GOLD MARKET DYNAMICS Part 1

by Philip Judge
1999
(c) copyright 2003
www.anglofareast.com

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"Central banks stand ready to lease gold in increasing quantities should the price rise" Dr Alan Greenspan 1998

THE FREE MARKET
The gold and silver markets are both complex and unique. Gold is an unrivalled metal differing from any other, and in the same way the gold market stands alone, not to be compared with any other financial or commodity markets.

In a free market where pricing is not being artificially set, fixed or maintained, the price of any given commodity will be set by the free market forces of supply and demand. The greater the supply and lower the demand for a given "thing" the lower the price will become and alternatively the lower the supply and greater the demand the higher the price will become to clear the market.

A METAL WITH A JOB TO DO
In general terms gold has several practical uses. The first and largest is fabrication into jewelry. Largely resulting from its unique characteristics, it has many industrial uses, including use within electronics and a host of other unique (and indispensable) applications.

As a financial instrument it is employed in two roles. For many centuries it has been "hoarded", or held as a long- term storehouse of value – as an "asset of last resort". While not seen today, it’s first and foremost traditional role has been "monetary" - as an item or medium of exchange.

Whether in its industrial or financial role, one marvels when considering gold, because it performs its job so well. While other substitutes may come along, they never work as well as when attempting to replace gold, this being particularly true with the financial and monetary use of gold.

THE FUNDAMENTALS
There is an estimated 125,000 ton of above ground gold world wide – annual production in recent years is averaging approximately 2500 ton per year. Total stocks grow at around 1.75% a year. In other words current world above ground stock far exceeds new production (1).

All the above ground stock is employed in one or more of its traditional roles at any given time (in other words there is no gold lying idle without a job to do).

A GROWING SUPPLY DEFICIT
Gold is different to other commodities. Most commodities are consumed, for instance, oil is burned and wheat is eaten, while gold is rarely destroyed in use. If the process is economical it will be reused latter for another purpose. Most commodities by comparison have a very short inventory time. Total world wheat stocks are turned around in a few short years while most of today’s gold inventory has existed for many centuries. This makes the gold market much more elastic – supply and demand may change a lot, in the short term at least, without radically changing the market price.

Since the early 1980's, more Gold has been used in jewelry, industry and fabrication into bars and coins than has been mined. Through to 1998 jewelry, industry and investment demand has grown to around 2800 tons annually with other uses adding another 150 ton. There is evidence to suggest that real demand is actually much higher than these more conservative estimates. Depending on how demand is measured some reports have put complete total demand in recent years in the area of 3500 to more than 4000 tons.

Most of the 1990’s the gap between supply and demand has been steadily growing. Some report the gap smaller than others. Metals analyst Frank Veneroso has claimed the supply deficit for 1997 to be between 1500-1800 tons. In 1998 this chronic deficit got worse. An average consensus is approximately 1000 ton a year.

THE PRICE IS RIGHT?
In a free market as we have already pointed out as demand increases and supply diminishes the normal result will be an increase in price for that given commodity. Yet in recent years the price of gold has been locked in a steady downward trend. In 1998 the average price of gold was $294 an oz, the lowest it’s been since 1978.

LENDING AND LEASING – BEHIND PHANTOM SUPPLY
While many analysts, reports and surveys disagree on the exact numbers of this growing deficit, one phenomena of this market that every one agrees on is the dramatic increase in the mobilization of aboveground stocks through central bank and bullion bank lending or leasing and producer forward selling and hedging.

The producers (mining companies) have their part to play. They sell bullion they don’t have or as yet have not mined, often because at $294 oz it is not as profitable to dig it out of the ground as they would like, so they borrow gold to sell into the open market. As the price falls they mine less and borrow more to sell more. This is usually referred to as forward supply.

TWO PLACES AT ONCE
On July 24th last year Federal Reserve Chairman Alan Greenspan said before Congress "central banks stand ready to lease gold in increasing quantities should the price rise". In short Alan Greenspan was verbalizing an already existing trend in central banks to lease or rent out their gold holdings.

Whether deliberate on behalf of the central banks or not, by meeting immediate demand, this leasing of stock has the effect of lowering the gold price. Now the same gold is performing two functions at one time, firstly, as a central bank reserve, and secondly satisfying immediate market demand. In banking this is referred to as "fractional reserves".

This phantom supply has increased dramatically since the early to mid 1990’s. A 1995 bank of England survey of London Bullion dealers reported an annualized borrowed gold flow of approximately 1500 ton for that year. This is up from a small traditional 150 tons through out most of the 1980’s.

GOLD INTEREST RATES
Further evidence of this increase in leased or loaned supply is the vastly increased interest rate paid on gold loans. Traditionally gold’s stability has led to steady low interest rates paid on these loans - around 1-2%, and interestingly that is throughout most of history. In the last half of this decade interest rates on gold loans have at times reached an unprecedented 6%.

Reflect on that in light of interest rates on "fiat" or valueless government paper money, to which we have grown accustomed, which in one year, to ward off hyperinflation can reach as high 18 – 25 %, and then just a few short years later, in a desperate effort to flight deflation, can be found as low as 1 or 2% (consider Japan today).

A WELL WORN STORY
Much reported central bank sales have impacted available aboveground gold stocks less than some may at first expect. When a central bank announces it is considering quitting some of its gold reserves, the world financial press crank up the old "gold is dead" gramophone and whip it into a frenzy. Their well worn scripts point refer to the woes of holding a dead and barbarous relic, its poor investment potential and why gold no-longer performs any of its traditional financial functions. What is not reported in all the hype is the quiet accumulation of gold reserves by other central banks.

Of the total 125,000 tons between 28,000 and 35,000 ton is held by central banks. The IMF, current official figure is 35,623 tons, although in a 1998 report Joseph Haubrich, an economist at the Cleveland Federal Reserve Bank, points out this may be underestimated as not all Central banks report their full holdings.

Despite what appears to be a concerted effort by the media to discredit gold in the minds of investors and the masses, this figure of a net total 35,000 tons has been surprisingly stable in recent years. In other words while some central banks are selling others are buying. Could it be that these changing levels in central bank’s gold holdings indicate rather a shift in sovereign powers?

THE REST OF THE STORY
In early 1997 Argentina was reported to have sold 125 ton. In July Australia sold a further 167 tons. That makes a total of 292 ton, which goes only a small way to service an estimated deficit of 1000 to 1500 tons for that year. What was interesting was the financial media forgot to explain that the Argentinean sale was not a sale of physical gold into the open market, but the exercising of put options – paper contracts that simply entitles it to sell at a previously specified price.

Some observers suggest that central banks have been quietly and covertly "dishoarding" or selling gold in a concerted effort to keep the gold price down, and so maintain all-important confidence in their fiat (valueless) currencies. While it can’t be conclusively proved, this conjecture makes sense. While gold has been, is and always will be the "barometer" of any economy, as long as it can be demonetized and kept out of the minds of investors and the masses, the longer they can keep their flawed and unsustainable system running.

by Philip Judge
1999
(c) copyright 2003
www.anglofareast.com

BACK TO THE LIBRARY