher dollar exchange rate.

There is a relative shortage of dollars in the foreign private sector commercial banking system, meaning there is an imbalance between supply and demand of "eurodollars". And when the foreign public sector bank (the CB) sells some of its dollar reserves in defense of its own currency's exchange rate, it is in essence adding to the supply of dollars in its private sector banking system, which reduces that imbalance between supply and demand. So if and when it finally decides to stop running down its reserves defending its own currency's exchange rate, that has the opposite effect, increasing the relative shortage of dollars and contributing to a rising dollar exchange rate.

Prior to 2013, these same CBs were doing the opposite, buying dollars from their private sector banking system to keep their own currency's exchange rate from rising, which had the effect of supporting the dollar's exchange rate. Those dollars they purchased would then be invested in dollar-denominated assets, some of which was US public sector debt (Treasuries), some of which was US private sector debt, and some of which was foreign private sector dollar-denominated debt. It was this latter investment that contributed to low borrowing costs in dollars for emerging markets, and helped create the $9T EME problem:

While I'm on this topic, here are a few quick excerpts from a 2005 BIS paper titled Distinguishing global dollar reserves from official holdings in the United States, with a few comments [in brackets] by me:

Official holdings of US dollar reserves are partly invested outside the United States. These offshore investments do not strictly speaking finance the US current account, but do support the US dollar. Offshore holdings grow fast when intervention is large. [That was 2005. Today intervention is disappearing as floating and depegging is now in vogue, and this is having the opposite effect of "growing" the offshore (eurodollar) holdings.]

The extent to which global official dollar reserves exceed official holdings of assets in the United States has come under increasing scrutiny in recent years. To be sure, official holders of dollars have invested a portion outside the United States for generations. But, as official intervention in the foreign exchange markets has reached unprecedented levels, so too has the sum of dollars placed offshore. [His point here was that the more foreign CBs were intervening in the FX market, the more dollars they had in excess of what they could invest inside the US, and so they invested more in foreign dollar-denominated debt.] What accounts for these holdings, and in what sense do they either finance US external deficits or support the dollar’s exchange rate? …while offshore placements do not strictly speaking finance the US current account deficit, they do support the dollar.

[…]

Foreign central bank acquisition or holding of dollars provides support to the dollar even if it does not finance US deficit or debt.

[…]

Recall, however, that these offshore holdings do not immediately finance US deficits, since they involve the liabilities of residents of other countries. But certainly the official increase in global official dollar reserves, whether placed on shore or offshore, supports the dollar. [The "official increase" stopped in 2013. So what supports the dollar now? The profit-driven foreign private sector does.]

[…]

Thus, it is both easy to understate and possible to overstate the role of foreign official support for the dollar. While global reserve managers have lost their strongest reason to place dollars outside the United States, they continue to place large sums offshore. The dollar is supported wherever officials place their dollars.

I guess my point is that times have changed. In a depegged world of free floating currencies, there is no intervention. There is no change in the volume of exchange reserves, except in the case of emergency. There is no "official support" for foreign currencies. There is no centralized settlement, because what isn't settled by individuals is balanced through the exchange rate. There is also no use for an SDR in a world of depegged and free floating currencies.

USD

It's a little ironic that the Fed raised rates, but the world is full of irony right now, like how depegging is now driving the dollar even higher. Here's a short video put out by Reuters recently, titled "When Rates Rise". You can ignore the beginning where they explain the supposed reasoning behind the rate hike. I'm only posting it because of the end where they say, "Were the Fed to hike rates… the value of the dollar would rise, as more investors will put money in the US, chasing higher returns. This matters for companies around the world that have borrowed in dollars, as they will find these loans harder to repay…"



Due to everything I've explained above, I see no reason the dollar should weaken short of an outright panic by the foreign private sector, which I do expect at some point, and which is why I keep an eye on the US stock market. But until then, willy-nilly support is in full force. So I expect this "dollar bull market" to continue, more or less, until it ends in what I would characterize as a dramatic paradigm transformation.

Now, the dollar bull contributes to a low $POG and $POO for multiple reasons. The most obvious is that they are dollar denominated prices, so a strong dollar means a low dollar-denominated price for real things. And today, the strong dollar is also bad for the global economy, which means aggregate demand for goods and services is depressed, which contributes to the low price of oil.

