Removing the “Lid” off the Gold Price

A ‘must read’ today.  Greg Canavan is a balanced, smart, cool head when it comes to investment.  He has learned the hard way about emotional investing and deploys a system of combining fundamental analysis with technical signals from charts.  In other words he recognises fundamentals and what you ‘believe’ only work so far but you should watch the market and not fight it.  He has a subscription service called Crisis & Opportunity (through Port Phillip Publishing) giving largely share recommendations on that basis with a great track record.  Greg has just penned his February issue and it gives one of the best combinations of the history of the gold market and the current set up that we have read.  The following is an excerpt from that issue that we put in the must read category.  It’s longer than normal but you have the weekend to read it….

“Pressure is building in the gold market. I can feel it. Perhaps you can feel it too.

I have followed gold closely for more than 15 years. After such a long period of time, it’s a market I have come to know pretty well.

And as we settle into 2019, my view is that it will be a breakout year for the yellow metal.

I’ll show you the evidence for this claim shortly. That will be followed by another gold stock recommendation to add to your portfolio.

Before I do that, though, let’s have a brief, but fascinating look back through recent history, to see what happened the last time ‘pressure started to build’ in the gold market. Because the results were spectacular...

When does pressure build? When you try to hold something in, or down. The longer you hold it down, the more pressure builds, and the more explosive the outcome when that pressure is finally released.

The following is a story of perhaps the greatest build up of pressure in financial history.

Failure of the London Gold Pool

In 1934, US President Franklin Roosevelt revalued gold (after confiscating it from US citizens) from US$20.67 an ounce to US$35. In effect, it was a devaluation of the US dollar.

The US$35 an ounce US dollar/gold peg was the lynchpin of the post-war international monetary system, often referred to as the Bretton Woods system.

Management of the gold/US dollar peg occurred in the London gold market, the largest gold trading centre in the world. It reopened in 1954, following its war related shutdown.

This is how central banks kept the price at US$35 an ounce, as told by John Koning , writing for the Mises Institute:

‘Through the 1950s the London price fluctuated between $34.85 and $35.17. These upper and lower limits were set by arbitrage and the threat thereof. Foreign central banks, as stipulated in Bretton Woods, could go to the Federal Reserve in New York and convert their dollars into gold or gold into dollars at $35 plus 8.75¢ commission. The cost of shipping and insuring gold from New York to London and vice versa was 8¢ to 10¢ per ounce.

‘Thus, when the London price traded down to $34.82 or so, it made sense for central banks to buy gold in London, ship it to New York for 8¢, then sell it to the US Treasury at the $35 official price less 8.75¢ commission, earning arbitrage profits of around 1¢ an ounce. Conversely when gold rose to $35.18 in London, it made sense to buy gold from the US Treasury at $35.0875, ship it to London for 8¢, sell it at $35.18, and earn arbitrage profits of 1¢.’ 

By 1958, the supply of US dollars began increasing. Foreign central banks exercised their right to convert their dollars into gold, and US gold reserves began to fall. Reserves declined 10% in 1958, 5% in 1959 and another 9% in 1960.

In response, the US asked foreign central banks to hold onto their dollars. It set limits on citizens travelling overseas, and restricted private investment in Europe.

At the same time, it became apparent John F Kennedy would win the upcoming election, with promises to lower interest rates and increase spending.

The gold price started to rise well beyond that, implied by simple arbitrage (US$35.18). In October 1960 it closed at $38/ounce. Such a premium exacerbated US gold outflow questioned the effectiveness of the Bretton Woods system.

In response, the Bank of England, in an agreement with the US, sold gold to get the price back down.

President Eisenhower also made it illegal for US citizens to buy metal overseas (US citizens were already banned from buying gold domestically).

Creation of the gold pool

The gold price fell back to $35.10. But western central banks feared another price spike. As a result, they (the US and eight European central banks) came up with a plan to pool several hundred million dollars’ worth  of gold to control the gold price in London.

As Koning writes:

‘The pool became an active buyer of gold when the London price fell below $35.08 an ounce and a seller at $35.20. In its first test — the week of the Cuban Missile Crisis in October 1962 — the pool effectively supplied the London market despite demand for the metal being greater than the 1960 gold rush. Prices could not penetrate $35.20. The pool’s reputation strengthened: gold would stay benign and near $35.08 for the next few years.’

Pool shuts down

But with military spending increasing due to the Vietnam War, US trade deficits were again on the rise. In addition, Lyndon Johnson and his Great Society program meant domestic spending was on the rise too.

US gold reserves started to flow out of the Treasury again. The London Gold Pool participants defended the dollar at $35.20, resulting in gold flowing out of the pool too.

In 1967, France bailed. The British devalued the pound and then, in 1968, the Vietnam war escalated with the Tet Offensive. The London Gold Pool had spent about $2.75 billion defending the dollar, but to no avail.

