The Gold Bull is Dead. Long Live the Gold Bull!

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Sheesh. What was that? Markets are cracking all over the place. Confidence in the Federal Reserve to make it all better is evaporating faster than a proverbial snowflake in summer. Confidence in the Bank of Japan to make it much worse is growing by the day. And confidence in the People’s Bank of China to have even the vaguest idea of what they are doing is out the window too.

Money is a con game. It requires confidence to keep the game going. And confidence in our monetary central planners just turned on a dime.

The conventional view is that this is all because the Fed is set to unwind its stimulus program. Apparently, the US economic ship is turning around.

Don’t buy it. Something else is going on that is not quite apparent. We don’t know what it is exactly, but we’ve been warning about it for a while. Over the past month or so, we’ve been working on a new report and video presentation warning of a crash. You can see it here . We didn’t know the crash would come so soon, but we do know that it was inevitable.   

The global monetary system is straining. China, which is integral to the system’s functioning, is in all sorts. Yesterday was the day when China’s credit bubble definitively popped. The interbank lending market froze as rates soared. This is how a credit crunch starts.

The rumour was that the market pulled funding from the ‘WMPs’, the ‘Wealth Management Products’ marketed by the banks to get around lending restrictions imposed by the government last year. These products were classic credit bubble vehicles…borrowing money short term on the promise of attractive returns and lending it long term. Back in October, the Chairman of Bank of China said these products were like a Ponzi scheme.

The thing with Ponzi schemes is that they collapse when the flow of credit stops. And yesterday the flow of credit stopped.

China’s central bank, the People’s Bank of China (PBoC), has yet to act to provide liquidity to a parched market. They want to send a signal that they are serious about curbing the credit boom. This could prove to be a grave error. The time to get serious is before the credit boom gets out of control. That moment is long gone for China. It now must manage the as best as it can. And it can’t do that by standing around acting tough.

In this environment, you’d think gold would soar, right? Instead, it’s getting smashed along with everything else. But as we’ve written before, the gold market is not what it seems. The physical market follows the paper market. The ‘paper gold’ market consists of the COMEX futures market in the US and the OTC (over the counter) market in London. OTC means trading occurs privately between two parties, not via an exchange like stocks.

And most of the trading that occurs privately in London is in ‘unallocated’ gold. This is gold deposited into a bullion bank account but not ‘allocated’ to a specific account. Therefore, the bank can lend this unallocated gold to multiple parties. That’s because they’re not lending physical gold, but a paper claim on gold instead. 

So physical gold trading is minimal. For example, the London Bullion Market Association (LBMA) tells us that OTC market gold turnover for the month of April was 24.1 million ounces, or 289.2 million ounces annualised. That equates to around 8,200 tonnes, about 4 times the level of annual gold production. It’s clearly not physical gold trade trading place, but rather paper claims to physical gold. This means the price is set by the ‘paper gold’ market.

Like conventional banking, the modern gold market is a fractional reserve market. Think of it as an upside down pyramid. Physical gold is the reserve base at the bottom of the pyramid. Paper gold expands on top of this base. This market, as far as we can tell, began developing once the US abandoned its official link to gold in 1971.

The fractional reserve system in gold grew in order to provide additional supply to meet growing demand, so as not to blow the price sky high. But demand became so great that the fractional reserve gold market nearly blew up in 1999. That’s when gold last traded around or below the average cost of production…similar to its situation today.

But something saved the fractional gold system at that time, and the gold market entered into a bull phase to relieve pressure on the physical market. It was a paper bull market, physical just went along for the ride.

Now, here’s the important bit…

In a paper gold bull market, the tendency of the Western trader (who effectively sets the price) is to be long paper gold and short physical gold. That is, the trade is to sell physical and go long a futures contract or some sort of paper derivative.

But, when the paper bull market ends and all the momentum traders (who simply wanted leveraged exposure to gold…not gold itself) exit the market, the dynamic changes. It goes from bullish to bearish.

Remember back in April when the gold price plunged? While the paper holders dumped in a panic, there was a global rush to physical gold. That is, there was a run on physical gold reserves. And like any run, when reserves deplete they bring down the credit instruments that pyramid on top of these reserves. Hence the collapse in paper gold prices.

So now the gold market has gone from bull to bear, the trade has gone from ‘short physical, long paper’ to ‘long physical, short paper’. In other words, if you want to hedge your physical exposure, what do you do? Short paper gold! And because the paper market sets the price…well, that’s why the ‘gold price’ is falling.

But with each fall in price, the demand for physical will increase, which heightens the bank run and puts pressure on the fractionally reserved gold system. To relieve that pressure, the paper gold price needs to rally. If the ‘long physical, short paper’ trade continues to gain momentum, we’re not sure how much longer the existing gold market can survive.

So if you’re holding physical, hold on tight. Long physical is the trade, it just doesn’t look like a winning trade while the fractional reserve system crumbles down around it.

