This is a continuation of What is Pushing Down the Gold Price: Part I.
One factor is the lack of rapidly rising consumer prices. If consumer prices aren’t rising, then this eliminates the need to buy gold as a hedge. Gold speculators are like everyone else. They get frustrated waiting for a rapid price gain that isn’t occurring. They see the financial news where talking heads and prognosticators reiterate the conventional theory that gold is a commodity bought on fear, it will go down more according to the experts, etc.
Just as I was writing this paragraph, I received an email from a reader with a link to this Bloomberg Businessweek article. It asserts:
“Why is gold plunging? The most important factor is that global inflation is falling, reducing gold’s value as a hedge against rising prices. Gold bugs who were betting on an outburst of inflation are scrambling to reverse their bets and exit their gold positions at any price.”
Here is a graph showing the prices of copper and crude oil. These prices were rising prior to February last year, but since then have been in a falling trend with cyclical bounces making lower highs, and now a lower low in copper. The purchasing power of the dollar is seemingly doing fine, if not gaining. Why hold gold indeed?
Copper and Oil Prices
Most people hold an imprecise definition of inflation. Inflation is not the phenomenon of rising prices, though this is a possible consequence of inflation (falling prices are another possible consequence as I will discuss in a future paper). Inflation is an expansion of counterfeit credit. This is typically when the borrower lacks the means or intent to repay. The inevitable outcome is defaults and losses to creditors.
The conventional view is not merely wrong descriptively. It is not just that prices don’t change as M0 or M2 “money supply” changes. The view also masks the problem with inflation: balance sheet stress. Every bank and financial intermediary can borrow enormous quantities of dollars at virtually zero interest, in order to buy every manner of asset. What happens if one of those assets should fall in price? The liability remains, of course. If liabilities > assets, then a bank is bankrupt.
Balance sheet stress can lead to forced selling, and not necessarily confined to the asset that fell initially. For example, a Japanese bank may have borrowed from the Bank of Japan in order to load up on Japanese government bonds. Then, they may have done a sale and repurchase agreement (Repo) to Bank B. B may have pledged the bonds as collateral in order to borrow and buy another asset.
As the Japanese government bond falls, the Japanese bank is now losing capital rapidly. If they are leveraged 20:1, then a mere 5% drop in the bond price will wipe out their equity in the trade (many banks, especially outside the US, are leveraged more than that). What can it do to stanch the bleeding? It could sell the bond. Alternatively, it might sell other assets that have gone up in price, and be happy to book a profit.
Still, the Japanese bank may have another problem. The Repo agreement may include a provision where it has a daily margin call, if the price drops. They may have to add cash or other assets every day that the bond drops.
On April 4, Japanese Government Bonds opened at $146.31 and hit a low of $143.18 (all prices from US futures markets), before recovering somewhat. By April 11, they closed at $143.77. Even assuming no intraday margin calls (the bank’s internal risk management group may be stricter than a third party creditor), the price fell over 2%. The government bond is defined as the “risk free asset”; 2% is a big drop. Incidentally, high volatility may itself lead to an increase in margin requirements. For reference, CME raised the margin requirements for gold futures on Monday by 18.5%.
That’s not all. Bank B may also be facing margin calls or other pressure to shrink its balance sheet. Its sale of assets could put pressure on other balance sheets.
The backdrop to this discussion is the chronic falling interest rate. Financial intermediaries are pressured to take on ever more leverage. The cost of borrowing is lower and they need more leverage to make the same return on equity. Also, the falling rate encourages them to borrow using short-term funding. The problem is that, if there is a glitch because the borrower needs to find more collateral, or the lender is having liquidity problems, then assets must be rapidly dumped (sound familiar?) in order to raise desperately needed cash.
The system, based as it is on high and rising leverage, low and falling rates, borrowing short to lend long, and financial engineering, has become very brittle.
Inflation, understood in this light, can pump up asset prices for a while, and then cause a violent crash. Inflation directly undermines the stability of the system.
There is another dynamic that we should consider for its role in the formation of the gold price. Let’s use Cyprus as a microcosm. Prior to March 15, the average Cypriot thought of gold as an inflation hedge. He may have felt that since prices weren’t rising that much, despite unconventional monetary policy, it was not worth holding. Today, he is regretting not having bought gold. Why? Because Cypriot banks defaulted, and gold is as good as ever.
I emphasize that the reason to own gold has nothing to do with consumer prices. The problem with the system is that every financial asset, except gold, is the liability of another party. Every one of them is leveraging up in a desperate attempt to chase yield and keep mismatching the duration of their funding to their assets, and their assets consist increasingly of counterfeit credit. The probability of default is rising. Gold is the only way to avoid risking default and total losses.
This risk creates a highly non-linear dynamic. A bank deposit or even a paper currency note can hold steady or maybe decline at a slow rate for a long period of time. Until, suddenly, it’s worthless. If I told you that I am selling a bond that will formally default tomorrow, what would you pay for it? The US Treasury bond will someday default, but the whole world bids on the Treasury bond and the price is rising.
“It’s not a problem until it’s a problem,” as the expression goes. Another way of expressing it comes from Ernest Hemingway, who famously wrote in The Sun Also Rises, “How did you go bankrupt? Two ways. Gradually, then suddenly.”
Before I answer my rhetorical question of the title of this article, I have one more question for every gold bug. When the final collapse comes, and the gold price is doubling every week, then every day, then every hour and then finally there is no gold price—there is no gold available at any price—will you sell your gold, and take your dollar-denominated profits? At what point will you recognize it for what it is and begin to think of your wealth in gold?
I asked what is pushing down the gold price. Now here is my answer, though it may not be what you wanted to hear.
Everyone who thinks of his wealth in dollars, whose balance sheet uses the dollar as numeraire, and especially, everyone who borrows dollars to fund gold purchases is contributing to the unsustainable spikes up and vicious crashes down that characterize the current market for gold. And I have one other unpleasant thing to tell you.
Volatility will rise, as the financial system gets closer to the terminal phase!
If you think that $250 down in a week is painful, you can look forward to $250 up or down in a day. Not necessarily this year, but it’s coming.
Once most of the speculators are flushed, then other buyers can begin to push up the price with their more steady—and unleveraged—accumulation. Patient, and relentless, these people think of their wealth in terms of gold. They are the driver towards permanent backwardation, as they are not motivated to sell by higher prices.
Unfortunately for the speculators, sentiment changed on Monday and there was heavy selling of physical metal leading the sales of futures.