In January, the contrarian investor in me won out: I decided to buy into gold miners.
In March I talked about how increased activity in the gold market might mean the precious metal has turned a corner.
But today, I ask that you forget all about gold’s recent price action. That’s a story for another day.
For now, let’s focus on what really matters: what I think are potentially explosive actions in the physical gold market.
Paper beats rock
Now, bear in mind that the physical gold market (dealing in wholesale bullion delivery) is tiny in relation its paper-based cousin (futures, options, leveraged trades, collateralised obligations, ETFs, etc).
In fact, it’s estimated that the paper gold market – which should be a derivative of the physical market – is actually some 100 times larger than the physical market – ie, if everyone holding paper gold ‘stood for delivery’ at the same time, it would be impossible for every party to fulfil their obligations.
The central banks don’t like it
Because the derivative market is so large, paper gold makes physical gold’s market price.
This is a problem for nervous central banks because when prices are perverted in this way, it causes anomalies in the market.
The big one right now is how the gold price seems to be completely out of kilter with underlying demand.
For example, how on earth can China and others be importing such massive amounts of physical gold – and yet the gold price refuses to budge?
All sorts of theories have been posited. One is that major Western central banks have been providing physical supply to balance the books, by leasing gold into the market.
But here’s the rub: this gold may belong to other nations, which is causing anxiety for countries that rely on the Western depositories to store their gold.
World to banks: Where’s my gold?
First, it was the Venezuela’s Hugo Chavez that kicked up a stink. He demanded Venezuela’s gold back from London and the US. That was a few years ago now.
Some astute nations took note. After all, Venezuela’s holdings are the 15th largest in the world – this was no piddling amount.
Then about a year and half ago, Germany was rumoured to be asking for an audit of its gold held in foreign depositories. Supposedly the American custodians said take a hike.
We don’t know if that’s true or not. But what we do know is that shortly afterwards, the Germans asked for much of their gold back. 674 tons, in fact – 374 from Banque de France and 300 from the US Fed in Manhattan.
Now, this certainly wasn’t a piddling amount either. But if the stuff was in the vaults, then what’s the problem?
Well, you can only imagine the Germans response to the announcement that the transfer, of their gold back to them, would take eight years to fulfil.
“What? Eight years? The Venezuelans took delivery within a couple of months. What’s going on here?”
What indeed? Perhaps the Americans placated the German delegation thus: “Now, now, keep calm. Don’t make a fuss. If you rock the boat and everyone gets nervous, this process could take a lot longer! We don’t want anyone else getting concerned.”
A full year after Germany asked for its gold back, a trifling 37 tons had been delivered. That’s way off the 87 tons envisaged… and even that figure was allowing eight full years for delivery. What’s more, a paltry five tons came from the US. The rest was from Paris.
When asked about progress on getting its gold back, the Bundesbank was rather coy.
Don’t worry, they said.
They would, though, wouldn’t they? It would hardly help to have other nations knocking on the Fed’s door asking for theirs back too now, would it?
The rumour mill is back in action
More recently, Austria was said to be giving its London custodians a prod.
A report in Austrian magazine Trend suggested they were planning to send auditors to check on the country’s gold holdings in the Bank of England.
Hey up, this is how the German repatriation thing started!
And Austria is no gold slouch either. Its IMF-reported reserves top 280 tons. That’s nearly half Austria’s foreign exchange reserves. They like the stuff!
In response to the rumour mill, Ewald Nowotny, governor of Austria’s central bank, recently played down matters:
“I acknowledge the request. Any grocery store is obliged to do inventory once a year.”
So the rumours of the audit appear to be true, then. And once again, the central bank tells everyone there’s nothing to see here. As I said – they would, wouldn’t they?
If there’s going to be a run, then get in line early, and don’t go shouting about it.
The perfect crime
Everything I’ve laid out above is conjecture, of course.
But don’t be surprised to learn that the central banks have been ‘leasing’ gold into the markets. In fact, we know for sure that they do – they’ve admitted as much.
And unlike dumping the stuff in the market – like Gordon Brown did with half our pot – lending the stuff can be done more surreptitiously.
In fact, it’s the perfect crime. This way they can dump it on the markets, and still record it on their own balance sheet.
And why not? The stuff is supposed to come back again after the lease is up.
But this isn’t like shorting shares. In the bullion markets, once the bullion has been lent short and dumped on the market, it’s mostly smelted into new bars that are demanded in Asia. It’s then shipped and stored in brand new vaults all over the globe.
Getting this stuff back after the lease is up could prove difficult for all the banks and hedge funds that have been shorting the stuff. ‘Only five tons delivery in one year’ kind of difficult!
Of course, if this story has legs, then it won’t be endorsed by any official any time soon. Mum’s the word.
It makes you wonder, doesn’t it? Venezuela, Germany, Austria… where are the whispering rumours gathering next?
And could there be an almighty run on the Western custodian banks to come?
Watch this space.