Most popular posts for 2014

Looking back over the 74 posts for 2014, these were the top five most popular in terms of what Google calls "view count":

 

In the land of the goldbugs who choose to be blind, the one-eyed blogger is king - 6128
Coin shortages and rationing are in our future - 5646
GLD amendment refers to "unforeseen reasons" for unallocated failure - 5624
Fractional reserve bullion banking and gold bank runs - how can I default on thee? let me count the ways - 4367
Fractional reserve bullion banking and gold bank runs - the setup - 4277

 

In most cases these posts were popular because they got picked up by Chris at GATA and his posts get republished elsewhere, giving more exposure. Even so, these are pretty pathetic numbers as unique visitors is much less than views. So pumpers, you can feel OK that my heretical views on your shtick is only reaching a few thousand people at best, and that my favourite post of the year which deconstructed some of your tricks - Gold blog writing for fun and profit - only got 609 views.

 

And what was the least popular post? Gaming futures and stocks with only 178 views. Hmm, maybe I need to give John Winklebottom a call.

 

Have a safe news years eve and lets hope for a more at least a more active, if not profitable 2015. I'll be back on deck on Monday. I was going to say I would get back to my 2 week holiday break, but it seems there is a disconnect between my idea of a holiday (sitting around doing mostly nothing) and my wife's (great opportunity for me to do a lot of jobs around the house she had in a list in her head).

ZH fail on Soc Gen fail on Russia selling its gold

Zero Hedge fails when commenting on gold are common, but I was surprised to see in this ZH piece to see that Soc Gen got sucked into due to poor research.

 

As is common in internet land, people pick up stuff by others without doing basic drilling down to the source. The reason you have to do this is because people often misinterpret the source. Other times the source is wrong.

 

ZH quote the following from Soc Gen: "It appears possible that the Central Bank of Russia has started to sell off some of its gold reserves in December, with some sources reporting that official gold reserves dropped by $4.3 billion in the first week of the month."

 

Now that is a very specific figure, $4.3b. It seems that Soc Gen got it from this Business Insider republication of a Vesti Finance article which said "On Thursday, the Central Bank of Russia announced that gold reserves dropped by $US4.3 billion in just one week, reports Vesti Finance."

 

However, if we check the source link provided we get the following:

 

"Russia's international reserves for the week from November 28 to December 5, decreased from $ 420.5 billion to $ 416.2 billion, the central bank said on Thursday. ... For the previous week, from 21 to 28 November, gold reserves increased from $ 420.4 billion to $ 420.5 billion. On November 14th the size of gold reserves stood at $ 420.6 billion, on November 7 - $421,400,000,000 rubles."

 

Now the decrease they are talking about is $4.3b in total reserves but the headline mistakenly assumes it is all gold. The gold specific figures they mention show completely different numbers. While Business Insider hasn't corrected its article, Frank Knopers noted the following update Yahoo Finance made to its republication of the Vesti Finance article:

 

"Editor's Note: Earlier it was reported that the Central Bank's gold reserves decreased by $4.3 billion, quoting Vesti Finance. However, in actuality, it is international reserves assets that have decreased — not gold. Appropriate changes have been made."

 

Now how hard was that fact checking Soc Gen and ZH?

Money, trust and gold

This is a companion piece to Tuesday's Love the Gold post, focusing on gold's role when people lose trust in money.

 

Izabella Kaminska is journalist/blogger I follow at FT Alphaville and her personal blog because she is an original thinker and hates gold (I'm not interested in gold haters with clichéd thoughts). Her work is demanding often because she is several steps ahead and I'm scrambling to catch up, often it is because she makes logic jumps that are evident in her mind but could do with more exposition, but sometimes she is just wrong.

 

This post from August on one of her favourite topics, money, is an example of all three. I just want to focus on the trust issue. Izabella notes that there is a whole range of monies (eg central bank base money, bank issued money, shadow banking) which for most of the time everyone treats equally. All these monies are thus mixed up or entangled. Problems happen when "a corrupted money type has been entangled amongst the remaining virtuous stock in the system" and "the more entangled it is, the greater the flight of capital to a clearly definable and unentangled money type in response".

 

So when people "start to question whether other people’s judgments about what is truly meaningful or not were correct at all" and where there is not "enough surplus stuff in the economy to ensure that money retains its purchasing power" to what clearly definable and unentangled money does capital fly? Not gold according to Izabella, as this "carries too much risk" nor anything else except the monies of :

1. someone who everyone trusts, and who everyone knows adds value (like a respected government)
2. someone who you know has something you need, and thus someone you can be sure has already added value (a collateralised money)
3. someone you can be sure will allocate the things you give him so wisely that there will be more of the stuff you value (like a reputable interest-paying investment institution)

The situation Izabella doesn't consider, and what I'm interested in, is to what does capital fly when:

1. people lose trust/respect in government because it is issuing money well beyond the meagre value it adds (or its bureaucratic inefficiency + stupidity result in net negative value)
2. Minskian ponzi borrower dynamics means that collateralised money is overvalued
3. a combination of point 2, lax regulation and skewed incentives mean banks unwisely create/lend money  

Izabella gets to the answer when she notes that "it's worth remembering that ancient cultures tended mostly to use gold for trade with strangers they did not trust", although she thinks it is debatable whether "gold counts as virtuous money stock". I would concede that when people begin to distrust monies #2 or #3, most will run to #1.

 

However, consider Izabella's point in this post that "today’s modern cities are ... huge hubs dedicated to information gathering and stand-alone consumption. But they also happen to be society’s most vulnerable pressure points, due to their dependence on supply chains". We live in a massively complex system, which, when its "distribution channels (the nervous system) have become clogged whether that’s due to natural disaster, famine, war, disease or corruption (over consumption by the few)" inflation is the result.