In March 1968, the Pool requested the Queen close the London gold market. Two weeks later, it reopened, and gold immediately shot up to $38.

So while the ‘official’ gold price was still $35, the market price was trading well above that level. 

While the London Gold Pool was officially dead, the US had other plans to keep a lid on the gold price. Upon the reopening of the gold market, US Treasury Secretary Robert Fowler announced that global central banks would no longer purchase gold...their reserves were sufficient. 

South African Gold Embargo 

The idea behind this announcement was to force South Africa, who at the time produced 75% of the world’s gold, to deliver their production into London (rather than to central banks) and therefore put downward pressure on the ‘market’ price of gold. 

The US Treasury sent letters to 95 central banks asking them to no longer purchase any gold. The gold embargo had started. 

But it was ineffective. The market price of gold rose to $42. This incentivised central banks to sell dollars and buy gold from the New York Fed, further draining US gold reserves. 

And South Africa’s Reserve Bank bought gold from its miners and hoarded it, instead of selling it into the London market. But gold was a primary income source for South Africa. It could only do this for so long. 

By 1969, a global bear market was underway. This resulted in capital flows into South Africa drying up. South Africa had to sell gold to pay for imports. Gold started to flood into the London market, pushing the market price down. 

By October 1969, gold fell below $40. By the end of November, it was back down in the $35 range. On January 16, 1970, gold traded at $34.80, the lowest price since the market reopened in 1954! Due to the effects of arbitrage, the US was now accumulating gold again.

This ‘victory’ over gold was short lived. By the end of 1970, gold traded at $37.50. And it kept moving higher during 1971. Obviously, at these prices it made sense for central banks to swap their ever-increasing holdings of US dollars for gold at $35. This resulted in gold again draining out of the US Treasury. 

The scramble for gold (or ‘attacks’ on the dollar) intensified to such an extent that on 15 August 1971, President Nixon went on national TV to declare the end of gold convertibility, and an end to the Bretton Woods financial system. 

The lid comes off! 

In effect, this move put an end to a coordinated gold price suppression operation. Central banks could no longer convert their excess US dollars into gold at $35. They could still buy gold in the open market, but would have to pay market prices to do so. 

Following the closing of the gold window in August 1971, the lid came off the gold price. Years of building pressure manifested in strongly rising prices. The annual price rises for gold were as follows: 

1971 — 14.65% 

1972 — 43.14% 

1973 — 66.79% 

1974 — 72.59% 

Then, the price corrected for two years, before picking up steam again... 

1975 — -24.2% 

1976 — -3.96% 

1977 — 20.43% 

1978 — 29.17% 

1979 — 120.57% 

1980 — 29.61% 

It was an extraordinary bull market. It reflected a decades’ long catch up after central banks (particularly the US) tried so hard to keep the gold price tied down.

I doubt you’ll see anything like it again. 

But I do think there are some parallels to today. 

The gold pot is bubbling again 

Before I explain, let’s look at the obvious differences... 

Gold is clearly no longer pegged to the dollar. There are plenty of people who believe gold is manipulated, but I have my doubts. Sure, certain players can manipulate the price in the very short term, but manipulating the major trend is all but impossible. 

The other major difference — and this is important — is that back in the 1960s and early 1970s, most of the trading in the gold market was based on physical supply and demand. 

Paper versus physical 

These days, most trading occurs in gold derivatives. That is, trades take place in paper products, such as US futures (COMEX) and the OTC (over the counter) market in London. 

According to an article published in BullionStar in 2017 

‘The international gold price is purely set by paper gold markets, in other words it is set by nonphysical gold markets. Based on their respective gold market structures, the London OTC gold market and COMEX are both paper gold markets. Supply of and demand for physical gold plays no role in setting the gold price in these markets. Physical gold transactions in all other gold markets just inherit the gold prices that are discovered in these paper gold markets.’ 

The article uses data from the London Bullion Market Association (LBMA) to estimate that the daily turnover of gold in London equates to an astounding 6,380 tonnes of gold per day. 

Given there is only around 6,500 tonnes of gold in London (held by central banks, ETFs etc) the article states:

‘...the trading of nearly 6,500 tonnes of gold per day within the London OTC gold market has nothing to do with the physical gold market, yet perversely, this trading activity drives global gold price discovery and the pricing of physical bullion trades and transactions.’ 

What do we know about physical gold trading? Not much, according to BullionStar: 

‘...there is very little known publicly about how much physical gold actually trades in the London gold market. This is because the LBMA and its member banks choose not to reveal this information. There is no trade reporting in the London OTC gold market, no reporting of physical gold vault positions, no reporting of the unallocated gold liabilities of LBMA member bullion banks, and no reporting of how much physical gold in total these bullion banks retain to back up their fractional-reserve unallocated gold trading system. However, physical gold trading is by definition an extremely minuscule percentage of average daily trading volumes in the London OTC gold market.’ 

