MPEG COMMENTARY - Page 3
September 29, 1999. Forward Rates Do Not Compute as COMEX Stays in Contango
Reread the second and third paragraphs of my commentary dated September 11, 1999, for an explanation of the relationship between lease rates, forward rates and interest rates, and how they are manifested in contango or backwardation. Today (at 3:45 EDT) Kitco reports largely inverted lease rates running from 8.9% for 1-month gold to 7% for 1-year gold, and corresponding forward rates running from negative 3.5% for 1-month gold to negative 1% for 1-year gold. Negative forward rates mean that gold should be in backwardation. But here are today's closing prices on the COMEX for the October 1999 through October 2000 gold futures contracts, respectively: $300.60, $302, $302.30, $302.90, $303.70, $304.60 and $305.60. The spreads are tight, but still wholly in contango. What, you may wonder as I do, is the significance of this unprecedented development? Will gold soon go into backwardation for the first time ever against the U.S. dollar? Or will lease rates, now at unheard of levels, come down? Could U.S. interest rates be forced higher? How long can this bizarre situation persist? The short answer is that your guess is as good as mine.
But there are three observations that I can make. First, soaring lease rates -- largely inverted -- on a sharply rising gold price suggest extreme stress in the gold banking business. Given the announcement by the European central banks, it seems highly unlikely that demand for leased gold is still being propelled by producers and/or speculators wanting to establish new short positions. Rather, today's lease rates almost certainly reflect near panic among current shorts seeking to rollover existing gold loans as well as extreme reluctance by gold banks to continue to take on what is now a much increased risk. Indeed, the failure of the COMEX to go into backwardation today may well signal that the gold loan market itself is now largely bereft of liquidity, and that currently quoted lease and forward rates can be converted into real transactions only under very restricted circumstances.
Second, the violence of the market response to the announcement from the European central banks, especially when coupled with a negative forward rate that does not manifest itself in backwardation on the public market, indicates (even if it does not prove) a level of manipulation in the gold market that few, probably including most of the European central banks themselves, suspected. What is more, it is almost inconceivable that this kind of manipulation could have been carried out without the knowledge, and probably the outright participation, of the Federal Reserve and the U.S. Treasury. Fed Chairman Alan Greenspan's assurance to Congress little more than a year ago that over-the-counter gold derivatives did not present any systemic danger because "central banks stand ready to lease gold in increasing quantities should the price rise" makes twentieth century "Greenspeak" about as redeemable in specie as a nineteenth century greenback. But be warned, the Fed and the Treasury may yet resort to other manipulative devices to try to stave off further chaos in the gold market.
And third, public awareness of what is really going on in the gold market remains virtually nil. Today The Wall Street Journal in its story on yesterday's gold action did not even mention high and rising gold lease rates, let alone discuss their significance. So too, there is still almost no suggestion in the mainstream media that last Sunday's announcement by the European central banks might indicate dissatisfaction with U.S. monetary policy or have future significance for the dollar. "Laissez les bon temps roulez" is a good motto for the French Quarter in New Orleans. But as a guide to managing the world's principal reserve asset, this motto is a recipe for changing its color from green to gold.
September 28, 1999. From Bre-X to the BOE: Gold Scams Exposed on the Net
The jungles of Busang, Indonesia, are a long way from Threadneedle Street and the trading offices of members of the London Bullion Market Association, but gold scams know no limits of geography, race, office or class. Indeed, the classics of the genre are almost always perpetrated by governments, usually with the acquiescence if not the support of the mainstream media.
Sunday's announcement by the European Central Bank on behalf of itself, its member banks and certain other European central banks of an agreement to limit their gold sales and gold leasing activities did not catch totally unawares those who regularly frequent the websites at my Recommended Links. Nor could these well-informed persons have been surprised by the gold market's reaction yesterday and today. They know the significance of gold lease rates, something The Wall Street Journal does not report and the Financial Times (London) reports only indirectly. And they recognize articles like John Dizzard's piece in Fortune ("The Great Gold Price 'Conspiracy','' Aug. 2, 1999, p. 254) for the uninformed propaganda they are.
The power of the internet to give quick and accurate information to gold investors was the good news part of the Bre-X story. The story of the Bank of England's gold sales reveals a far more significant power of the internet: the empowerment of ordinary citizens. It is good news and bad news: good news for honest citizens seeking to hold governments and leaders accountable; bad news for officials and others whose favorite schemes cannot stand the light of day.
