Gold and the Coming Short Squeeze

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Greg Canavan is the editor of Sound Money. Sound Investments, a weekly report on the best value investment ideas in the Australia share market, with a commentary on the global economy and economics. For a free four-week trial to Sound Money. Sound Investments, go here.

A few weeks ago a momentous event occurred in the precious metals market. As we detailed in a report to paying subscribers, a London metals trader by the name of Andrew Maguire recently blew the whistle on gold and silver price manipulation orchestrated by JP Morgan.

He provided exact details of the fraudulent trading to officials at the Commodity Futures and Trading Commission (CFTC) before and during the manipulation episodes. Unbelievably, the CFTC ignored these claims. Even further, they did not allow him to give evidence at the recently held CFTC hearings into position limits in the commodities markets.

(The hearing was in part designed to investigate whether allowing market players to hold large positions would lead to price distortions or manipulations).

So Mr Maguire went public and told his story to Gold Anti-Trust Action Committee (GATA) member Adrian Douglas. GATA have been claiming for years that the precious metals prices are manipulated in order to boost confidence in fiat currencies. Without the manipulation, gold prices would be much, much higher.

There are many who dispute this claim. But to be honest their reasons are flimsy. It’s far easier to reject something out of hand than to be labelled a ‘conspiracy theorist’, as GATA and their supporters are. But if you take the time to actually think about the claims and study a bit of history, you’ll see that government manipulation of the gold price is nothing new.

Let’s take just a few examples.

Roosevelt’s Attempts to Manage Gold

Soon after Franklin Roosevelt’s inauguration in 1933, he set about the highly controversial policy of ‘inflationism’. Funnily enough, the same policy is accepted wisdom today.

His first step was to ‘temporarily’ – which actually meant permanently – end the export and hoarding of gold. The next step was to announce that the US was off the gold standard.

The impetus for this was, as always, political. Roosevelt’s primary motivation was to appease the farmers, who were groaning under the size of their mortgage debt and were demanding higher prices for their product. His aim was therefore to raise the price level for commodities, agricultural commodities in particular.

He became wedded to the theories of a Professor Warren from Cornell University. Warren believed that if the price of gold was increased, commodity prices would follow. Even the inflationist Keynes thought the theory was ‘rubbish’.

But it didn’t stop Roosevelt. He arranged for the Reconstruction Finance Corporation (RFC) to purchase gold on the US Treasury’s behalf. Each day for weeks on end, the RFC would announce the price it was willing to pay for gold, a price that was always higher than the prevailing free-market price.

Needless to say the plan did not work, commodity prices did not benefit but the policy was causing grief in other parts of the economy. And faith in the value of the US dollar was at rock bottom.

Roosevelt convened a meeting to halt the experiment. With some of his advisers fearful of the effect of a weak dollar, Roosevelt said: ‘…if at any time the dollar should get too weak, the RFC could always reverse itself and sell some gold to the world markets’.*

And a few days later, that’s just what they did. But it wasn’t long before the period known as the ‘gold standard on the booze’ came to an end. In January 1934, Roosevelt announced the return of the US to gold at the prevailing market rate of $35 an ounce. In nine months the US dollar had lost 40% of it value against gold.

The London Gold Pool

Fast forwarding a few decades and we come to the second example of blatant government manipulation of the gold price. It concerns the London Gold Pool, established in 1961 to maintain the price of gold at $US35 an ounce. The paragraphs below are taken straight from Wikipedia.

‘The London Gold Pool was the pooling of gold reserves by a group of eight central banks in the United States and seven European countries that agreed on 1 November 1961 to cooperate in maintaining the Bretton Woods system of fixed-rate convertible currencies and defending a gold price of US$35 per troy ounce by interventions in the London gold market.

The central banks coordinated concerted methods of gold sales to balance spikes in the market price of gold as determined by the London morning gold fixing while buying gold on price weaknesses. The United States provided 50% of the required gold supply for sale. The price controls were successful for six years when the system became no longer workable because the world’s supply of gold was insufficient, runs on gold, the British pound, and the US dollar occurred, and France decided to withdraw from the pool. The pool collapsed in March 1968.’

Once again, this method of controlling the price of gold to maintain faith in the value of paper currencies (or in Roosevelt’s case, to placate special interest groups) proved to be useless. A few years after the London Gold Pool collapsed, the US refused to exchange dollars for gold and the dollar price of gold went from US$35 and ounce of over US$800. It took a decade to get there but the gains, even if you participated in some of the move, were sensational.

