December 20, 2006 (RHH). Gold Derivatives: Elephant in the Boardroom

Pierre Lassonde, the soon-to-retire president of Newmont Mining and chairman of the World Gold Council, began his speech at the October dinner of the Committee for Monetary Research and Education (audio available at by declaring that gold is "real money" and then made the case for investing in gold as a separate asset class. It is an argument that he makes well, having done so for years. See, e.g., P. Lassonde, The Gold Book (Penguin, 1990). And to judge by the success of the WGC's exchange-traded bullion fund, now at over 500 tonnes, it is an argument that is finding an increasingly receptive audience.

But having recognized the essential monetary nature of gold, Mr. Lassonde then lapsed into analyzing it like any other commodity. He equated annual demand to annual supply, presented in chart form by bars for each year piling scrap recovery and net official sector sales on top of new mine production. Production, which peaked at around 2500 tonnes in 2003, is expected to decline over the coming years, as are official sales, which in any event are simply a redistribution of existing stocks. See, e.g., K. Morrison, Gold sales fall well below limit set in central banks' pact, (Sept. 27, 2006).

However, he earlier estimated that of the 160,000 tonnes of gold thought to exist above-ground, almost half might in favorable circumstances become available to the market. Neither this hoard nor private transactions in gold played any role in his figures on annual supply and demand, a frequent omission among gold analysts. See R. Blumen, The Myth of the Gold Supply Deficit, (Oct. 30, 2006). Nor did gold derivatives.

One questioner asked how much gold the central banks had loaned into the market, to which Mr. Lassonde replied that total forward sales by gold mining companies now stood at around 1600 tonnes and would continue to go down. See also GFMS, Global Hedge Book Analysis Q3-2006 (Nov. 2006). Although the answer was scarcely responsive, the question has long plagued serious gold analysts due to the opaque, not to say outright misleading, nature of central bank reporting. See, e.g., N.R. Ryan, Gold Market Lending (Blanchard & Co., Dec. 1, 2006), discussed in D. Kosich, IMF should mandate total central bank gold loan disclosure, Mineweb (Dec. 15, 2006).

In the absence of better data, commentaries at this site have argued that total forwards and swaps as reported by the BIS are a pretty good proxy for the total short physical gold position, which largely consists of gold loans, deposits and swaps from official reserves. See Gold Derivatives: Hitting the Iceberg (12/20/2003), and commentaries cited.

Gold Derivatives. On November 17, 2006, the Bank for International Settlements released its regular semi-annual report on the over-the-counter derivatives of major banks and dealers in the G-10 countries for the period ending June 30, 2006. The total notional value of all gold derivatives rose from $334 billion at year-end 2005 to $456 billion at mid-year 2006 while period-end gold prices over the same period rose from $513 to $614 (London PM). Reflecting the higher gold prices, gross market values rose from $51 billion to $77 billion.

As subsequently detailed in table 22A of the December issue of the BIS Quarterly Review, forwards and swaps rose from $128 to $148 billion and options from $206 to $308 billion. Converted to metric tonnes at period-end gold prices, total gold derivatives increased by more than 2800 tonnes, with options rising by some 3000 tonnes and forwards and swaps falling by 200.

However viewed, the relative tonnages represented by OTC gold derivatives are substantial. In total amount, they are nearly equal to total claimed official gold reserves of roughly 30,000 tonnes. The increase of 3000 tonnes over the first half of 2006 was more than twice new mine production over the same period. Thus Kelvin Williams, former executive director of AngloGold Ashanti Ltd., has described supply and demand in today's gold market quite differently than Mr. Lassonde. According to Mr. Williams (Toast to the LBMA, LBMA Biennial Dinner, Nov. 2, 2006):

Another distinctive feature is that the balance of supply and demand for the metal plays only a minor role in the pricing of the metal. This is a market where price direction is determined largely by investors or speculators in the derivative sector of the gold market, and not by physical consumers or physical sellers of the metal. Nevertheless, physical demand does play an important role in supporting a floor price for the metal in times of weaker markets, and physical demand certainly saved the price of the metal repeatedly in the 1990s. Although not the critical price determinant, it does from time to time encourage sentiment one way or another in the investment sector.