Nothing could be more threatening to paper money as an international standard of value than the possibility that it might actually be understood by a wider public than in the recent past. For the gold community in general, for those who believe in honest money in particular, the internet is at once a tool, an opportunity and a challenge.
September 27, 1999. Shades of de Gaulle: The New, New World of Gold
By its stunning announcement Sunday evening, the new European Central Bank served notice that it will not tolerate politically motivated Anglo-American interference in the gold market, and that the Bank of England is now on probation as the central bank with principal responsibility for overseeing this important market. The details of the announcement have received full coverage by the financial press and wire services. Only time will reveal its full significance. But what already seems clear is that not since Charles de Gaulle and the Banque de France mounted the Franco-American gold war in the 1960's has a European central bank so directly confronted Anglo-American hegemony over the international monetary system. And this time it is not merely a European central bank, but the European Central Bank.
The classical international gold standard became an unintended casualty of the First World War. Ever since, first the British and then the Americans have essentially dictated the basic features of the world monetary system: the gold exchange standard after World War I, Bretton Woods after World War II, and floating rates after Viet Nam. Each time the new system finally led to an unprecedented credit expansion and an equally unprecedented bull market in stocks. But the process of unwinding the great bull markets of the 1920's and the 1960's brought down the very international monetary systems that spawned them. The final outcome of floating exchange rates and the great bull market of the 1990's is yet to be written. However, the advent of the Euro was intended to make Europe what perhaps no single European country could be: a necessary player in any future fundamental restructuring of the international monetary system.
For now, the gold market itself may provide sufficient fireworks. One-year lease rates today hit 4.7% as existing shorts scrambled to secure adequate borrowings. Under the circumstances, the odds for one or more high visibility failures or defaults cannot be insignificant. In the longer run, Sunday's announcement by the ECB may be just the first shot in a far larger battle for long overdue and much-needed reform of the world's monetary system. But in any event, it is a reminder that what General de Gaulle termed "an exorbitant privilege" -- the dollar's key currency status -- cannot be maintained indefinitely by a policy of trashing gold.
September 22, 1999. The Triffin Dilemma: Still Searching for a Solution?
Robert Triffin, the late Belgian economist and Yale professor, was a member of the jury that awarded the Bank Lips AG International Currency Prize to The Golden Sextant in 1992. While I joked at the award ceremony that "Yale economists were not usually assigned reading for Harvard undergraduates," in truth Professor Triffin (who held a Harvard doctorate) was a definite exception by reason of his 1960 book Gold and the Dollar Crisis, predicting more than a decade before the event that the Bretton Woods system must fail. Why? Because the increasing demand for world liquidity could not forever be met through U.S. balance of payments deficits without ultimately undermining credibility in the U.S. dollar itself, i.e., in the U.S. promise to redeem dollars at the established rate of $35/oz.
Thus it was with some astonishment that I read Marc Chandler, chief currency strategist at Mellon Bank, invoke the "Triffin Paradox" in support of his argument that "the dollar will remain the world's key reserve currency for years to come" and is not "just as good as gold" but "better." M. Chandler, "Dollar vs. Euro," Barron's, Aug. 9, 1999, p. 53. In Chandler's view, the Euro will not challenge the dollar as an international reserve currency because, in his words, "Europe's current-account surplus -- a deficit isn't likely soon -- means that the supply of euros in the rest of the world is not sufficient for it to function as a reserve asset." Gresham's law has been used to stand Triffin on his head.
Unlike many economists of his era, Triffin opposed floating exchange rates. He argued instead for creation of a new international monetary unit to be managed by a world central bank, i.e., free from the control of a single country and accepted by all. The creation of SDR's under the IMF were a too little, too late effort along these lines. Indeed, like many economists before and since, Triffin dreamed of a money better than gold. At the end of Gold and the Dollar Crisis, he reprinted a fantasy from The Economist in which gold, after being demonetized by all the nations of the world, fell to a price of $2.50/oz., exactly what it would fetch as the raw material for gold dental fillings. In those days, as a former Federal Reserve Governor once explained, "Nobody ever thought what would happen if we went off gold and the price went sky high."