Today’s Gold Market

A similar situation is unfolding today. Andrew Maguire’s revelations and subsequent testimony at the CFTC hearing, which basically conceded that 100 times more gold is traded than actually exists, will eventually produce a massive short squeeze in physical gold.

A short squeeze means that players who are ‘short’, i.e. those that owe gold to someone else but don’t actually have any, will be forced to buy gold on the spot market to honour their contracts. Either that or default.

We think there will at some point be a scramble for physical metal and the price will surge higher.

This will happen because gold is like no other asset. The whole reason you own it is to avoid counterparty risk. Gold is a store of wealth and by owning physical gold you are not relying on the solvency of any other party.

So while some might think that $100 of outstanding claims on gold versus $1 of actual gold availability is ok because that’s how other markets operate miss the point completely. They say the leverage inherent in the gold market is ok because if short sellers cannot deliver, ‘cash’ settlement is always available.

But gold is the ultimate form of cash, and those owning physical gold do so because they want to diversify away from paper currencies. Why would they settle for a paper cash settlement?

Up until now, hedge funds have been predominant in the gold futures market and they have been willing to settle for cash. They have simply been playing the theme that increasing monetary disorder will be good for gold. In other words they have participated in the gold bull market without actually owning bullion itself.

But that might be about to change. Recent revelations have highlighted a weakness in the market structure. In financial markets, weaknesses eventually get exploited.

We believe more and more large gold investors will begin to take delivery of their bullion to ensure that they actually possess what they own. The benefits of having ‘exposure’ to gold (via the futures markets or in unallocated accounts) without the costs of storage, insurance etc will soon be outweighed by the risk of not actually owning gold when its most needed.

This move to take possession or have gold securely stored has already begun on a small scale but it will intensify. Physical gold will slowly diminish in circulation, producing the short squeeze discussed above.

This process is known as Gresham’s Law, named after 16th century English financier Sir Thomas Gresham. Its basic premise is that bad money drives out good money. It’s happening right now and will continue to do so.

Greg Canavan
for The Daily Reckoning Australia

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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55 Comments on "Gold and the Coming Short Squeeze"

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NT
Guest

It may also be worth mentioning that Silver will rise higher in terms of a percentage. Not everybody can afford gold, but for $20/ oz of silver, you’re on a good wicket. Combine that with the fact that silver is overconsumed and you’ll understand the term “precious metal”.
The real question is, is it worth buying metals with the Australian dollar given it trades in USD and we are looking past parity? take it one step further, what happens if the USD becomes worthless?

Food for thought.
NT

Xan Go
Guest

While there may be truth to the arguments, is it not the case that every
bubble has its spruikers loudly proclaiming “There is a shortage, get in
quick before you miss out!” One has only to look at the Australian property
market to see the lengths to which people will go to develop sophisticated looking
arguments to that effect. What I worry about is that this is precisely what we see
here. ANOTHER and his THOUGHTS! from the late 90’s are presently being recycled.
Can anyone comment on the verdict on this thread at the time? Why did this die out?

Firebug
Guest

Great question NT, one that I asked an informed person last week.

The view I was given is that all fiat monies are in various degrees of danger. If senior currencies are falling, juniors are unlikely to be spared.

Also, when China’s demand on our resources slows, there will be pressure on AUD.

AUD is rising against USD, but Gold will probably rise at faster rate.

Gold is hedge against government risks which is rising fast.

I have no physical Gold at the moment, plan to buy several ounces later this year as insurance.

mike
Guest
…i usually rate articles with the thumbs up or thumbs down(rarely) but after reading/thinking and thinking this article, i’m wondering if i should switch to the gold star system…thumbs up or down is to declare life or death, it is the hand of absolute power subject to the whims of the hands’ body, it is fiat…hmmm…funny how in my imagination i always seem to use the left hand for the thumbs up or down because i’m a right handed person most of the time…hmmm…HMMMM!!!!…if i rated articles with gold stars, let us say for example, 10 gold stars, then wouldn’t… Read more »
simon
Guest

I wonder if you could survive with your gold coins if the fiat currencies becomes trash and banking systems really collapsed.

Scott McLagan
Guest

NT’s comment on silver is quite right – silver is pretty much assured to rise higher and faster than gold, and is therefore a better proposition.
I’ve been buying up for months and will continue to do so, especially given the way the US fiat currency economy is headed (ie down, down, down)!

NT
Guest

All, Im not one to advertise a site with another sites details, but for the sake of the article and giving it more substance, i have pasted the link to the only interview (that i know of) Andrew McGuire made & GATA made.