As discussed in the Complaint in the Gold Price Fixing Case and prior commentaries (see, e.g., Gold Derivatives: Skewing the World (6/15/2005)), gold derivatives -- particularly forwards and swaps -- experienced their most explosive growth from 1995 through 1999 as central banks markedly increased their gold lending activities in an effort to suppress gold prices. Expressed in tonnes, the level of forwards and swaps remained fairly stable at around 10,000 tonnes from 2000 through 2003, and since then has declined marginally to stabilize at around 7000 tonnes. Option tonnages, on the other hand, continue at or near their peak levels, suggesting that they are playing a larger relative role in the behavior of gold prices than previously.

While most if not all of the reduction in forwards and swaps can be attributed to reductions in forward selling by the gold mining industry, their stabilization at current levels appears to reflect more fundamental limits, including: (1) the amount of gold prudently available for lending by central banks; and (2) the constraints on lease rates imposed by their relationship to dollar interest rates and the risks of borrowing gold in the face of rising prices. See Gold Derivatives: Moving towards Checkmate (12/4/02).

In 2002, falling dollar interest rates forced lease rates below their historic floor of 1% to near zero, otherwise gold would have gone into backwardation. More recently, although higher dollar interest rates have allowed room for lease rates to rise to more normal levels, they have not done so. Instead, lease rates have remained at derisory levels, wholly undercutting any notion that central banks are lending gold in order to earn a return on this allegedly sterile asset.

Derivatives on Other Precious Metals. Turning to OTC derivatives on other precious metals, total notional values rose from $62 to $84 billion, with options accounting for most ($16 billion) of the increase. Converted to ounces of silver at period-end silver prices, forwards and swaps remained at right around the same level as in the prior three periods.

Although the assumption on which the second chart is based is not literally correct, silver derivatives most likely represent the bulk of other precious metals derivatives, especially with regard to forwards and swaps where the nature of the transactions generally assumes delivery for sale into the market of an equal amount of physical metal.

As is the case with gold, forwards and swaps on other precious metals appear to have stabilized in physical terms at around current levels over the past three years. However, unlike gold, silver is not held in significant quantities by central banks. What is more, although it retains its monetary characteristics, it is generally regarded as an industrial metal. Accordingly, the constraints on further growth in silver forwards and swaps probably owe more to private market forces than in the case of gold.

Derivatives on Other Commodities. Unlike derivatives on gold and other precious metals, derivatives on other commodities have experienced their most explosive growth since the end of 2004, first in forwards and swaps and most recently in options. Nor is it possible given the number of commodities involved to express their value in physical units. However, as the chart below shows, forwards and swaps on other commodities appear to be stabilizing in dollar terms while options remain on the upswing.

The strongest growth in forwards and swaps for gold and silver took place during, and by adding to current supply contributed to, depressed prices for these metals. In contrast, the recent upswing in forwards and swaps for other commodities has occurred amidst sharply rising prices, especially in the energy and base metals sectors, apparently for the purpose of generating supply to meet speculative and investment demand, much of it from hedge funds.

While gold and silver are normally in contango, other commodities are frequently in backwardation. For more explanation on this point, see The Golden Sextant, the essay from which this website draws its name. An important consequence of the recent large influx of investment funds into commodities has been to push many of them into contango, thereby substantially increasing the costs of rolling over forward positions as they mature. Against this background, a slowdown in the growth of forwards and swaps for these commodities is not surprising.

Some argue that the upsurge in derivatives for other commodities reflects a bubble in commodity prices, which they predict will soon collapse. See, e.g., F. Veneroso, The Coming Nuclear Winter Base Metals (Geneva Conference On Base Metals Investing, Oct. 3, 2006). Others believe that commodity prices are underpinned by strong growth in the Asian economies, particularly China and India, and thus are likely to remain generally firm for the indefinite future. See, e.g., D. Uren, Mineral demand to prop up price, The Australian (Nov. 20, 2006); A. Evans-Pritchard, Monday View, (Oct. 2, 2006) (alternate link).