 

When money loses its purchasing power, Izabella notes that "well being and richness is ultimately determined by physical coercion, intimidation tactics, cartel-like organisation or self-sufficiency." And the group of people in the best power position to protect their well being and richness with oppressive tactics? Government and its bureaucracies. That's when people will run from money #1 to gold.

Zero Hedge fail on undocumented gold supply story

Zero Hedge really dropped the ball on the Bloomberg story that commodity trading firm Gunvor Group was giving up trading physical precious metals partly due to "difficulties in finding steady supplies of gold where the origin could be well documented".

 

Firstly, their spinning of the story came out three days after the Bloomberg story. That is an eternity when we have been told by experts that "the London hub is failing" (more on that in a future post) - I mean, the bullion banking system could have blown up in that time!

 

Secondly, ZH were obviously only half committed to their meme as they couldn't be bothered to do their signature LinkedIn profile highlighting. If you look at Cedric Chanu's profile you'll see that he only joined Gunvor in January, after having spent over 5 years with Deutsche Bank! Need I say more? And Francois Beuzelin, who worked at Soc Gen from 1998-2009 as "head of metals swap trading"! Gold swaps! Need I say more? And finally, coincidental that Cedric also worked at Soc Gen from 2004-2007, the same time as Francois?!

 

Seriously, ZH's last two paragraphs are a mess in terms of trying to spin a meme out of this story - it reads like a first draft and I've seen a lot better from them. Gold is one of ZH's mainstay themes and it is surprising to see them give this story such slack treatment; maybe it is a sign of the bottom that ZH's heart is not in to pumping this story for all its worth.

 

ZH starts off trying to link this story to the "rehypothecated commodities scandal in the port of Qingdao" and twist it to being about "gold whose ownership traders are unable to validate - has now flooded into the global trading infrastructure". Two misdirections here. First, "flooded" - where in the Bloomberg article is their any indication that undocumented gold is flooding the market? Zero.

 

Second, the Bloomberg quote talks about the undocumented "origin" of gold, not "ownership". Zero connection between those two concepts (maybe this is what the "zero" in Zero Hedge means - they just make stuff up of nothing). Any knowledgeable commentator on the professional gold markets would be aware of the LBMA's responsible gold framework, which implements "OECD Due Diligence Guidance as well as Swiss and US KYC, Anti-Money Laundering and Combating Terrorist Financing regulations". Not just refiners, but anyone trading in the gold market, needs to comply with this. Therefore Gunvor's reference to "origin" and "documentation" is clearly referring to the need to be able to verify that gold is conflict-free. It is not a reference to the "ownership link", as ZH puts it, of the gold that is the meme spin that ZH tries to put on this story.

 

Finally, ZH tries to play up the unusual nature of Gunvor pulling out of trading gold, since they are "the world's fifth largest trader of commodities". Well what is unusual is that Gunvor was in the gold market in the first place because Bloomberg notes that "neither Glencore Plc (GLEN), the biggest metals trader, nor Trafigura Beheer BV, the second largest, trade physical gold." The gold market is dominated by a handful of bullion banks who have a deep contact list and often contractual supply arrangements in place with miners and refiners. It is not surprising therefore that a "handful of people in Singapore and Geneva" were not able within a year to crack this market and gain enough business to justify a specialist division within a large firm. That is the mundane reality behind this story, not a biblical flood of ownership undocumented gold.

 

While we are talking about people who don't know what they are talking about, this Bloomberg piece on the possibility of Russia's next move being to sell their gold is a classic piece of gold bashing. In support of the thesis they quote two bullion market nobodies:

• A guy "who oversees $150 million at Parsippany, New Jersey-based" financial advisor
• Founder of Optionsellers.com in Tampa, Florida

The only credible source is "Michael Widmer, metals strategist at Bank of America Corp. in London" It is not surprising that he is the only one who notes that Russia could use their gold as collateral, rather than selling it. The others just simplistically argue that Russia will sell their gold outright. Given that Russia has been accumulating gold almost every month since mid-2006, I think it is highly unlikely they would sell it rather than just swap/repo it. I'd ignore this Russia-to-sell-gold meme only except that it may be a narrative influencing some traders.

How I Learned to Stop Worrying and Love the Gold

Bullion Baron had an excellent post out last Monday on how cash is not some bedrock asset without risk, based on a Barry Ritholtz statement that it is a huge investment mistake to hold an asset which you can never envisage selling. On the assumption you've read the post including comments by Cullen Roche and Kid Dynamite, here are some thoughts.

 

Cullen's comments that you hedge your equity exposure with non-correlated assets (excluding gold), options and insurance misses the point. He says these "provide you with a certain future value in the case of catastrophe" but I think his definition of catastrophe differs markedly from that of gold investors. His hedges are just promises, which to gold investors are likely to fail in a real catastrophe. Cullen, who represents the views of Mainstream Investor Adults (MIAs), only envisages a catastrophe sufficient to cause significant damage to his portfolio, but not that much that the insurance contracts wont be honoured. Convenient. MIAs are doing a Barry: saying that there is nothing that would change their view that their proposed insurance promises will not work. They are effectively dismissing Kid Dynamite's scenario of "when people are *desperate* to allocated out of cash", that is, hyperinflation.

 

OK, so MIAs sees zero chance of SHTF, so they holds zero gold - that is logically consistent. But the only way this makes any sense to me is if MIAs believe that financial panics will not get out of hand because government or central bankers will do something to prevent it. I guess the lack of a complete breakdown after the financial crisis gives MIAs a reason for this view, and gold investors would have to concede that. However, readers of this blog, as diverse and disagreeing as we are, would all argue I bet that the underlying problems are not fixed. Maybe some new Committee to Save the World will come along and get us out of the next blow up, but gold investors don't see a zero chance of no blow up, so they don't hold zero gold. How much depends on how confident they are in these masters of the universe.