Hope DR passes it on.

http://kingworldnews.com/kingworldnews/Broadcast/Entries/2010/3/30_Andrew_Maguire_&_Adrian_Douglass.html

Cheers
NT

SV
Guest

Simon, it looks like you can:
http://www.certifiedmint.com/y2k-1.htm
“Gold and Silver for Survival Purposes”

Lachlan
Guest
I’m starting to get some silver together just buying every few weeks with income saved and I’ve been impressed with the strength in silver lately but better still note the fact that it has possibly a lot more upside than gold as said above. I like cheap silver coins too in case a day comes where people aren’t accepting the current fiat offerings but thats just insurance so to speak. And yes I believe if their is no other sound currency to use people will learn again to use PMs esp silver to trade with and quickly IMO. Six to… Read more »
Lachlan
Guest

Gee the gold bugs seem to be getting away with murder here..must be baygon due to arrive soon :(

Biker Pete
Guest

Lachlan: “Gee the gold bugs seem to be getting away with murder here..must be baygon due to arrive soon :( ”

Well, changes to CGT / Super laws affect _all_ asset classes, Lachlan!
Mind you, any apocalypse will erase Super, anyway. And the banks. Jobs will get washed away, too. Fiat currencies will crash, but Ferrari currencies may be OK. ;)

Didn’t see too many supermarkets in ‘MM2: The Road Warrior’. Think I’ll start growing more veges and investing in more chooks!~ :)

Don
Guest

I hear if you plop those silver coins in milk it lasts longer as well :)
Is there nothing that silver cannot do?!

Lachlan
Guest

Interesting Don ..will keep in mind if fridge breaks down. AgNO3 used as a flower preservative on a hydro farm I worked on…for carnations.

Biker re CGT… then gov knows PMs going to moon also and they dont wanna miss out ;)

Don
Guest

Lachlan, just one thing, dont ever ever ever drink silver nitrate solution thinking it is some kind of health/protection against those super bugs. This is the result :(

comment image

Richo (the Second)
Guest

I think the only short squeeze in 2010 will be those shorting $USD. Silver and gold are on downward spiral…

89peterg
Guest

I for one would be putting the gold into my teeth, just in case i have to hit “The road” (joseph mccormack’s).
but Im with Biker Peter, you can always barter your surplus of real and necessary things (assuming theres a shortage, or comparative advantages) , but how many people, really, would be interested in gold if things go reaally topsy-turvy.
how do you field test the quality of gold anyway in primitive conditions?

89peterg
Guest

edit: Cormac McCarthy. “The Road” – (confusing with Joseph Mccarthy )

http://en.wikipedia.org/wiki/The_Road

Biker Pete
Guest

“The Road”

Enjoyed the link, mate. I’ll get the book and Quickflix the DVD. Definitely my genre. Deliberately skipped the last para… didn’t want to know how it ends… yet…. .

You should read some Kurt Vonnegut on the business of sons. It’s pretty complex… . :)

Worth reading ‘Pip’, too… if you’re into Dickens. Once you’re past the first coupla chapters, you’ll thank me… .

nv
Guest
SBD
Guest

“how do you field test the quality of gold anyway in primitive conditions? ”

Few methods, with an appreciable volume, you can weigh the gold, and determine the volume with displaced water, thus getting the density.

Another is streak test, you streak the gold onto a ceramic tile, along with known carat samples, treat with acid and match. Should be kits available on the net.

Steve
Guest

I was reading blog today Biker and one guy said they should introduce a VENDORS GRANT of 7k,

7k to get out of the market

I think it would be a great idea just think instead of sell one of your 20 houses for 500k it would sell for 507k

You would be even more richer, I know I would support it

Biker Pete
Guest

A few less than twenty, sorry, Steve. There’s very few of mine you’d want, mate. Most of ours are in the $380K – $550K range. There are probably only three of mine you’d want.

If they’d pay me $7K for each sale, I’d look at it… .

Interesting to see rents rising here in WA, though. Agent says we could be charging a lot more, but we’re happy with all our tenants. (Seems some owners are now charging $90 pw more than we are, for similar homes.
We’re surprised at that… .)

Biker Pete
Guest

89peterg: “..how do you field test the quality of gold anyway in primitive conditions?”