Both of these views assume that commodities will continue to behave as commodities. Neither addresses the possibility that rising doubts about paper money generally and the U.S. dollar in particular are now leading to the increasing monetization of commodities other than gold or silver. See, e.g., report by Bloomsbury Minerals Economics discussed in Copper now behaving as financial instrument, not a metal: BME, Metals Placc (Jan 12, 2006); M. Bendeich, Commodities and Islam, the start of something big, Reuters UK (Dec. 8, 2006).

The Looming Monetary Crack-Up: Like gold and silver, copper has a long history of serving as monetary metal. See, e.g., S. Pamuk, A Monetary History of the Ottoman Empire (Cambridge Univ. Press, 2000). Just as rising silver prices caused the United States to abandon silver coinage in the 1960s, rising copper prices ended minting of a real copper penny in 1982. See U.S. Treasury, History of the Lincoln Cent. Today the melt value of even the current ersatz penny exceeds its face value. See U.S. Mint, United States Mint Moves to Limit Exportation & Melting of Coins (Press Release, Dec. 14, 2006); M. Crutsinger, U.S. Mint bans melting pennies, nickels, AP (Dec. 14, 2006).

In Human Action (4th ed., B.B. Greaves, ed. (Irvington: Foundation for Economic Education, 1996), Ludvig von Mises described the "crack-up boom" that marks the denouement of all great monetary inflations (at pp. 427-428):

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the [p. 428] country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.

The Cancer of Derivatives. Although large relative to physical supplies, forwards and swaps on commodities appear ultimately to be limited by both the size of the physical markets and the dynamics of the forward markets with respect to contango and backwardation. However, as the chart below illustrates, total derivatives on commodities represent no more than a rounding error relative to total OTC derivatives, which continue to grow at a rapid rate.

The Office of the Comptroller of the Currency reports that as of September 30, 2006, the total notional value of derivatives held by U.S. commercial banks amounted to $126 trillion, of which 82% were interest rate contracts. It further notes:

Derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large banks represent 97% of the total notional amount, 84% of total revenues and 88% of net current credit exposure.

While bank supervisors normally have concerns about market or product concentrations, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products, such as investment banks and foreign banks, whose activity is not reflected in the data in this report. As a result, there is aggressive competition in the market for providing derivatives products. Second, the highly specialized business of structuring, trading, and managing the full array of risks in a portfolio of derivatives transactions requires sophisticated tools and talent. Typically, only the largest institutions have the resources, both in personnel and technology, to support the requisite risk management infrastructure. As a result, derivatives activity is appropriately concentrated in those few institutions that have made the resource commitment to be able to operate the business in a safe and sound manner. Third, the OCC has examiners on-site at the largest bank providers of derivatives products, who continuously evaluate the credit, market, operation, reputation and compliance risks arising from derivatives activities.

Perhaps. But compared to other major financial products, derivatives are subject to minimal regulation, not least because they offer a way for central banks, acting through favored big banks and dealers, to push markets in the directions favored by government policy makers. See Olympic Special: Will the Enron Tar Baby Go for the Gold? (2/6/2002); Gold or Dross? Political Derivatives in Campaign 2000.

Gold bugs were victimized by this fact of modern market life sooner than others. But as these interventions have become more frequent and widespread across many markets, others have caught on, undermining public confidence in the integrity of financial markets generally while at the same time throwing handsome profits to the inside players. See, e.g., G. Burns, How about that $50 million bonus?, Chicago Tribune (Dec. 17, 2005); Goldman bonus envy rocks rivals, Times Online (Dec. 17, 2006).