 

Side Note: I think it is interesting that MIAs who put their faith/trust in governments and central bankers to manage the economy, and not gold, don't see the contradiction in the fact that those very governments and central bankers hold gold themselves. If gold is such a stupid investment, doesn't that make governments and central bankers stupid? In which case you shouldn't trust them. In which case you need some gold.

 

Cullen/MIAs then argue that gold is a poor form of insurance because its value is extremely volatile and uncertain. Volatile and uncertain - I couldn't agree more. This is what you should expect from an asset that reflects the sum total views of the market about the likelihood of governments and central bankers losing control. That is a very difficult thing to analyse and come to a view on so we should expect diverse views on the matter, and the whipsawing in the gold price reflects the changing balance of sentiment between MIAs and, dare I say, the less naïve. As an aside, I would note that WGC research shows that gold can reduce the volatility of a portfolio without sacrificing returns and also help to reduce potential losses for tail risks, but lets stick to the facts here.

 

Anyway, even if gold has no benefits for portfolios during normal times and the occasional (recoverable from) tail risks, and as such is a poor investment, what MIAs miss is that gold will perform in a real catastrophe. Putting up with gold's volatility is something the buy-gold-for-insurance investors do for that hedge. Whilst MIAs may see gold's value as too volatile and uncertain, I'd suggest that we can be certain gold will be valued during catastrophes. This because the narrative (there I go again with Ben Hunt) or common knowledge around gold is that it is a safe haven in such extreme circumstances: everybody knows that everybody knows gold is where you run to when the SHTF. MIAs think this is a "faith put", that it is a myth that gold "warrants a price premium well above its cost of production". That is very logical, but we aren't talking logic here, we are talking human behaviour, perception and belief.

 

I can understand why MIAs who analyse stocks and bonds using hard numbers find this too fuzzy. Indeed some goldbugs who read this blog find Ben Hunt's work too wishy-washy. I am a hard numbers person myself, but surely the MIAs will concede that markets can be irrational (Dot Com, QED)? In which case, I know that when people get fearful they will run to gold. Irrational? Maybe, but rational me accepted that gold will "work", when I need it to. So just get over it and Learn to Stop Worrying (about its irrational volatility) and Love the Gold*.

Reserve Bank of India 92:1 meme

One of the most persistent memes in the blogosphere is the supposed massive fractionalisation that goes on in bullion banking. Historically bloggers used Jeff Christian's 100:1 statement as proof but I rarely see that mentioned these day. Instead, bloggers focus on the following from a Reserve Bank of India Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loan NBFCs (non-banking finance companies) in India dated January 2013, page 58:

 

"Interestingly, in the Financial Markets, the traded amount of ‘paper linked to gold’ exceeds by far the actual supply of physical gold: the volume on the London Bullion Market Association (LBMA) OTC market and the major Futures and Options Exchanges was over 92 times that of the underlying Physical Market (Table 5.1)."

 

The popularity of the 92:1 fractional meme I suspect is due to:

1. You don't have to give Jeff credit/exposure
2. It is a more recent reference
3. It is from a Central Bank

I think that the last reason is the main one, and indeed if you search on the times the 92:1 has been used, it is almost always referred to as coming from the Reserve Bank of India with the implication being that as they are a Central Bank they really know what is going on in the bullion banking game so you are getting the Truth from an insider.

 

The really amusing thing about that implied inside information is that if you actually look at the report on page 58, which I bet few of the commentators referring to the figure have, you find that in support they have a table showing figures on physical vs futures and LBMA volumes sourced from CPM Group, Jeff Christian's firm. So the 92:1 meme is not confirmation from the Reserve Bank of India about the fractional bullion banking system but just a reference to trading volumes in different markets using figures from a source that goldbugs hate and distrust.

 

On that last point, for readers new to the issue of confusing turnover with fractional, I have covered that a number of times, here on Sprott and here on Rob Kirby making this mistake, as well as at the 100:1 link in this post above. I would also recommend my series on fractional reserve banking, particularly this one which discusses the difference between turnover, leverage and fractional.

Why WGC's India gold policy won't make much impact on import "problem"

For all the laudable recommendations (yes, Indians using their own gold to fund their own gold jewellery industry is OK) in the WGC & FICCI's Why India needs a gold policy, I think it fails to articulate a compelling case for the only thing that matters to the Indian Government - reducing gold imports (ie currency leaving the country).

 

Stating it simply, imports will only be reduced by the amount of gold tied up in manufacturing inventories, thereafter Indian's net accumulation urges will have to be satisfied by imports again. The failure of the report to identify the size of manufacturing inventories means the size of import substitution cannot be quantified, denying the report the sort of hard numbers that could attract policy makers' attention.

 

First some facts. The report mentions 22,000 tonnes of gold held in India. Yearly consumer demand is around 800t and WGC's global stock estimates put industrial/manufacturing inventories at around 10% of total gold stock. So that would work out to:

 

Physical Gold held by Indians - 22,000t
Physical Gold held by Manufacturers as work in progress - 2,400t
Yearly demand/addition to stock - 800t

 

Note that Indians are net accumulators of gold (the report notes they spend 8% of their income on jewellery and coins). This means any mobilisation of the 22,000t into bank gold savings schemes does not mean that those people will not buy more gold. All they are doing is changing the way they hold their existing gold savings; they will still want to add to their existing savings (in aggregate). Any mobilised/recycled gold is just sold back to others who don't want a bank gold savings scheme - the total amount of physical gold in the country stays the same, it is just that some are now holding bank gold savings schemes.

