Shanghai Gold will change the current gold market
“consumption in the East priced in the West” situation.
Xu Lode
Chairman
Shanghai Gold Exchange
May 2014
Confidence in our determined
cabal of global central bankers had never been higher than on the morning of
January 15, 2015. Investors were convinced that central bankers had the global
stock, bond and currency markets under their complete control and no great harm
cold be done to them.
Then everything changed.
The Swiss, who had pegged
their currency to the euro in 2011, and who had pledged to maintain the peg
just days prior, suddenly had a change of heart and the let the peg go.
Instantly, the Swiss franc
vaulted as much as 30% higher versus the euro. Those who had been shorting
Swiss francs against the euro in order to generate cheap carry-trade financing
were destroyed.
This was something investors
had not prepared for. For the past fifteen years, central bankers had been
telegraphing their intentions to investors well ahead of acting. Investors felt
that central bankers now owed them a heads-up before they changed policy and
invested as if this were a pact ordained by God.
Like seeing a squirrel fall
from a tree, no investor ever expected to see a sudden and rash move from a
major central bank, though both of these things do happen.
The peg seemed to have been
set in concrete, allowing investors to utilize leverage in this carry-trade.
The lifting of the peg, therefore, was catastrophic for those positioned the
wrong way.
For those unfortunate
speculators, the trade had seemed to be a sure and simple one. With the peg in
place, there seemed as if there was no risk in leveraging up and shorting the
franc versus the euro. For those on the other side, buying protection was cheap
because everyone believed the peg would never be broken.
This set up a potentially
very asymmetric outcome; the franc almost couldn’t fall against the euro while
the upside for the franc was enormous.
This ends our history lesson.
As I look around the world
today, it seems to me that nearly every investment opportunity possesses an
asymmetric outcome quality. Equity market capitalizations seem to be at
all-time highs relative to GDP. Interest rates are at multi-century lows. Art
prices are in the stratosphere as a Gauguin painting just went for $300
million. Everything seems to have been
taken to an extreme. Everything seems to be a one-way bet with no possibility
given to any chance of a reversal.
The gold market is another of
these places that appears to have all of the hallmarks for a potentially
asymmetric outcome. In gold’s case, however, market participants scream that
“down” is the only possibility for gold’s price.
For years, commercial
participants (namely bullion banks) going short gold has been a signal to the
marketplace that gold’s price is headed lower. Below, crushthestreet.com shows
us graphically the relationship between aggressive commercial shorting and the subsequent
downturn in gold’s price:
The relationship has been a strong one and, like the Swiss franc trade, there seems as if there is some easy, low risk money to be made here.
There are a few caveats,
however.
First, despite some serious
effort on the part of the bears, it has been difficult to move gold’s price
below $1200/oz. for any length of time. That is, with the price today at $1233,
there doesn’t seem to be much money to be made by aggressively shorting gold.
The reason that the bears
haven’t been able to push gold’s price to new lows is that China has been an
insatiable buyer at these low prices. As Koos Jansen at Bullion Star informs
us, Chinese off-take in the month of January was 255 tonnes,
nearly all of the gold mined in the world in the month of January.
We can see via this graph
from goldbroker.com that China has been serious about accumulating gold for
quite some time:
The curious thing about all
of this shorting of gold that happens at the COMEX and is reported via their
weekly commitment of trader’s report is that there exists almost no physical gold to
back up the trades. Currently, there exists about 770,000 ounces of registered
gold in COMEX warehouses that are available to settle open trades. Open interest is about 430,000 contracts and
represents potential claims on 43 million ounces of gold. That is, there are
potential claims on about 56 ounces of gold for every actual ounce of gold in COMEX
warehouses.
It remains shocking to me the
level of potential risk that the shorts on the COMEX are taking in the gold
trade.
This brings us back to our
opening quote from the chairman of the Shanghai Gold Exchange. He is expressing
frustration that China now dominates the physical gold market while unbacked
paper gold sales in the West dominate pricing, and he
intends for this to change.
To sum up, China is
buying huge quantities of physical metal supporting gold’s price at around the
$1200 level for most of the past two years. They are upset that the West still
dominates the pricing of gold in the marketplace. There exists only about $1
billion in registered gold in COMEX warehouses and everyone seems to think that
gold’s future price has only one possible direction, down.
For as little as $1 billion,
China could break the COMEX gold shorts at any moment that they choose. Sure,
at higher prices some more gold could be made available, but suppose China owned
half of the open contracts on COMEX and demanded delivery. We are still talking
about peanuts here to destroy Western short positions, and all the while central banks continue to print unbacked fiat money like crazy.
I am not suggesting that I
know which way gold’s price will move in the near future, but I can see that
the gold market has all of the hallmarks of a potentially very asymmetric
trade.
Then again, why should gold
be any different than any of the other markets that I
see around the world?
It may be wise to remember
that despite the present understanding of market participants that every trade
is just a one way bet these days, squirrels do sometimes fall from trees. When everyone is on one side of a trade, as
we saw in the Swiss franc market, reversals can be violent.
Disclaimer: Nothing on this site should be construed as investment advice. It
is all merely the opinion of the author.