The current U.S. treasury secretary and former head of Goldman Sachs is no stranger to derivatives. See Gold Derivatives: Da Goldman Code (6/21/2006); Gold Derivatives: Skewing the World (6/15/2005). Nor does he appear as sanguine as the OCC about the risks they pose to the financial system. See Comstock Partners, Paulson Believes a Financial Crisis is Overdue (Market Commentary, Nov. 30, 2006). Not surprisingly, he recently turned to another Goldman veteran, William Dudley, to head the New York Fed's market operations, the same post held by BIS alumnus Peter Fisher when the collapse of the derivatives-laden Long Term Capital Management hedge fund threatened to bring down the global financial system. See S. Kirchgaessner et al., Goldman's top alumni wield White House clout, (Dec. 3, 2006) (alternate link).

The scourge of unlimited paper money is an addiction, operating on society much as alcohol or drug addiction does on an individual, and just as hard to shake. Derivatives are more like a malignant cancer. In scarcely more than a decade, they have rapidly metastasized to exert a controlling influence on the fundamentals of world finance, particularly interest rates. An international financial system beset by both afflictions cannot have a bright future.

Dreams of four- or even five-digit gold prices are thus in the cards. But when this house of cards collapses, even gold bugs are unlikely to enjoy the world that follows, proving once more the wisdom of the old adage: "Be careful what you wish for; you may receive it."


June 11, 2007 (RHH). Gold Derivatives: Chinese Torture

In a recent article as important for its source as its content, the Director of International Economics at the Council on Foreign Relations adapted a metaphor first employed by Jacques Rueff to describe the "absurdity" of the Bretton Woods post-war international monetary monetary system a few years before its collapse. B. Steil, "The End of National Currency," Foreign Affairs (Vol. 86, No. 3, May/June 2007), pp. 83-96. Rueff had compared the chronic balance-of-payments deficit then being run by the United States to buying from a tailor who, whatever you paid him for a suit, would loan the money back to you the very next day. Bringing the metaphor current, Mr. Steil writes (at p. 93):

With the U.S. current account deficit running at an enormous 6.6 percent of GDP ... , the United States is in the fortunate position of the suit buyer with a Chinese tailor who instantaneously returns his payments in the form of loans -- generally, in the U.S. case, as purchases of U.S. Treasury bonds. The current account deficit is partially fueled by the budget deficit ... , which will soar in the next decade in the absence of reforms to curtail federal "entitlement" spending on medical care and retirement benefits for a longer-living population. The United States -- and, indeed, its Chinese tailor -- must therefore be concerned with the sustainability of what Rueff called an "absurdity." In the absence of long-term fiscal prudence, the United States risks undermining the faith foreigners have placed in its management of the dollar -- that is, their belief that the U.S government can continue to sustain low inflation without having to resort to growth-crushing interest-rate hikes as a means of ensuring continued high capital inflows.

The rising nervousness of America's Chinese tailor is reflected in its recent efforts to redeploy a portion of its mammoth foreign exchange reserves, mostly held in U.S. dollars, into other investments. See, e.g., F. Gimbel, Trickle of money could become investment flood, (May 21, 2007) (alternate link).

Mr. Steil's preference (at p. 95) is for a world in which governments "replace national currencies with the dollar, the euro or, in the case of Asia, collaborate to produce a new multinational currency over a comparably large and economically diversified area." Of course, as he freely admits, this solution requires the United States to get its fiscal house in order and the European Union to deal effectively with similar fiscal concerns. "It is," he concludes (at p. 96), "the market that made the dollar into global money -- and what the market giveth, the market can taketh away. If the tailors balk and the dollar fails, the market may privatize money on its own (emphasis supplied)."

When Mr. Steil talks about privatizing money, he pulls no punches. He asks (at p. 94): "So what about gold?" And he answers:

A revived gold standard is out of the question. In the nineteenth century, governments spent less than ten percent of national income in a given year. Today, they routinely spend half or more, and so they would never subordinate spending to the stringent requirements of sustaining a commodity-based monetary system. But private gold banks already exist, allowing account holders to make international payments in the form of shares in actual gold bars. Although clearly a niche business at present, gold banking has grown dramatically in recent years, in tandem with the dollar's decline. A new gold-based international monetary system surely sounds farfetched. But so, in 1900, did a monetary system without gold. Modern technology makes a revival of gold money, through private gold banks, possible even without government support.