While Chandler admits that "ignoring the [Triffin] dilemma doesn't solve it," his argument seems to suggest that Pax Americana and floating exchange rates can trump it. I doubt that Triffin would agree, and it is in this context that what Triffin said about gold -- that other alternative -- becomes relevant:
Although basically absurd, a drastic revaluation of current gold prices is by no means an unlikely solution to the world illiquidity problem. It will become well-nigh unavoidable -- and far preferable indeed to the alternative solutions of world deflation or world restrictions -- if international negotiation fails to develop in time other and more constructive solutions to the problem.
I never got to ask Professor Triffin whether his vote for The Golden Sextant represented a mellowing of his views on gold or just increasing disdain for the post-Bretton Woods system of floating exchange rates, of which he remained a harsh critic to the time of his death. Declining health prevented him from attending the award ceremony, which was held in Zurich on Thanksgiving Day, 1992. But the final paragraph of my acceptance speech was especially for him, so I will repeat it here:
Winston Churchill said that democracy is the worst form of government except for all the others that have been tried from time to time. The same may be said for free markets and money tied to gold. Let us be grateful this Thanksgiving Day for the rebirth of democratic government and free market economies in so many nations. But let us remember that America grew from a struggling new nation to the world's dominant power on a dollar as good as gold. And let us ask whether economists' dreams of money better that gold are but another tragic case where, as Voltaire put it: "The best is the enemy of the good."
September 20, 1999. BOE's Gold Sales: To Rescue the Fed?
Here is what seems clear about the Bank of England's gold sales: (1) the stated reason -- to adjust the composition of the BOE's forex reserves -- makes no sense; and (2) the decision was made at the highest political levels, apparently against the wishes of the bank's senior officers. What can possibly explain and reconcile these two facts?
There are some who say that the bullion bankers got to the politicians. Plausible, perhaps, though I for one consider this degree of venality at these levels to be unlikely. What is more, if the bullion banks themselves were in real trouble, I would expect to find the BOE both more prepared and more supportive than it appeared.
Several people with serious credentials in the gold business have suggested the possibility that although the Federal Reserve claims not to lease gold, it may write (sell) call options which are then used by bullion banks to hedge their gold leasing activities. If this assertion is correct (something I have no way of knowing), it is possible last May that not only was the Fed surprised by the strength of the gold price, but also that it was caught short with a lot of call options outstanding at around US$ 300/oz. Were this the case, it is something that would only have been known at the very highest levels of the Fed and the U.S. Treasury. And under these circumstances, it is not hard to imagine a call going out directly to the British Prime Minister for help. In particular, depending on the maturity schedule of the options, holding gold in check for just another few months could make a huge difference.
Of course, if the Fed were writing call options, one effect -- intentional or not -- would be to stimulate gold leasing. Turning off the option spigot, therefore, would also cause the bullion banks to rein in their activities, driving gold lease rates sharply higher. Indeed, at this point it would be in the interest of the Fed, the BOE, the other central banks and the bullion banks all to cooperate to keep a lid on the gold price for sufficient time to permit an orderly reduction in net gold derivatives.
September 16, 1999. Gold Leasing by Central Banks: Reaching the Limits
Gold lease rates are soaring. What is going on? This commentary gives my best guess, which is in many respects a refinement of certain views expressed in my last essay, War against Gold: Central Banks Fight for Japan.
Were Machiavelli alive today, he might title his seminal work The Central Banker instead of The Prince. Figuring out what these princes of money are doing, not to mention why they are doing it, can be difficult. But it is not reading tea leaves. And it has a long tradition.
The original purpose of central banks was to make the classical gold standard function more smoothly than it did under free banking, to protect bank depositors (i.e., the public), and to prevent or at least ameliorate serious banking panics. Central banks, therefore, focused on three key problem areas: (1) the adequacy of gold reserves in a fractional reserve banking system; (2) the quality of bank assets derived from investing customer deposits, particularly the mismatching of maturities (i.e., borrowing short and lending long); and (3) international settlements, particularly loss of national gold resulting from imbalances in international accounts. But while central banks tried to prevent serious problems from developing, they almost never gave public warnings of imminent crisis. Quite to the contrary, banking panics and devaluations almost always took place in the wake of repeated official pronouncements that whatever the perceived problem, it was under control. For today, the lessons are two: (1) central banks are no strangers to assessing the risks in gold banking; and (2) central bankers are masters at dissembling in the face of potential crisis.