 

Lets say the WGC's proposals are so successful that they manage to mobilise 800t a year. So Indian banks don't have to import gold and can instead loan the mobilised gold to manufacturers who then transform it and sell it (their total holdings stay the same). This is how the gold "balance sheet" of India looks after this first year:

 

Indian Physical Gold asset - 22,000t
Indian Gold Savings Schemes asset  - 800t
Bank gold liabilities to Indians - 800t
Bank gold asset (loans) to Manufacturers -  800t
Manufacturer liability (borrowings) to Bank - 800t
Manufacturer Physical Gold asset - 2,400t

 

After three years of this we would have this situation:

 

Indian Physical Gold asset - 22,000t
Indian Gold Savings Schemes asset  - 2,400t
Bank gold liabilities to Indians - 2,400t
Bank gold asset (loans) to Manufacturers -  2,400t
Manufacturer liability (borrowings) to Bank - 2,400t
Manufacturer Physical Gold asset - 2,400t

 

Now what happens in year 4? The banks get another 800t from Indians but they can't loan it to manufacturers as the manufacturers have all the gold financing they need. The manufacturers would be happy to buy the gold from the banks but this would leave the bank with short gold position. If the bank sold the mobilised gold they would have to use the cash to buy replacement gold. As Indians are not net sellers (in aggregate) the banks' only option is to buy gold overseas, but in doing so they send currency out of the country, which is what the Government is trying to prevent.

 

So gold mobilisation is probably only good for a few years worth of gold import substitution and thereafter the Indian Government is back to its "problem". One could add another year or two if the Indian export jewellery industry expanded based on the other recommendations (WGC estimates exports could increase five-fold - but that doesn't translated to work in progress inventory increase of the same size as manufacturers would just increase their inventory turnover). But in the end mobilisation is a temporary solution. Maybe that explains the lack of hard numbers in the report.

 

It is not like the WGC and FICCI could not have worked out the amount of gold tied up in manufacturing - a November 2013 FICCI report in conjunction with AT Kearney (All that glitters is Gold: India Jewellery Review 2013) has a lot of very detailed numbers on the jewellery industry and so working inventory estimates obviously would not be difficult to obtain. My only conclusion is that it was a deliberate strategy of the WGC to avoid putting numbers to the real import substitution potential.

 

Given that many of the recommendations would make it easier to invest in gold both in jewellery and coin/bar, once the mobilisation import substitution ran its course the result would actually be increased Indian gold demand compared to doing nothing and leaving the industry in its current less than optimal state. Maybe I'm too cynical thinking that the WGC knows this and deliberately allows the report to imply to less savvy policy makers that it solves the "gold problem", in which case you certainly don't want to have any hard numbers focusing on real physical gold and currency flows.

 

In my opinion the report does spin the 5006 person (not much in a country that size) survey results quite hard. The survey seems heavily skewed to urban (only 2.44% employed in agriculture), but I don't know what the general population distribution is, and nor does the report indicate if their sample is representative of India in general. The report notes that "more than 49 per cent of respondents said they would be willing to deposit their gold to earn interest while a further 12 per cent said they might do so. Moreover, 72 per cent said they were happy to receive different gold from their initial deposit." OK, so (49 +12) x 72 = only 44% who would actually go with a mobilisation scheme that could recycle gold.

 

The report also noted that "more than a third of respondents would be willing to deposit 25-50 per cent of gold in their possession" (didn't indicate the other respondents % they would deposit). Once you get the 44% then apply a third then apply 25% it would look to me that we are talking about a much smaller amount of the 22,000t that would actually be mobilised, certainly less than the report implies (note that the report says that Turkey only "monetised around 300 tonnes of gold").

 

How much gold Indians would be willing to mobilise is questionable, especially considering the following from the November 2013 FICCI report: "Unlike other financial investment options, many retail transactions in gold can still be done in cash without any documentation. This provides an easy route for investing unaccounted (black) money."

 

Probably the best source of mobilised gold would be the temple trusts, which the earlier FICCI report says "it is estimated by various sources that about 1800-2000 tons of gold is present with the temple trusts in the country" That would probably fund the gold jewellery industry.

Chinese regulations: rule of law or rule by law?

Following on from yesterday's post on the Chinese leasing market, there was a small amount of back and forth on Twitter between Koos, DP and myself (see here). While nothing was resolved in respect of the double counting and fractional issues I raised, I mention the discussion because Koos made a few references to SGE rules and I sense that from his other writings he relies on these and other (interpreted) documents heavily. That is fine but given Chinese is a reader responsible language, I think one has to be careful not to read such documents in a Western black and white manner.

 

Until recently, I had no idea there was a difference between communication approach in Chinese and English that could result in misunderstandings. My first inkling of this was a comment to an October 2013 Koos post to Andrew Maguire (comments seem to have been lost in moving them all over to Bullion Star) which read in part (original link):

 

"In Chinese, the "delivery" word is translated into 交割(jiao ge). And this is what the "Delivery Volume" in the daily price table means. "Moving the physical out of registered depositories" should be translated into "出库“(chu ku). The number you have in the SGE weekly report is the number of "出库”. It is the SGE that causes the confusion. It refuses to use the generally accepted terms. Instead, it uses 交收(jiao shou) to mean 交割. And the SGE uses 交割 to mean 出库. Then the SGE uses the same English word "delivery" to translate both 交收 and 交割. That makes you confused."

