Even Squirrels Fall From Trees

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:

 

https://www.goldbroker.com/news/shanghai-gold-exchange-gold-withdrawals-601

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.