So there it is, straight from the Council on Foreign Relations: James Turk's GoldMoney and other digital gold payments systems could supplant the dollar and the euro in international trade if the United States and the members of the European Union cannot bring their structural budget deficits under control. What is more, a nudge or misstep from America's Chinese tailor could accelerate the dollar's fall and rapidly plunge the international payments system into crisis.

Under these circumstances, one might reasonably expect the historically pro-gold European central banks to be augmenting their gold reserves. But in fact, they are doing just the opposite, laboring to reach the annual sales of 500 tonnes allowed under the current Central Bank Agreement on Gold ("CBAG"). See World Gold Council, Latest statistics on sales under the Central Bank Agreements; A. Prakash, Europe central banks to miss gold sale quota again, Reuters (May 31, 2007). One commentator has suggested that these sales may be required to prevent sharply rising gold prices from triggering "a collapse in the dollar with the worldwide financial and political chaos which could ensue." L. Williams, Should Central Banks manipulate the gold price?, Mineweb (May 27, 2006). In this view, official intervention in the gold market amounts to nothing less than a defense of Western civilization itself.

Gold Derivatives. Of course, as discussed in numerous prior commentaries, what portion of these reported gold reserves are held in actual physical form as opposed to paper claims on gold is an open question due to the failure of most central banks to report physical holdings separately from receivables such as deposits, loans and swaps. While these practices conform to current guidelines of the International Monetary Fund, the matter is under review and pressure is building for greater transparency. See IMF Draft, Sixth Edition of the IMF's Balance of Payments and International Investment Position Manual (March 2007), esp. chaps. 6.68 thru 6.73.

In the meantime, as also discussed in numerous prior commentaries, the best approximation of the total net short physical position in gold arising largely as the result of gold lending in one form or another by central banks is the total notional value of gold forwards and swaps as reported by the Bank for International Settlements and converted into tonnes.

On May 21, 2007, the BIS released its regular semi-annual report on the over-the-counter derivatives of major banks and dealers in the G-10 countries for the period ending December 31, 2006. The total notional value of all gold derivatives remained almost flat, rising just $7 billion from $456 billion at mid-year 2006 to $463 billion at year-end, while period-end gold prices increased from $614 to $636 (London PM). Gross market values fell from $77 billion to $56 billion.

As detailed in table 22A, forwards and swaps fell from $148 to $139 billion while options rose from $308 to $324 billion. Converted to metric tonnes at period-end gold prices, total gold derivatives fell by 465 tonnes, with a decline of 703 tonnes in forwards and swaps being partially offset by an increase of 238 tonnes in options. The data is summarized graphically in the three charts below, updated from the prior commentary on this subject. Total forwards and swaps now stand at 6800 tonnes, options at 15,850 tonnes, and total gold derivatives at 22,650 tonnes.

According to Gold Fields Minerals Services, the global delta-adjusted gold mine hedge book declined by 390 tonnes in 2006 to end the year at 1347 tonnes. GFMS, Global Hedge Book Analysis (Q4-2006; Q1-2007). What is more, the decline took place entirely in forward sales and gold loans with options actually showing a modest increase. This trend has continued into the first quarter of 2007. See also R. O'Connell, Global gold hedge book contracts to 1,241 tonnes, Mineweb (May 21, 2007).

Two points stand out. First, were the global hedge book of gold producers reduced to zero tomorrow, the BIS's figures indicate that almost 5500 tonnes of forwards and swaps would still remain on the books of of major banks and dealers in the G-10 countries. This amount, equal to two years of new mine production, may fairly be taken to represent gold loaned by the central banks to the bullion banks and sold by them into the market to facilitate the formerly highly lucrative gold carry trade. This gold, ostensibly loaned in order to earn a modest return of one to two percent on an otherwise "sterile" asset, cannot be repaid out of new production because it was not loaned to producers. For these loans, repayment in bullion implies repurchase in the market, with obvious implications for gold prices given the quantities involved.