 

At the time I passed this off as an interpretation technicality, but later I came across this article which said that:

 

English is a writer-responsible language. That means it is the responsibility of the writer to make sure the message is understood. Writing is clear, direct and unambiguous. Schools teach from early on the importance of structure, thesis statement and topic sentences when writing in English. A good writer assumes no or little background knowledge on the part of the reader.

 

Korean, Chinese, and Japanese are reader-responsible languages. That means the reader is responsible for deciphering the message, which is often not stated explicitly. For an American who is expecting direct and explicit information, this style can be very confusing.

 

These style differences can create cross cultural misunderstandings in emails, job applicant cover letters, and even technical writing.

 

This attracted my attention given our reliance (via Koos) on mostly formal Chinese documents and speeches etc on their gold market. It raises a number of issues:

• We cannot read Chinese documents in a Western black and white manner, and must be aware of context and what is being said between the lines.
• We are reliant on interpreters deciphering the message correctly, getting the context right.
• For technical gold market matters (see the comment above about delivery vs settlement), interpretation by non-gold market specialists may result in an incorrect translation.

So when it comes to SGE regulations or even official statements, this passage from a language blog is always uppermost in my mind:

 

Good speakers in the West see it as their responsibility for the audience to understand them. In contrast, Dave says that when he has heard a regulatory official in China give a less-than-captivating talk (i.e., reading from a script), Chinese colleagues have explained, “he’s important, we need to listen and understand what he says.”

 

In his daily work, Dave says that he often gets involved in discussions with colleagues from Europe and elsewhere about how to interpret Chinese regulations and how to deal with confusion about the law’s requirements. There is an issue with ambiguity in how Chinese regulations are written and this can make compliance difficult.

 

To further emphasise the point, see this from the same blog:

 

When fǎzhì 法治 is being used to designate the application of law as it is conceived of by the Chinese Communist Party, I would be very careful always to translate it as "rule by law".  When we are referring to the application of law as it is conceived of in the West, then I would be careful to translate it as "rule of law".

 

And even more blunt in a comment to that blog post:

 

The way my Chinese law professor explained it to me was the same way it's been explained above: 依法治国 (rule of law) indicates that the government creates laws that explain how things are going to work and then follows those laws; 以法治国 (rule by law) indicates that the government first makes an arbitrary decision about the outcome it desires and then finds/interprets/creates/ignores laws as expedient to achieve that interpretation — i.e. the law exists as a tool for the government to enact its will.

 

So that is why I'm not so convinced by statements by Chinese officials or formal Chinese rules - I don't discount them, but nor do I accept them as a black and white fact. Just another case of ambiguity.

 

In case you think I'm exaggerating, Perth Mint has experienced this first hand. I can't get specific, as it would give away which entity I'm talking about and Perth Mint runs under some pretty hard confidentiality rules (Section 74 of Gold Corporation Act 1987 is black and white rule of law that sends me to jail), but Perth Mint investigated and found that there was no rule against doing X in China but when we attempted X we were not able to do it.

 

On yesterday's post, Nutster noted the "black hat/white hat" narrative of the West vs China. If indeed China is a "white hat" and SGE rules mean what they say and everybody follows them properly and it is such a transparent market, isn't it a bit odd that SGE only reports gold withdrawals and doesn't report deposits into SGE warehouses nor warehouse stocks? I mean, this is less transparent than those black hats at Comex! Such reporting would help a lot in resolving Koos' debate with WGC on what is China's real demand. The fact that they don't tells us that China is as much into perception management (in this case how big the Chinese gold market is to help along their ambitions re pricing power as well as attracting foreign traders to their market) and use of ambiguity in regulations as the West is with their MOPE and lawyers.

 

Since we are on the topic of interpretation of language and rules, that leads perfectly on to accounting standards and double counting. In yesterday's post, "Out of the woodwork" asked the following question:

 

"Are commercial banks in China free to record a transaction on their balance sheet in a misleading way when it is recorded in an unambiguous, non-misleading way in their SGE account?"

 

Now I used to think as a lay person (pre university) that the words "accounting standards" mean, well, that there is a standard accountants follow and given they deal in hard numbers that what they do is all black and white. Those who have studied accounting, as I have unfortunately done, know that "accounting standards" just means standards for how to make a judgement call on which of X number of authorised ways you can treat a "number".

 

The result is that, yes, banks are free within bounds to record transactions differently, which can result in double counting, no matter what SGE rules says. In a lot of cases I'd guess this would happen due to accountant interpretation of what is "material". Case in point, see Scotiabank's annual report, a reasonable player in the bullion market. They explicitly report precious metal assets at $7,286m because it is material compared to their total cash and other deposits of $64,000m but when it comes to derivative financial instruments, they report foreign exchange and gold contracts as one line item and don't break it down.

 

Contrast this to JPMorgan's 344 page annual report. The word "gold" is not mentioned at all and the word "precious" is only mentioned twice in text commentary. Nowhere in their financial numbers is gold or precious metals reported. Heck, not even in their detailed "major product category and fair value hierarchy" assets and liabilities table do they show it. And this from a bank which is one of the biggest players in the bullion market. The reason? As big as it is in bullion, it is just not material on their $2.4 trillion balance sheet.

PBOC paper recommends leasing its reserves to manipulate gold price

“PBOC paper recommends leasing its reserves to manipulate gold price” should have been the headline Koos Jansen used for his blog post on a paper produced within the People’s Bank of China which recommended that China “consider employing some of the PBOC’s gold reserve for market operations and as a macro-control tool.”

 

For some reason, Koos instead thought that the “key takeaway” from the paper was that in China “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets” (which is incorrect, but more on that later).