Fast forward to late 1995. My contention that the central banks decided to mobilize their gold as necessary in support of an effort to prevent a complete financial and banking collapse in Japan is really no more than an educated guess -- a deduction made after the fact on the evidence available. It rests on my view that nations, no matter what officials may say, do not part with gold absent very good reason, usually touching issues of national survival or monetary sovereignty. The claim that a government is selling gold merely to adjust the composition or yield of its foreign exchange reserves strikes me as deeply suspect. The Dutch and Belgian sales are far better understood as measures taken in preparation for the Euro. My guess is that Canadian sales were not unrelated to the Quebec issue, but that is a subject for another time. The Bank of England's current sales are quite simply inexplicable on this ground. And in time, if the proposed Swiss sales ever do occur, we will probably learn that they involved some sort of calculation or quid pro quo having to do with the protection of Swiss banking or Switzerland's uniquely independent status within an integrated Europe. In any event, the Swiss, who actually can make a reasonable claim to having excess gold, are unlikely to hold a fire sale like the British.
By 1997, with the amount of gold reserves on lease having risen sharply since 1995, two events suggest the first signs of central bank alarm. First, the London Bullion Market Association (LBMA) disclosed for the first time ever the volume of its gold trading activities and promised to release average daily clearance figures every month in the interest of greater market transparency. These are now available at its website, www.lbma.org.uk. Second, the Federal Reserve commissioned and made public an internal study on government gold policies.
The LBMA disclosure was announced under the headline "Gold global market revealed" in The Financial Times on January 30, 1997. At the time the daily volume of gold trading by the 14 market-making members of the LBMA was about 30 million ounces or 930 metric tons. Some traders said that the number was misleadingly low because matched orders were not included. While the LBMA has reported average daily clearing numbers as high as 40 million ounces (1240 tons), the 30 million figure seems to be about average. For purposes of comparison, 50,000 contracts or 5 million ounces, is a busy day on the COMEX, and 100,000 contracts or 100 tons a very busy day on the TOCOM. In short, the over-the-counter London gold market dwarfs the public gold markets in New York or Tokyo. More importantly, it is where most transactions that involve gold leased from central banks are conducted. Not surprisingly, therefore, the LBMA's disclosure received prominent attention in the BIS's 67th annual report released in June 1997. There, as part of an extended discussion of gold leasing (pp. 95-96; see my earlier essay), the BIS noted that the amount of daily gold turnover in London "rivals that of London trading of sterling against the Deutsche mark." It added: "According to a Bank of England survey, most of the trading was spot -- both physical and book entry -- with a significant forward market and an active option market." Exactly why in January 1997 the LBMA broke with a tradition of secrecy going back hundreds of years has never been fully explained. My opinion: the central bankers were demanding a better picture of what was happening with their leased gold.
The Fed study can be read at www.federalreserve.gov/pubs/ifdp/1997/582/ifdp582.pdf. This study contains the usual disclaimer that it presents the views of its authors, not the Fed or other staff, and could be dissected endlessly for obvious errors and omissions. It purports to analyze the costs and benefits of various courses of action, including immediate sale of all government gold and no sale of government gold. A startling feature of the presentation is the treatment of gold to be mined as part of the available gold stock. The final paragraph suggests a compromise policy (p. 26 text; p. 45 pdf):
Of course, any benefits of government ownership of gold are lost at once under a policy that involves selling all government gold immediately. However, any such benefits are lost much later under a policy that involves leasing out all government gold immediately and selling it gradually after some date in the future. It is clear that if governments lent out all their gold but wanted to keep open the possibility of using it in a crisis, they would have to structure their loan contracts so that they could get their gold back immediately in a crisis.
This study appears more an effort to rationalize a policy after the fact than to develop a new, well-thought out one. It is the sort of memo a bureaucrat might wave in explanation of a failed policy, but it could hardly persuade a smart central banker to adopt the policy in the first place. Why? The authors fail to appreciate what central bankers know too well: leased gold does not stay in the possession of the lessor.
The term "lease" is a misnomer, confusing the basic difference between banking on the one hand and bailments and leases on the other. A bank deposit of currency or gold creates a liability for repayment in currency or gold, but the money actually deposited passes to the bank for use in its business as it sees fit. The depositor necessarily becomes a creditor of the bank. A bailment creates an obligation to return the item bailed and gives no right to use it. A lease creates an obligation to surrender the item leased at the end of the lease term, during which period the lessor has the right to use but not to convert or sell the leased property. A lessor does not become a creditor of the lessee except as he may agree to accept rent in arrears. A gold loan by a central bank is a deposit in a bullion bank, not a lease in the ordinary sense of that word. The gold "leased" is effectively put out for immediate sale into the physical market, where ultimately the gold for repayment will have to be purchased. The basic point: gold leasing is not leasing at all; it is banking. The great irony of gold banking as practiced today is that the central banks are the principal depositors. Like private depositors before the era of central banking, they must protect themselves.