They tell you should be looking for rose quartz down your way, pete.
Pretty good book on the history by one of your local plumbers, too, I think.
And the limestone a little further south has given up a few nice chunks of amber, too…

Steve
Guest

Yes biker you are right I dont want them far too expensive for me

Biker Pete
Guest
“Yes biker you are right I dont want them far too expensive for me…” There’s not much going for under $380K, mate. That’s really our cheapie… 4 bedrooms, single bathroom, double garage, A/C, brick and tile, on 700m2 block. Bedrooms all relatively small. Five minute walk to a great beach. Close to schools and shops. We paid $325K for it three years ago. Very nice looking place, but it hasn’t really moved up in value much. Rents well, but it’s not one of our best buys. The places we’re building now cost almost the same to build, but have an… Read more »
Steve
Guest

380k

Biker thats over 9 times my annual income and thats a CHEAPIE???

Woow sorry NO DEAL

Biker Pete
Guest
Apologies. For some reason I thought you were on $80K pa… . If you’ve managed to save over $100K+ on that wage, you’ve done incredibly well… . But I wasn’t trying to sell you anything, Steve. Hadn’t thought you were going to drop your job, leave friends and family and move to WA! My point was simply that these days $380K doesn’t go all that far. There’s _nothing_ at all in that suburb under $380K*. I guess that’s the point you’re making anyway. Getting in, even at the very low end, is difficult. I really can’t see that changing, particularly… Read more »
Steve
Guest

Yes I have been saving since I was 18 thats why I have that much.

If I had saved the equivalent of that much 15 or even 10 years ago (inflation adjusted)
I would probably almost own that house outright by now

It may get much worse???

But what happens when interest rates keep going up?
Banks lend less?

Biker Pete
Guest

Steve: “But what happens when interest rates keep going up?”
I don’t think anyone really knows. The last time they really went ballistic, the market flattened. Then it took off like a rocket, due to massive inflation.

You _may_ be able to take advantage of a flat period. We have, at times. Highly desirable homes in good areas may not fall (much).

You should definitely be putting $5K per year into that tax-free 17% account. You’ll get around 6% on top of that… but the 6% will be taxed…

Steve
Guest

Highly desirable homes in good areas may not fall (much).

If I am not wrong they fell about 20% or something like that here in Sydney not too long ago.

Biker Pete
Guest
That would have been the time to take Rudd’s $14K, Steve. A $450K house would have been discounted to $360K, less the $14K FHOG, less your $100K deposit. Your loan would have been for $246K. You could have lived in it six months, then rented it out… or sold it, making almost a hundred thou., less your costs, of course. In other words, you might have close-to-doubled your savings in a short time… . (Two years?) You’re in a good position to take advantage of any _future_ fall in values. We picked up two bargains during the flat spell, but… Read more »
Steve
Guest

“You’re in a good position to take advantage of any _future_ fall in values.”

yes I suppose I am now that Rudd has finally

Cracked down on foreign property ownership!!!

and interest rates are rising and that alot of demand has fallen off after it was brought forward from last year

:)

prozak
Guest

Steve,
Yes they did. But they didn’t fall anywhere near the price you are looking at…. some fell from 2M to 1.6M… think as a percentage there were some 30 to 40% drops in the 3-4M range….. but that’s the north shore for you….. not sure about other areas….

Don
Guest

Ouchies – 40% tax on mining profits, maybe on top of royalties? I can tell you that there are a few ore bodies in our reserves that wont be seeing the light of day – literally – because of that :(

Steve
Guest

What is everyones view on the removal of the distortion?

Biker Pete
Guest
Foreign ownership distortion, or one of the others? We’ve attended a few auctions, mainly for a laugh (we’d never enter that emotional arena) and we’ve never seen any sign of ‘foreign bidding’… . It’s mainly Aussies in the 45 – 55 age group, here. Oh, with a few Boomers and young’uns thrown in, for good measure. But those 45 – 55 seem to be the successful bidders. Capital gains is quite another situation. For those who knew the ropes, regardless of type of asset (property, shares, bullion) the ability to wash off almost all CGT through Super was, admittedly a… Read more »
Steve
Guest

yes that distortion Biker

We will see if they get rid of that other distortion in a week or so
not holding my breath on that one though.