 

Now saying what the headline should have been (from a Winklebottom point of view) isn’t the same as saying it is true. The reason is because the PBOC paper is focused on what I’d call “good” leasing, that is, leasing to businesses involved in manufacturing gold products, and not leasing for short selling purposes. We can confirm this by the quote “gold leasing is a no-leverage, low-risk transaction”, which only make sense in the context of inventory financing and not short selling. Within that context this quote provides more detail on what was meant by “market operations” and “macro-control”:

 

“Therefore, while restricting gold export, taking part of PBOC reserve gold to participate in leasing operation is a win-win policy. Specifically, the PBOC may select commercial banks as counter-party to lease out reserve gold when supply is tight. Gold lease rates may be established through bidding, PBOC participation would increase liquidity.”

 

The paper noted that the supply of physical gold to industrial users was limited at the time, so recommended utilisation of PBOC’s reserves when “supply is tight” and to “increase liquidity” within the lease market to support the gold industry. Assuming the PBOC did implement these recommendations it is likely that today their leasing may be minimal given that the PBOC did implement the recommendation “limitation to imports should be loosened in favor of a policy that is ‘easy in, strict out’” and as such today physical supply to Chinese industry is being met by significant amounts of imported gold.

 

However, in some sense my headline is true, although not that PBOC is explicitly short selling gold. In the paper they recommend that “enterprise participants can be left to commercial banks to be evaluated for risk of doing business, not unlike evaluating business loans.” In other words, you can trust the banks to be prudent in choosing who to lend gold to. Subsequent events indicate that Chinese banks weren’t so prudent, the result being “bad” leasing for short selling.

 

By September 2012 we first hear of abuse of improved liquidity in the Chinese leasing market with growing round tripping and collateral trades (the gold tied up in such would be financed/hedged by leasing). Business Week reported “rapid growth” in precious metals leasing business in September 2014. Koos’ sourcing of PBOC paper also confirms the observation in a WGC report that “most of the gold stuck in financing deals has been built up since 2011” (note the PBOC paper is dated January 2011) and provides evidence that PBOC paid attention to the paper’s recommendations. Later we find out how individuals and non-gold businesses were using gold loans in risky leveraged transactions. How much of Chinese bank leasing was for such short selling we don’t know, but given that the paper recommended

• “increasing gold reserves optimizes the makeup of China’s assets which will lay a good foundation for RMB internationalization” and
• “when gold in the domestic market is sufficient, or for strategic needs, PBOC may purchase gold from commercial banks to reach its gold reserve target”

it is probably not unreasonable to expect that the PBOC wouldn’t be too worried that a light touch approach to regulating gold leasing may result in downward pressure on gold prices.

 

Back to Koos’ statement that “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets”. Regarding double counting, the IMF paper Koos quotes is referring to how many central banks report physical gold and gold loans as one line item. When done this way, the addition of such figures with other figures of gold holdings will result in double counting of physical gold.

 

However, Koos incorrectly thinks that the SGE rulebook that possession/title of gold from lessor to lessee somehow gets around this problem. The very same transfer occurs in the situations the IMF is referring to, and this doesn’t solve the problem. It is not about transfer but about reporting. To the extent that Chinese bank’s financial reports do not break down physical gold stocks from gold loans, there will be double counting. To the extent that banks following accounting standards, like the Reserve Bank of Australia does, there won’t be double counting.

 

In respect of Koos' claim that Chinese gold leasing is not fractional backed, well, by definition gold leasing results in a bank being fractionally reserved. As Koos notes, the SGE rules result in transfer of physical gold from the bank, in which case, they no longer have physical gold backing their gold liabilities! Hence they only have a fraction of physical gold against all their gold liabilities. Hence “the gold on lease IS … fractionally backed”. Chinese bullion banks are no different from their Western counterparts, as Koos himself reported: “ICBC launched gold accumulation schemes, swaps, forward hedging, lease/financing, collateralized loans and other financial services ahead of time”. That sounds exactly like what bullion banks do in Western gold markets to me.

Gold and silver bugs have already experienced a hyperinflationary event

Dominic Frisby has a couple of podcasts out from the Mines and Money conference in London. Dominic is a great interviewer and probably the only gold friendly one who is willing to ask some very pointed questions, instead of the usual soft ball stuff.

 

The one with Ross Norman, CEO of Sharps Pixley is good but I found the one with Ned Naylor Leyland of Quilter Cheviot the most interesting.

 

As an example of Dominic's pointed questions, this is what he asks five minutes in: "I put it to you that gold and silver bugs have experienced their worst dream only in the opposite in that all their options on gold and silver aka their junior mining stocks have wiped them out in much the same way that a hyperinflationary event would have done."

 

Some other interesting bits include Dominic recounting a conversation with an educated moneyed Malaysian on a plane trip about whether Asian countries would follow the path of Western countries where use and investment in gold has faded, and how people still think the pound is redeemable in gold.

 

The most telling part is towards the end where Ned tells a wealthy investor, who isn't invested in gold and is using residential property as his hedge against the current rocky financial architecture, that property is a poor illiquid hedge "and I could see the penny slightly dropped but he didn't like it and so he just looked at me and went don't give me that goldbug look". If you want to understand why Westerners are not buying gold, the "but he didn't like it" cognitive dissonance explains it all.

Profiting from the delta between stupidity & fact

Tekoa Da Silva has an interview out with Rick Rule with a great headline: Speculative Profits Are Made On The Delta Between Stupidity & Fact.

 

It is a bit long at 77 characters, Tekoa could have simplified it to Rick Rule: Speculative Profits on The Delta Between Stupidity & Fact, which is 68 characters, just shy of the magic 65. But other wise it is brilliant, combining name recognition; "speculative", a hot word in the gold blogosphere; "profits", which implies you'll make money; "delta", which makes it sound technical and intelligent; and switching Rick's use of opinion in the original quote with "stupidity", a much more emotional word. Maybe Tekoa is a subscriber to John Winklebottom's service?