The gold bull is dead, long live the gold bull!

Regards,
Greg Canavan
for The Daily Reckoning Australia

Join me on Google+

From the Archives…

Truth or Dare Time for the Investment Industry
14-06-13 – Vern Gowdie

The Launch of Revolutionary Tech Investor
13-06-13 – Kris Sayce

The Architecture of Oppression
12-06-13 ­– Dan Denning

The Upside of a Dive to 85 for the Australian Dollar
11-06-13 – Dan Denning

Courting Controversy Over Australian Property
10-06-13 – Dan Denning

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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12 Comments on "The Gold Bull is Dead. Long Live the Gold Bull!"

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RonaldR
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KILL THE BIS-APRA BANK ‘BAIL-IN’ PLAN BEFORE IT KILLS YOU! In a case of kill or be killed, Australians must band together to kill off the bank “bail-in” plan reported in Monday’s (3 June) Australian Financial Review. Otherwise, have no illusions: in the very near future you will assuredly find yourself stripped of your savings and thrown into the same financial ruin, impoverishment, and soaring death rates as the people of Cyprus. Think “it can’t happen here”? Don’t be ruled by your own wishful thinking and downright cowardice, but consider the evidence. Two months after the CEC first blew the… Read more »
RonaldR
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STOP PARLIAMENT FROM SECRETLY LEGISLATING TO STEAL DEPOSITS; DEMAND GLASS-STEAGALL LAW INSTEAD The Citizens Electoral Council has just discovered that legislation is being secretly prepared to give Australia’s banking regulator “bail-in” powers to confiscate the savings of the Australian people, just as in Cyprus. The CEC is mobilising to expose and stop this secret plan, and force the Parliament to instead fully protect deposits and essential banking services from an inevitable collapse by passing a Glass-Steagall separation of speculative investment banking from banks that hold deposits. Except for the CEC, the only information reported to the Australian people that “bail-in”… Read more »
BP
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Greg C: “Something else is going on that is not quite apparent. We don’t know what it is exactly…”

Well, the gold miners are w-a-y down, many 75% off their high. The West has, historically, been dotted all over with heavily worked leases, most of which rose with the gold price, but which eventually became ghost towns.

It aint pretty…

slewie the pi-rat
Guest

there’s something happening, here
what it is, ain’t exactly clear
there’s a man with a gun over there
etc.

Lachlan
Guest

The same thing happened to gold (30% sell off) five years ago and then it went up while everything else went south.

BP
Guest

Not sure if the ‘this-means-that’ thinking (representedness) which inspires goldbugs provides any real reassurance, Lachlan.*

As Canavan notes: “In this (present) environment, you’d think gold would soar, right?”

It’s interesting to see my grandfather’s leases being worked again. During the decades he was mining, WMC employees hinted their tunnels had extrcted most of the ore below his shafts.

* But for your sake, I hope you’re right…

gaz
Guest

Gold bug commentaters are either fanatics, spruckers, or both. they twist and distort the ‘facts’ and the ‘truth’ in order in suit their ‘gold religion’ agender. Never trust a fanatic.

Lachlan
Guest

I certainly agree there is no guarantee of anything here BP. I think gold is too oversold to sell here but if the bear market does continue then somewhere just above 1000 may be the next long term support. For bulls the 1500’s area will need to be overcome before champagne can be popped.
I believe Ben Bernanke did say something of value. People buy gold to cover tail risk. The caveat is you cannot guess where it may be valued at too easily.
Btw BP…http://www.miningaustralia.com.au/news/coal-mine-looks-to-green-solution-to-reduce-dust
Keep up the good work fellas ;)

BP
Guest
Very sensible initiative, Lachlan! I was watching a doco recently regarding new approaches to dust reduction in Aboriginal communities. Their solution was mounding around the camps and small towns.* Maybe their next step should be seed dispersal. We did note, when living ‘out-in-the-middle’ that seeds, carried hundreds of kilometres by birds, only survived in shallow depressions where water infrequently collected… On gold: I commented elsewhere on my son’s quick entry-and-exit into bullion. He made around $40/oz(!) I was therefore just a little surprised to cop a serve from a moderator… . :D * This initiative was claimed to have reduced… Read more »
BP
Guest

I see Mr Cockburn Central has offered two l-o-n-g soliloqiues, plugged in out-of-chronology, above.

Our banks, Ron? Most successful in the world, three years in a row… .

BP
Guest

While you’re at it, Jay Arrrrghhh, check out ‘plagiarism’ in an online dictionary. Are you still campaigning for a 1% (per month) interest rate rise, son?! :D

Steve
Guest

Yep make sure you hold onto gold while it keeps crashing. If your smart you’ve unloaded both gold and silver and buy back in when its again moving in the right direction.

For now Gold is about as bad as it gets for an investment the trend has clearly reversed.

wpDiscuz
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