Second, with lease rates at a fraction of one percent, the central banks are no longer earning even a modest return on their loaned gold. Given the bullish predictions of many analysts for gold prices, it is fair to suggest that current low lease rates reflect very weak demand to borrow gold. But it is equally fair to question why any central bank would risk its gold for such a derisory reward. The most rational explanation for current low lease rates is that they are effectively roll-over rates for essentially past due gold loans which can be neither thrown into default nor repaid without serious risk of unacceptable consequences for the world financial system.

Angling in the Brown Bottom. With current Chancellor of the Exchequer Gordon Brown being the odds-on favorite to succeed the retiring Tony Blair as leader of the British Labor Party and, at least until the next general election, as Prime Minister, Mr. Brown's political enemies have tried to paint the British gold auctions announced in May 1999 and carried out under his direction as a monumental blunder. See, e.g., H. Watt et al., Goldfinger Brown’s £2 billion blunder in the bullion market, Times Online (April 25, 2007) (alternate link with additional comment). Nothing could be further from the truth, at least if the blunder is not getting a good price or selling at the bottom of the market. As discussed in the Complaint in the Gold Price Fixing Case and numerous prior commentaries, these bimonthly auctions of 25 tonnes every other month, amounting in total to 415 tonnes over nearly three years, were intended and designed to push down gold prices.

Mr. Brown's tactical errors, if any, were two: (1) he did not foresee the magnitude of the price decline, from almost $300 to below $260, that announcement of the auctions would cause; and (2) he failed to anticipate the response of the European Central Bank and over a dozen other European central banks, including the Banque de France and the Bundesbank. Without warning on September 26, 1999, they unveiled an agreement to limit their annual gold sales and not to expand further their gold lending over the next five years. This first Washington Agreement on Gold precipitated an explosive rally in gold prices to over $330, creating a panic that nearly bankrupted at least two heavily hedged gold mining companies and threatened a string of defaults and cross-defaults among the major bullion banks. In the memorable words of Edward A. J. George, then Governor of the Bank of England (Complaint, paragraph 55):

We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K.

Bringing the gold price under control was a necessary first step, but insufficient to solve the underlying problem: grossly imprudent gold lending by the central banks and gold borrowing by the bullion banks. As the chart above shows, roughly 12,000 tonnes of forwards and swaps were outstanding at year-end 2000, and most of these represented gold lending to bullion banks for use in the gold carry trade. In the intervening years, the gold producers have largely withdrawn from the forward market, leaving the central banks and the bullion banks to work out the forwards and swaps unrelated to producer hedging.

This process has almost certainly required the central banks in some cases to accept cash settlements, thereby converting loans to sales, and in others to write options so that their counterparties can meet their value at risk parameters. Indeed, the fact that option tonnages remain near their highs suggests that options may have been used to replace or unwind significant amounts of forwards and swaps. Still, as noted above, some 5500 tonnes of forwards and swaps wholly unrelated to producer hedging remain outstanding. No wonder Mr. Brown, having sold as much British gold as he dared, would like to see the IMF start selling some of its.

The big mystery, however, is not what motivates Mr. Brown's current interest in new IMF gold sales. It is what motivated his decision in May 1999 to auction 415 tonnes of official British reserves held in the U.K. Treasury's Exchange Equalisation Account. That it was his or Mr. Blair's decision is clear. So too was their intent to force down gold prices. No one intent on getting the best price would choose the method of selling that they did. But why? What interest did the British government have in making sure that gold did not go over $300 in May 1999 when it became clear that planned gold sales by the IMF would not materialize?

The Bank of England, if it did not oppose the auctions, certainly seems to have been less than supportive, suggesting that it did not then perceive the problems with gold lending and gold derivatives that would subsequently surface. Possibly alarms on this front had surfaced in one of the well-connected bullion banks, but it takes a lot of political juice to bring about the sale of 415 tonnes of official gold reserves.