What does all this mean? 

Put simply, there is a massive ‘short’ position against gold. More precisely, the world is ‘long’ paper gold and ‘short’ physical gold. 

Gold, like modern day banking , works on a fractional reserve basis. As the image below illustrates, a tiny amount of physical gold supports a huge amount of paper gold trading.

But this is not a new development. This market has been in existence — indeed it has been growing — for years. I’m not suggesting that it’s about to blow up. 

Confidence is the key 

The point to note here is that this system works very well while confidence is high. Confidence in the international monetary system, confidence in the global economy, and confidence in global share markets. It is my view that confidence in all three is starting to shift. 

When investor sentiment sours on any of these fronts, capital moves into wealth preservation mode. It seeks refuge in physical gold. When this happens, the fractional reserve gold banking game comes under pressure. It risks being exposed for the fragile system it is. 

This buying , combined with China and India’s ongoing demand for physical metal, would put significant stress on the physical market. As the BullionStar article states: 

‘As more and more gold goes into destinations such as China and India in quantities which exceed annual gold mine supply, there is less gold available in above ground stockpiles to meet supply deficits. This is akin to a slow bank run on gold. There is also very little gold stored in the London gold market that is not already accounted for by central bank gold holdings or ETF gold holdings. ‘Coupled with this, if in the future the paper gold holders shift to a preference for converting their paper claims into physical gold, this could also be a catalyst for tipping the physical gold market even further into a situation of excess demand and acute supply stress.’ 

Don’t expect a ‘gold reset’ 

At this point, most gold bugs believe that a ‘gold reset’ will take place. They see a shut down in the gold trading system, and when trading resumes it will be at $5,000 or $10,000 an ounce. 

While this sounds exciting , I view it as a very low probability event. 

The higher probability scenario is that the ‘gold’ price (meaning paper gold) continues to rise in a controlled manner. 

To explain why, let me ask you a question. 

If you’re a bullion bank, making big profits from running a paper gold-based trading system, and physical gold supplies start to tighten and thus threaten this profitable system, what are you going to do? 

Are you going to increase the leverage of the system and threaten to blow it up? Or would you pull back in the expectation of prolonging the game? You would preserve the system, of course. 

How do you do that? 

You ‘let’ the paper gold price rise. Now, I don’t mean that these people control the price completely. But in a paper market, when demand increases, you can satisfy that demand in one of two ways. You can create more paper gold (and thus increase system leverage) or you can let rising prices absorb demand. 

To explain, think of the amount of capital absorbed by 10 ounces of gold at $1,000 an ounce and $5,000 an ounce: $10,000 versus $50,000. Do that on a much larger scale and you get my point. 

Granted, rising prices increase demand in the short term as speculators sniff out an opportunity. But if prices rise high enough, it eventually encourages the big physical gold holders to sell as other assets become attractive on a relative basis. 

Higher prices, then, eventually cause physical gold to flow back into the market again, thus underpinning and preserving the system. Confidence is restored, and the bullion banks continue to shuffle paper gold around and make easy money. 

I know this can be a little confusing. So let me put it another way. The bullion banks are ‘short’ physical gold. As long as physical gold continues to flow and change hands based on the price set by the paper gold markets, they are sweet. 

But if the flow of physical dries up because of increasing demand to hoard physical gold, their only option is to hope a bull market (and higher prices) eventually releases enough physical gold back into the system to prolong the game. 

That’s what I think we’re on the cusp of now. I think higher prices are on the way. The supply of physical gold, via new mine production, is tiny. According to the World Gold Council, in 2018 global gold production was 3,347 tonnes of gold. 

At $1,320 an ounce, that’s just $155.8 billion. In today’s market’s, that is nothing , especially considering China consumes all its gold production (430 tonnes). 

The only way a lot more supply can come into the market is via selling from existing stockpiles. And that only happens when prices are high...much higher than where they are now.

Is the pressure on gold about to be released? 

Ok, enough talk, let’s look at the chart for gold. You can see how the pressure has been slowly building over the past few years in the US dollar gold price. It’s not 1960’s type pressure, but it’s just been simmering away, rising to around US$1,360 an ounce and falling to around US$1,130. 

This trading range has defined gold for more than six years now. In technical terms, when prices break out of such a range, the eventual destination is determined by the length of time spent bouncing around with the range. 

Six years is a long time. That tells me, if prices break higher, you will see a very strong move in the gold price in subsequent years. My guess is that gold will trade well above US$2,000 an ounce, at the least. 

There is no guarantee that gold prices will break out of the trading range anytime soon. But with the gold price trending higher, and the global economy looking shaky, there is a decent probability it will happen.”