The point is, gold and oil prices are not low just because the dollar is strong, but the strong dollar is a contributing factor. And putting it all together, I expect the current trends on the dollar, oil and gold to continue, basically until they end in what I would characterize as a dramatic paradigm transformation. ;D

$POO

I don't know what the price of oil will do in 2016. If you held a gun to my head and demanded a prediction, I'd say it will probably go lower, then higher, then end the year right around where it is now, or maybe a little lower, or higher, but the $20s certainly aren't out of the question, and neither are the $40s.

There was one CEO I saw on CNBC recently who said, "There is no question that oil prices are going to continue to fall. Where the bottom is will be a combination of factors: There will be geopolitical events, there'll be budgetary events, there'll be supply-demand fundamentals, and there'll be herd mentality… but there's no question that oil is heading down to the low $30s. Will it break the $30s to the $20s? That's quite a possibility in 2016."

And here's the conclusion of the article I mentioned above, titled If Saudi Arabia Abandons Its Currency Peg, Investors Should Worry:

"However, if Saudi Arabia does decide to abandon the dollar peg, investors should be worried. It would be the country's way to show it is ready to do "whatever it takes" to defend its supremacy in the oil market -- and therefore, it would signal that low oil prices are here to stay for a long time."

GOR

Since WWII, the price of oil has ranged from $1.63 per barrel all the way up to $145 per barrel, and the price of gold has ranged from $35 per ounce up to $1,896.50 per ounce. But remarkably, the GOR or the gold-oil ratio, the price of gold divided by the price of oil, has stuck to a pretty tight range of between 8.888 and 29.388. The 70-year average is about 15, and today we are near the upper bound of that range at 28.672.

As you can see, whenever the GOR reaches the extremes of its range, it promptly reverts back to its average, even overshooting it more often than not. And that's exactly what I expect to see this year. In fact, the data above are annual averages (except for the last two), so the intra-year overshoot was always more extreme than is shown in the above data. For example, 1990 is the prime example of a reversion that didn't quite hit the average (red arrow below), but in fact, the GOR spiked all the way down to an intra-year low of 9.5 in October of 1990:

Of course the GOR in Freegold inferred by Another was 1,000:1, but we're not talking about physical here. We're talking about paper gold, and paper gold is "chained to all of these other commodities through the regressive expectations of a massive Superorganism of traders that far outnumbers the gold bugs," as I wrote in My Candid View – Part 4; "That's because it is chained to commodities. It can't break free until the physical flow runs out. Then it will break free and there'll be no more paper gold market for the traders to 'arbitrage' between gold and commodities."

You see, I expect the GOR to revert to at least 15 at some point, and I see more reason for paper gold to do most of the work getting there than oil. But even if oil rises all the way to $50/bbl. this year, a GOR of 15 puts gold at $750, and don't forget the intra-year overshoot. More likely, I think, oil may test the $20s and $40s, and then stay somewhere in the $30s or low $40s. So if we had an average GOR for the year similar to 1990 which was 16.538, and oil averaged $40 for the year, that would mean an average $POG for the year of $661.52. And if the intra-year overshoot was similar to 1990 at 9.5, then that would mean an intra-year low of $380 for gold. If, on the other hand, oil averaged only $35 for the year, a GOR low of 10 would mean a gold price of $350.

And that's how I came up with my range at the top. Pretty conservative, huh? Of course the next question is whether or not you'll be able to buy physical at those prices. More specifically: At what price does the flow of physical dry up to the point that the premium over spot skyrockets if there's any to be had? No one knows the answer to that question, but someday we will. Will that someday be in 2016?

Fire sale is a term which means the sale of goods at extremely discounted prices, often used in closeout sales where prices are lowered until all inventory is gone. I think there is a good argument to be made that 2016 could very well live up to this name, and I hope I did it justice.

“We expect gold prices to break below $1,000 per ounce in the coming months.”

-Georgette Boele, coordinator for foreign exchange and precious metals strategy at ABN Amro, Dec. 27, 2015

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Happy New Year everyone! :D

Sincerely,
FOFOA