04 December 2013

Gresham’s Law, Suicidal Strategies and Pure Speculation on China

Gresham’s Law for Interest Rates

Lars Schall has an interview with Dr. Tom Fischer covering the ground in his Faux Gold Arbitrage article. The Q&A format forces Tom to compress his ideas down into short paragraphs and the interview is worth a read IMO. One quote:

"Gold is not just another commodity. It historically has the role of a world currency that cannot be inflated into oblivion. It is a financial safe haven. However, for currencies like gold, the Dollar or the Euro, contango or backwardation follows from a difference in their interest rates. For instance, because of that interest rate differential, usually either the dollar is in contango towards the Euro and at the same time the Euro in backwardation to the Dollar, or vice versa. Now replace the word “Euro” by “gold” and you get the picture. So, gold is in backwardation when its interest rate, which is also called the “gold lease rate”, is higher than that of the Dollar. The question is now: why should the interest rate of gold be higher than that of the Dollar? In my opinion, the answer is obvious: gold is the much better currency, so, you should have to pay up to get a loan in it. I would call this a version of Gresham’s Law for interest rates."

From this interest rates perspective, futures markets for currencies like gold are effectively lending (for a backwardation or decarry trade) or borrowing (for a contango or carry trade) trades. See this blog post for more detail.

Suicidal Strategies

James Turk has an interview with KWN where he asserts that "the attempt to shake out physical metal by driving the price lower is a suicidal strategy" as it "increases the demand for physical metal more than the weight of metal sold on to the market."

Now I agree with his statement that the bullion banks may well be hedged so they don't have any exposure to gold prices and that their real risk is more likely physical liquidity maturity mismatches. James notes that "we don’t know the size of the fraction of available metal backing delivery obligations" but sees the episodes of backwardation and drawdowns on "visible inventories of the ETFs and on the Comex" as evidence of their liquidity risk.

I would take exception to the quality of this evidence. Note the use of the word "visible". As I noted in this blog post years ago, the ETFs and COMEX are a minor part of the total investment stocks. We have evidence in terms of UK to Swiss to HK import/export figures that part of the visible inventory reduction is going to Asia, but we don't know where the massive amount of invisible inventory is going, if anywhere. If it is staying in London or other western warehouses, then we have to consider the possibility that there is sufficient physical liqudity for the bullion banks.

In any case, even if the above analysis is incorrect and these attempts to shake out physical are not working, don't you think the bullion banks know this? I mean, bullion banks have extensive webs into all aspects of the gold market so would they not be the first to see the impacts of their strategies? In that case why would they persist with it when it threatens their existence? I can see some validity in the shake out theory regarding April's price smash, but given the Asian response, I can't see validity of the theory that the bullion banks are suicidally repeating this strategy. If they were that stupid they wouldn't have survived as long as they have.

Pure Speculation on China

Nice to see gold making the mainstream papers in Australia in a positive way with this quote sent to me by a reader (you'll need a subscription to read the whole article):

"So here's the latest Pure Speculation gold theory: there will be no gold surplus in 2014 (as there never has been, unlike with most metals), China will keep taking advantage of the subdued price to buy both metal and the foreign mines that produce it, and one day, probably too late, Western investors will wake up to the fact that China controls so much of the world's gold and is using it to back the yuan as a reserve currency."


  1. In your other post you mentioned that "Tom makes the case that if anything, backwardation should be the normal state for gold".

    I agree. Why? Because "gold is not just another commodity". Gold is the highest quality, it is already the most valuable. Gold cannot be monetised through futures contracts like say sugar or pork bellies, because it IS money. The futures exchange monetises commodities, makes them more valuable, same as a bank monetises debt. As something becomes more 'money' its price will rise, just like the stockmarket right now. Stocks are 'money good' right now, a few years ago they were junk. For paper gold to trade at a premium to physical gold, smacks of Ponzi scheme.

    The natural state of paper gold, unlike lesser commodities, is bacwardation. If paper gold is moving into backwardation then it is moving towards a natural state, a discount to the real stuff.

    If backwardation ever increases then I can see that could be a issue for the COMEX, but doesn't automatically mean there is about to be a run on the Fed. There are other sources of physical gold. The Fed hasn't redeemed its obligations for decades anyhow, yet it still trades 'money good'.