 

Anyway, the money quote from Rick is:

 

Remember that making money in speculation is done by taking advantage of the delta between opinion and fact. It has been said by many knowledgeable observers that the market in the near term is a voting machine. In the long term it’s a weighing machine. Speculative profits are the delta between the way people vote (which is always stupid) and what stuff weighs.

 

In the article he is talking about mining equities but in offline email discussion with a bunch of gold iconoclasts, the point was this stupidity/fact delta equally applies to the tabloid end of the gold blogosphere. They make money selling stupidity and you can make money trading on fact.

 

Coincidentally, a few days ago in another email discussion I had with a pro market trader he made the following comment:

 

I noticed just now that someone had forwarded you that fine example of someone who understands nothing about how metal is used nor invested in writing about that of which he is ignorant. That’s what I love about the precious metals markets: They are full of fools who make it easy to make money betting against them.

 

What's that saying about not knowing who the sucker is at a poker table?

Blatant and massive market intervention

Kid Dynamite tweeted the pic below yesterday, cc @pcraigroberts, in response I guess to this post. He has stopped posting his monthly summaries (see here) of one-eyed gold commentary that only sees big downwards moves but ignores the big upwards moves.

 

 

The text in the Paul Craig Roberts post is a classic of this type. For a bit of fun, lets take that text and rewrite it to fit the chart above. I can guarantee you will never see this sort of analysis on the gold blogosphere.

 

In a blatant and massive market intervention, the price of gold was ripped on Monday Right in the early hours when the US was sleeping with 15,000 paper gold contracts bought representing 42.5 tonnes of gold. Prices were jacked higher on Comex futures market again at 9:30a.m. EST with ANOTHER 15,000 contracts. Finally after lunch 20,000 paper gold contacts were pumped on the Comex futures market.

 

No relevant news or events occurred that would have triggered this sudden rally in gold. In fact, any logical person would have expected gold to FALL on the news that the SNB would not be buying billions of Francs worth.

 

A rational person who wants to buy gold because he believes the price will rise wants to obtain the lowest price for the contracts he buys in order to maximize his profits when he settles the contracts. If his purchase of contracts drives up the price of gold, he reduces the spread between the amount he pays for his contracts and the price at settlement, thus minimizing his profits, or if the price goes against him maximizing his losses. A bona fide buyer speculating on the direction of the gold price would choose a more liquid market period and dribble in his contract purchase so as not to cause a significant impact on the price.

 

As you can see from the price-action on the graph, massive purchases concentrated within a few minutes maximizes costs and are at odds with profit maximization. A rational buyer would not behave in this way. What we are witnessing in the bullion futures market are purchases designed to drive UP the price of bullion. This is price manipulation.

 

BTW, I note that gold commentators have not given much if any coverage on the Senate Permanent Subcommittee findings on “Wall Street’s massive involvement in physical commodities" that was all about restricting physical deliveries, warehousing etc that industry claimed was pushing UP the price of commodities.

Gold lease rate curve inversion

Following on from Monday's post on this unhistoric GOFO, I've got around my problems with image upload on blogger by putting it up on twitter first.

 

Below is the 1 month and 12 month lease rates back to 1998. I think it is pretty clear that this current situation, while trending in the direction of something historic, is not there yet.

 

 

What is interesting is that the gold lease (interest) rate curve has just started to invert, with 1 month rates at 0.54075% while 12 month is at 0.52980%. Such inversions are rare, with the significant occurrences being in 2008, 2001 and 1999.

 

It is worth noting that during these periods the lease rate spikes lasted for at least 3 months before returning to pre-spike normal lease rates. There is also no correlation with action in the gold price. In 2008 for example, the gold price continued to weaken as lease rates went up during early Q4 2008. In 1999 you can see that the gold price was stable during Q3 1999 all the while lease rate spiked to record highs. So I think it is premature of commentators to spin this high lease rate/negative GOFO as guaranteed indicator of a bottom - history shows that price could weaken further before climbing.

 

On Monday I gave a number of reasons why we are seeing the action we do. The 2008 experience where the price fell while lease rate were high does suggest shorting. I would note that such shorting action could come from futures markets where speculators see the initial price weakness and then pile in. In such one-sided situations bullion banks will make a market and take the long side and hedge themselves by shorting gold in the OTC spot market. Such shorting activity will result in demand for borrowed gold, hence lease rate rise.

 

Such a theory means that lease rate spikes (if speculative driven, not liquidity driven) may be indicative of excessive shorting and thus market bottoms. If one saw futures speculative positioning on the short side, bullion banks on the long side and high levels of open interest at the same time as lease rates spiking off recent normal levels, then that could provide strong confirmation of excessive short sentiment.

 

By the way, Steven Saville has also just blogged on the recent "backwardation", saying much the same as I did on Monday but his post has GOFO and LIBOR charts which show the identical behaviour - worth checking out to see what I was going on about.

Continuing Sprott PHYS Redemptions

At the start of each month any redemption request lodged on the 15th of the prior month shows up on the website of Sprott's precious metals fund. On December 1st we had 36,915oz redeemed, which would have been related to trading between 16 Oct and 15 Nov. I've posted on this activity here and here.

 

The table below shows the redemptions by month since they first started and the average daily arbitrage profit/loss a trader could make by buying PHYS, redeeming it, and selling the physical at spot.