Biker Pete
Guest
That _other_ distortion? It’s one of a _dozen_ known to most property investors, Steve. You may recall I listed many on SW well over a year ago. The issue is this: Australia’s economy depends on its three largest industies: Mining, Agriculture and Construction. The first two are by far the most important, economically; but Construction is critical economically AND politically. Recently the ACT was deemed the most successful state or territorial economy… off the back of housing and construction(!) Which critical area(s) did Labor jump to protect the moment a GFC loomed? Clue: Was it Mining? Was it Agriculture? Was… Read more »
Steve
Guest
The distortion (RORT)that will be advised to be removed but the government will probably ignore the advice in about a week or so, you can work it out I am sure. *simply because you _want_ or even _need_ it. Yes most people need a roof over their head *An even sadder reality is that you don’t comprehend the comparative wealth of families who really _value_ property. Biker Property is a NEED everyone VAULES it, just like I VALUE oxygen, just like I VALUE food, just like I VALUE water. As I have said many time to you why should I… Read more »
Biker Pete
Guest
“As I have said many time to you why should I have to pay over twice as much as you did for the same thing???” Well, you described a situation in which you state property in Sydney fell by 20%, Steve. Even though it fell far less than that here, probably 8% at most, we acted. We didn’t say “Hey, the developer _paid_ half as much as that for the land! We’re being robbed!!~” We said “Mrs Biker, where’s the chequebook?!~” As you’ve stated, several times, you _have_ a roof over your head. You _want_ your own. I don’t blame… Read more »
Roy
Guest

“An even sadder reality is that you don’t comprehend the comparative wealth of families who really _value_ property” (read miss value property).

MMM and other countries where large corrections have taken place, didn’t have these TRUE believers. I wonder how these people feel about PROPerty now?.

But don’t worry “its different here in Australia”.

Steve
Guest

Biker it is in my best interest, the best interest of my fellow Australians and the best interest of FUTURE GENERATIONS of Australians that house prices fall.

Coight
Guest
I can’t see how it is in anyones interest to see property prices fall dramatically. The flow on effects from a price crash would be damaging to the economy as a whole, even for those who don’t own property – Jobs would go left, right and crooked in Construction, Retail etc (Think of all Julia Gillards precious Apprentices and Tradies employment prospects; the people she used to justify the School hall rorts etc and the Shop assistants and SME owners – the people Rudd, Swan & Gillard used to justify the importance of the $900 handouts). I believe the most… Read more »
Biker Pete
Guest
Roy, it’s great that your lengthy experience living here in Australia has assisted your conviction that we’re different. Too many young people make the mistake of believing we’re just another county of the UK, or state of the US. You’re completely correct that Australia is different. Steve, I know your own wants and needs are your secondary consideration. You’re really only concerned about _Australia’s_ best interests. Australia really _needs_ that 50% fall in property values to help its citizens. Australia also needs property and shares to crash, to assist those who have conscientiously invested in bullion, to create a greater… Read more »
Steve
Guest

. Australia also needs property and shares to crash, to assist those who have conscientiously invested in bullion

bullion????

those who have invested in property have knowingly made me and my fellow Australians WORRSE OFF thats why I dont give a Sh!t about them

So if they fall why should I care about them???
When they knowingly wanted me and my fellow Australians to be a a worse off situation

They use housing as a means of making others worse off through their greed over something that everybody not desires but NEEDS
thats why I hate them

prozak
Guest
Roy, Australia isnt different to the UK, not when it comes to property. But that still doesn’t mean there will be a crash. If you like indexes, NOMINAL prices fell between 16 and 23%… they are all now back up 10%. Prices in the UK fell dramatically in some locations and property types – i.e those such as investment flats that were over built (up to 70%!), but hardly fell at all for the 4+ Bed houses. Now don’t get me wrong, I am no property bull or spruiker, though I do hold property here (my house) and in aus… Read more »
ric
Guest

I can understand that demand is an influence on Sydney and Melbourne prices….. But why is Dubbo (infinite land) so expensive? This screams at me that it is easy money that has driven prices so high…..

Google Jeremy Grantham…The guy that has identified (and predicted many) 34 bubbles…….32 have burst……2 to go…Aust and UK housing…

Biker Pete
Guest

“I dont give a Sh!t… I hate them… ”

Medical researchers have reported a medical link between constipation and unresolved anger, Steve. You should see someone about it. Probably _not_ a realtor… .

Meanwhile, I appreciated your heartfelt commitment to property:”Biker Property is a NEED everyone VAULES it, just like I VALUE oxygen, just like I VALUE food, just like I VALUE water.”
Why, that’s exactly how _I_ feel!~
I knew there was another Property Bull here…
As the Gyrocaptain intoned, “Paaaaaartnerssss… “

Roy
Guest
Biker Pete
Guest

Nice link, Roy… especially the message at the top left hand corner of the home page. :)

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