  2. Leaving aside the discussion if naturally gold should be in backwardation or not, it seems that we all agree that it is the lease rate that is the ultimate cause of the slope.
    Makes sense, but it is here where I got puzzled, I feel to miss something.
    Quite often, and more often than not just the 1-2 front, the futures curve is backwarded while lease rats positive.
    Lease rate 0.06: http://www.lbma.org.uk/pages/index.cfm?page_id=55&show=2013
    1m Libor 0.16: http://www.bankrate.com/rates/interest-rates/libor.aspx
    (mid bid/ask)
    JAN- 13.5
    FEB- 12.75

  3. You are puzzled because your explanation does not follow Ockham's Razor.

  4. Many interesting aspects:

    1. The USA gold stock is reported at about 8100 tons. It's gold stock has been unchanged since 1975 and see no change going forward. 95% of its gold is held at US Mint in denver, ft. knox and west point. Balance held at nyfed. Check out the sources of data - Fed, Treasury and US Mint - all consistent. The US Mint issues annual report. KPMG gives them a clean audit year after year. I believe their data. My guess is that any gold on loan has been done via a direct lease to a bullion bank followed simultaneously by swap back to Fed so there is no physical movement. Cash invested in Treasuries to increase demand and reduce interest expense. They split the "profits".

    2. The same however, I don't believe can be said of the Europeans. Their central banks own 12000 tons of gold. Much of it is kept at the NY Fed in "safekeeping". Current balance is around 6000 tons most of which is owned by the Europeans. Balance however, almost dropped in half prior to Washington agreements 1/2/3. This suggests that it's been leased out? Why has Germany made such a big deal of the 300 tons of gold kept at the NY Fed in "safekeeping" and not mentioned the balance of their gold - another 1200 tons of gold which is supposed to be vaulted in new york? My guess is the Europeans control 6000 tons and not 12000 tons. The rest is gone via direct leasing and is in the form of jewellery and bars.

    3. Gold forward rates are slightly positive. Why would anyone pass up gold when you can use it as collateral to borrow fiat at very low cost to invest in securities? Get the best of both worlds. Gold is the best currency and gofo is likely to go negative which is an additional bonus.

    4. USA only imports 20% of their oil from opec. What happens if opec wants payment in gold not dollars? Why are the Saudis reported to be recasting their gold stock into kilo bars? Are they going to trade it on the Asia exchanges which will be opening soon??

    5. 70% of global fx is US dollars. China and other countries will diversify out of dollars. China has already entered into 25 swap agreements to eliminate dollars as the medium of exchange. So dollar will go down and gold should go up.

    No idea what the strategy is of the central banks but they're gifting gold to the East and they're only making their long term situation worse.

  5. Justin,
    where do you think the overcomplicated or superfluous assumptions are?
    Simplifying should not mean superimposing any dogmatic hypothesis.

  6. Listening to Turk is a suicidal strategy. However, " the ETFs and COMEX are a minor part of the total investment stocks." seems irrelevant. If that stock is locked up tight as it seems to be, it cannot flow to meet demand. Rather, the high stock to flow ratio is evidence of demand overhang. Until Bron can explain how the stock becomes available his view seems incomplete.

  7. I wonder if Mr. Turk has been reading my blog... of course smashing prices to try to shake out product is a suicidal strategy - it's a fantasy of the goldbugs that doesn't jive with reality. I explained this years ago, here:


    and I agree with Turk about the potential maturity mismatch of obligations

  8. Everywhere. Endless reams of complete bullshit.

    Next time you go to the market, stop & think WHY you pay the ask. Hint, it's not because of quantity.

  9. "if that stock is locked up tight as it seems to be"

    Do you have any evidence of that. We don't know how much investor stocks are held in London nor how locked up it is. If you look at the LBMA survey (http://goldchat.blogspot.com.au/2012/07/on-imbalance-between-buy-and-sell.html) and turnover estimates (http://goldchat.blogspot.com.au/2009/10/king-of-currencies.html) there is a possibility that the metal is traded and flows quite a lot. We just don't know.

  10. Yet another "superfluous assumption" eh Bron? Quite likely.

    Anonymous is good at overcomplicating.

  11. http://www.ingoldwetrust.ch/alex-stanczyk-physical-supply-never-been-tighter ... thoughts?

  12. and from a comment against the link above, http://www.arabianmoney.net/gold-silver/2013/12/06/is-china-colluding-with-top-bullion-traders-to-suppress-the-gold-price-while-it-buys-up-global-gold-reserves/