 

Date of Redemption	PHYS Gold PHYS Redemption (oz)	Average Daily Arbitrage Profit/Loss
Jul 2nd 2013	400	0.139%
Aug 1st 2013	8,354	0.214%
Sep 3rd 2013	12,500	0.045%
Oct 1st 2013		-0.234%
Nov 1st 2013	17,260	0.122%
Dec 2nd 2013	19,200	0.144%
Jan 1st 2014	83,890	0.327%
Feb 2nd 2014	91,680	0.125%
Mar 3rd 2014		-0.093%
Apr 1st 2nd 2014		-0.175%
May 1st 2014		-0.068%
Jun 2nd 2014		-0.012%
Jul 1st 2014	6,150	0.006%
Aug 1st 2014	12,028	-0.022%
Sep 1st 2014		0.000%
Oct 1st 2014		-0.008%
Nov 3rd 2014	27,911	0.086%
Dec 1st 2014	36,915	0.077%
Total	316,288

 

You'll note that any month the arbitrage is negative (a loss), there is no redemption, and when it is positive, there is a redemption. The only month that doesn't fit this pattern is August 2014, however, while on average August showed an arbitrage loss, there were 8 days when it was profitable.

 

It is clear now that this is arbitrage driven activity which takes advantage of any discount to NAV on the Sprott funds. Since PHYS first moved out of a premium to NAV in July 2013 it has lost 19.6% of its gold. As long as there is little retail interest in PHYS to bid up its share price above NAV, PHYS is going to continue to lose metal.

How historic is this negative GOFO?

So is this occurrence of negative GOFO a "Gold Shortage, Worst In 21st Century" as Zero Hedge recently claimed?

 

Keith Weiner notes that by his strict definition of backwardation (a positive cobasis) there are now four futures contacts in backwardation when "prior to this, the most we’ve seen is three". He considers this serious and suspects "that this time, it’s a matter of price. We believe that when the price rises enough, this backwardation will subside".

 

JP Koning has an interesting take, suggesting that negative GOFO is revealing the market's "convenience yield", a price businesses in the trade are willing to pay for "uncertainty-shielding services". As he explains:

 

"Gold merchants seem to be anticipating choppiness in the future supply and demand of the metal, and see growing benefits in holding inventories of the stuff in order to cope with this choppiness. The convenience yield on these inventories has jumped to a high enough level that it currently outweighs the costs of storing and financing gold, resulting in an inverted gold market."

 

In contrast to Keith, JP notes that gold forward prices are only inverted "over a narrow range of five or six-months. By mid-2015, forward prices return to their regular pattern of trading at a premium to current prices ... So no, gold is not becoming money. Rather, we are running into some short-term jitters, and merchants think that holding the stuff provides a few more ancillary benefits than before".

 

The more interesting part of JP's post for me, which leads us to an answer to my question, is his observation that "earlier disruptions occurred when U.S. interest rates were already high enough that they continued to outweigh the metal's suddenly-augmented convenience yield. ... Going forward, all gold market disruptions could very well create sharp inversions of -1 to -2% in the 1 to 12-month horizons, insofar as we are living in an era of permanently low interest rates".

 

To explain JP's point, have a look at this chart from his post below.

 

Note the unusual chart pattern where GOFO moves up in a straight line from 2004 to mid-2006, is then flat for a year and a bit and then drops sharply over the next year and a half. I wonder what was going on in the gold market during that time to account for that behaviour?

 

For the answer go to http://www.lbma.org.uk/pricing-and-statistics and select LIBOR in the chart drop down box. Isn't that amazing, US interest rates during 2004-2008 exhibit exactly the same chart pattern as GOFO.

 

In actual fact, there was nothing going on in the gold market. GOFO is mathematically equal to US Interest Rate minus Gold Interest Rate. Thus if US interest rates go up and Gold's Interest Rate is stable, then GOFO will rise. If you select "LIBOR minus GOFO" (ie, Gold's Interest Rate) in the LBMA's chart, you will see that it was indeed flat during 2004-2008.

 

If you look at that "LIBOR minus GOFO" chart you will see that while the interest rate on gold has moved up, it is not "historic", for which we would need to see interest rates above 2% (which at ZIRP would equate to circa -2% GOFO). The only reason current GOFO rates look historic is because cash rates are basically zero. Comparing GOFOs over time is not really comparing apples to apples - the only way to look through the effects of ZIRP is to look at gold's interest rate. It is like looking at cash interest rates during the 70s and 80s and noting how much better depositors were off compared to today because bank deposit rates were 15%, and completely ignoring the differing inflation rates between now and then.

 

This then leads on to the question of why would lease rates be rising (or it could be GOFO falling, it is hard to tell which market is in the driving seat sometimes)? I've said this a few times, but there are only two things you can do with borrowed gold:

• hold it
• sell it

For the first, JP's suggests that gold manufacturers and merchants are willing to pay to hold stock of gold to cover them for any future supply disruptions or choppiness. Another explanation may be that some gold businesses are very busy converting gold Westerners don't want into forms that Asians do, which would cause them to temporarily increase their working inventories. Another may be that bullion banks, who engage in maturity transformation, have a liquidity mismatch and are needing to borrow gold to cover unallocated redemptions until their gold loans mature.

 

For the second reason, sell it, this basically means that people are shorting gold. It could be speculators, or maybe miners have resorted to hedging again (I note there was a 55 tonne increase in the global hedge book in Q2 2014). Consider that when miners stopped hedging and started to reduce their hedges in 2002 that gold interest rates crashed to their current low levels.

 

So while Zero Hedge may spin a falling GOFO as bullish, it could be indicative of a rising interest rate on gold, which could be an indicator of short selling/hedging, which would result in a falling gold price. And what has gold been doing recently? I'm not saying this is the explanation, mostly likely all the explanations mentioned in the last two paragraphs are in play, we just don't know which is the main driver at this time, but at least here you will get some of the negative explanations to weigh up.