By 1998, with net gold derivatives rising in step with the increased leasing of gold by central banks, concern about the risks involved were rising too. Certainly they were on Fed Chairman Alan Greenspan's mind. On July 28, 1998, testifying before the House Banking Committee looking into the regulation of over-the-counter derivatives, he distinguished financial derivatives from agricultural derivatives, saying that it would be impossible to corner a market in financial futures where the underlying asset (e.g., a paper currency) is of unlimited supply. The same point, he continued, also applied to certain commodity derivatives where the supply was also very large, such as oil. And he further volunteered: "Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise." Needless to say, this statement provoked considerable comment in the gold community, much of it having to do with a conspiracy by central banks to control the gold price. The real question, however, is to what extent and at what risk central banks "stand ready to lease gold," whether into rising prices or otherwise.
The amount of gold available for this purpose is large, but far from infinite. In the July issue of its quarterly Gold in the Official Sector, the World Gold Council (www.gold.org) puts total official gold reserves at the end of 1998 at about 33,500 metric tons, amounting to just over 15% of total world foreign exchange reserves. Of this amount, the five largest holders (U.S., Germany, France, Italy and Switzerland) accounted for just over 20,000 tons. The U.S., which holds a little over 8100 tons, claims not to lease gold. In 1999, the numbers for Germany, France and Italy will decline in aggregate by over 500 tons due to transfers by them to the new European Central Bank (ECB). Because accounting for leased gold varies by country, it is virtually impossible to tell from official statistics how much government gold is out on lease. What is known is that some governments withdraw gold from the lease market near year end to improve the risk profile of their balance sheets. What is also clear is that at a daily rate of 1000 tons, the LBMA's annual turnover is around 250,000 tons, or almost 8 times total official reserves.
After excluding from world reserves the U.S. and the international financial institutions (BIS, IMF and ECB), there are some 20,000 tons theoretically available for lease. Reasonable current estimates of the net short position in gold derivatives run from under 5000 to over 10,000 tons, implying that about this same amount is out on lease from the central banks. Why? Because, subject to the caveat discussed in the next paragraph, it is the destiny of such leased gold to be sold at spot into the physical market, creating a short position of equal amount. This position may be hedged many times over, but it remains a net short position until the gold is repurchased and returned to the central bank that deposited it.
An ancient rule of thumb in gold banking is that under ordinary circumstances gold placed at sight (i.e., in demand deposits) should be backed by a reserve of 40% in physical gold. Indeed, as recently as 1946 the legislation governing the Federal Reserve System required a gold cover of 35% against deposit liabilities of Federal Reserve banks and 40% against Federal reserve notes in circulation. Although I have seen nothing to this effect, it is possible that the bullion banks engaged in gold banking with deposits from the central banks are holding some of this leased gold in reserve. If so, the amount of central bank gold out on lease would exceed the net short position in gold derivatives by an amount equal to the total leased gold held in reserve by the bullion banks. Of course, in this event the bullion banks' rate of return would also be less. On the other hand, if the bullion banks are not retaining significant physical reserves (as I rather suspect), the risk profile of the central bank gold out on lease is increased, and at a time when general financial conditions are far from ordinary. Adding to the risk, the central banks by their own leasing have driven gold prices to bargain levels that have stimulated unprecedented physical demand, accelerating the withdrawal of physical gold from the reaches of western bullion bankers into India, other parts of Asia and the Middle East. Finally, now pressing in on the central banks is a real wild card -- Y2K, a subject on which the BIS has issued several far from reassuring reports (www.bis.org/ongoing/index.htm).
By any historical or common sense measure, and particularly under current circumstances, a net short gold derivatives position of anything like 10,000 metric tons is pushing the limits of any reasonable assessment of central bank tolerance for risk. To me at least, the message of today's high gold lease rates is that central banks no longer "stand ready to lease gold in increasing quantities" and are instead focusing on the problem of recovering their gold in preparation for Y2K and whatever other crises may lie directly ahead. Expect them to issue reassuring statements; don't expect them them to part with a lot more gold. No central banker wants to be remembered in history for losing his nation's gold, or for giving it away.