Most Britons appear to think that Mr. Blair blundered into Iraq by playing too much the British poodle to the American cowboy now in the White House. What British gold traders now call the "Brown Bottom" may represent a similar blunder. One plausible purpose of Mr. Brown's gold sales could have been to give support to the previous American administration's strong dollar policy, possibly a quid pro quo for some other under the desk deal. In any event, before installing Mr. Brown at No. 10 Downing Street, our British cousins would be well-advised to insist on a complete and detailed explanation of exactly why he sold 415 tonnes of their nation's gold.

Nor is it only the British electorate that should concern itself with Mr. Brown's antics in the gold market. Investors in the World Gold Council's exchange-traded bullion fund (GLD on the NYSE) should also pay attention. Most of its gold, an amount now well in excess of his gold sales, is stored in a special vault outside London, making it vulnerable to expropriation or mandatory lending at the whim of the British government.[1] Recent shenanigans regarding nickel at the London Metal Exchange should serve as a caution to investors in GLD. See, e.g., C. Flood, LME intervenes in nickel market, (June 7, 2007).

Drip, Drip, Drip, Bang! The mainstay of the gold market over the past decade has been physical demand from Asia, recently augmented by the liberalization of the Chinese market to permit gold purchases by private parties.[2] See, e.g., A. Hamilton, China Gold Technicals (June 8, 2007). Western civilization may not yet be hanging by a thread of Chinese silk, but the East does seem to have Western central bankers by their golden nuggets. Much of the gold loaned into the gold carry trade went to the Asian markets, giving the women of India an effective "corner" on the gold market, to borrow Frank Veneroso's description of the situation.

Martin Murenbeeld, chief economist for Dundee Wealth Management in Toronto, has calculated that were the Asian central banks to bring their official gold reserves up to the 15% level originally targeted by the ECB, China and Japan alone would have to purchase an additional 10,500 and 8100 tonnes, respectively, an amount roughly equal to half again as much all the gold currently claimed by the signatories to the CBAG and six times the amount held by the IMF, which should have no trouble finding a purchaser for as much of its gold as it wants to sell.

But even in the absence of announced official purchases by dollar-heavy Asian countries, physical gold continues to move from new mine production and Western official stocks into Asia, putting ever greater pressure on the Western central banks as they continue to struggle with the consequences of their past excessive gold lending while trying to prevent any dramatic upside breakout in gold prices that could trigger a dollar crisis. Thus the endurance of gold bugs is also being tested, tortured by repeated hits to gold prices as they try to move past the $670 level to over $700. See, e.g., J. Embry, Gold's foes are fighting a losing battle, Investor's Digest (June 1, 2007).

Many are predicting that gold prices will surmount the $700 barrier before year-end, with some harboring private predictions of much higher prices sometime in the future. To gauge just how high gold prices may go, one useful measure is the Dow Gold ratio, which was discussed at length in a prior essay. See Dow/Gold Ratio (12/2000). Although there have been occasions when to two or even fewer ounces of gold would buy the Dow, four ounces is not at all uncommon at the end of a bull run in gold. Today, the Dow at roughly 13,500 implies a target gold price of $3375. Should the Dow crash to 7000, as some predict, the target for gold at 1:4 would drop to $1750.

More unnerving, perhaps, is the possibility that the Dow may continue to rise, propelled by investors with depreciating dollars seeking safety in common stocks. That is the world of the collapsing dollar, one which even gold bugs are unlikely to enjoy despite being relatively better off than those who placed their trust in government management of unlimited paper money.


Addendum. For those interested, updates of the other charts on OTC derivatives contained in the prior commentary are reproduced below.


After reading this commentary, Nick Laird, the proprietor of, sent the following charts, which illustrate the growth in the WGC's ETF and the shifting of gold demand to the East.

The demand chart is based on information from CPM Group.