CURRENT COMMENTARIES September 8, 2006. Purloined Minutes (Bob Landis, Fence)
A dealer in purloined manuscripts recently approached Bob Landis with a document that purports to be a set of minutes for a recent meeting of the Exchange Stabilization Fund, one of the nation's most important financial market managers. We don't know exactly what to make of it -- whether it's another appalling breach of security by the Bush administration or just a prank. We post it, however, as both a caution against unauthorized disclosures and a warning to be ever on guard for frauds and forgeries.
June 21, 2006 (RHH). Gold Derivatives: Da Goldman Code
On May 19, 2006, the Bank for International Settlements released its regular semi-annual report on the over-the-counter derivatives of major banks and dealers in the G-10 countries for the period ending December 31, 2005. The total notional value of all gold derivatives rose from $288 billion at mid-year to $334 billion at year-end while period-end gold prices jumped from $437 to $513 (London PM). Reflecting the higher gold prices, gross market values more than doubled, from $24 billion to $51 billion.
As subsequently detailed in table 22A of the June issue of the BIS Quarterly Review, forwards and swaps rose from $109 to $128 billion and options from $178 to $206 billion. Converted to metric tonnes at period-end gold prices, total gold derivatives dropped by a marginal 260 tonnes from 21,420 to 21,160, with forwards and swaps actually rising slightly from 8106 to 8109 tonnes while options fell from 13,238 to 13,051 tonnes.
Along the same lines, Gold Fields Minerals Services reported minimal adjustments in the global producer hedge book over the last half of 2005, with the delta-adjusted forwards portion of the book ending the year at around 1300 tonnes and options at roughly 350 tonnes. GFMS, Global Hedge Book Analysis - Q4-2005 (13th ed., February 2006).
In short, with the notional dollar amounts of OTC gold derivatives increasing more or less in line with gold prices, the physical quantities of gold represented recorded no significant net changes in the last half of 2005. At the same time, gold prices finally managed to break through months of resistance at around the $435 level and to close the year over $500. All these developments were consistent with the central banks being forced to take a somewhat less aggressive attitude toward the control of gold prices. See Gold Derivatives: Footprints of Retreat (12/12/2005).
Likely of far greater interest to goldbugs will be the BIS's next semi-annual report on OTC derivatives covering the first half of 2006, which has produced a strong rally that took gold prices above $725 by mid-May, followed by a crash to under $560 within less than a month. See, e.g., A. Evans-Pritchard, Gold crash brings on the bargain hunters, Telegraph.co.uk (June 14, 2005).
The first quarter also saw a large drop in the global producer hedge book, largely due to Barrick closing out the hedge book it acquired from Placer Dome. See GFMS, Global Hedge Book Analysis - Q1-2006 (14th ed., May 2006); see also R. O'Connell, Dehedging forecast at 12 million ounces of gold, Mineweb (May 10, 2006) and Producer gold de-hedging surges in first, Mineweb (June 3, 2006).
Of particular interest, Barrick stated in its First Quarter 2006 Report (at p. 9, emphasis supplied): "[T]he net gold sales obligation of the combined company was reduced by a combination of deliveries, financial closeouts and offsetting positions to 15.3 million ounces, a net reduction of 4.7 million ounces since year-end." While 4.7 million ounces amounts to just 145 tonnes and Barrick gave no indication with respect to how much was eliminated through financial means as opposed to deliveries, there would seem to be some possibility here for at least a marginal impact on OTC derivatives, probably in an upward direction.
The Canary Sings. As the Australian gold and financial analyst Bill Buckler regularly points out, e.g., The Privateer Gold Pages (May 26, 2006):
The global paper currency system is very young. It depends for its continued functioning on the belief that the debt upon which it is based will, someday, be repaid. The one thing, above all others, that could shake that faith, and therefore the foundations of the modern financial system itself, is a rise (especially a sharp rise) in the U.S. Dollar price of Gold. [Emphasis in original.]
So it is hardly surprising that as gold prices surged toward the end of last year, the mainstream financial press not only took notice but also contemplated the possible monetary implications, including for interest rates and bonds. See, e.g., A. Evans-Pritchard, Soaring price of gold predicts bout of carnage in bond markets, Telegraph.co.uk (November 5, 2005), citing the Wainwright study discussed below; J. Dizard, Lustrous Gold Outshines the Big Currencies, FT.com (December 9, 2005).
As gold prices continued their upward march in 2006, more evidence surfaced that at least some central banks were hedging their dollar bets, either by reducing planned gold sales and or adding to their gold reserves. See, e.g., A. Hotter, Central bank gold sales unlikely to fill quota, analyst says, Dow Jones Newswires (January 27, 2006); German govt drops Buba gold sale plan - sources, Forbes.com (February 16, 2006); P. Klinger, China's gold reserves double in value, The Times (London) Online (March 21, 2006); China Should Buy Gold, Central Bank Adviser Says (Update2), Bloomberg (June 1, 2006); A. Evans-Pritchard, Russia leading global 'stealth demand' for gold, Telegraph.co.uk (June 5, 2006).
Meanwhile, doubts about the strength and viability of the global paper currency system continued to attract attention, and not just from goldbugs. See, e.g., D. Ranson et al., In Gold We Trust, The Wall Street Journal (May 18, 2006); J. Embry, Paper assets seeking safety send gold soaring, Investor's Digest (June 2, 2006); J. Dizard, Gulf divides goldbugs from those only bullish about gold, FT.com (June 5, 2006).
Indeed, while not discounting the message of higher gold prices, Mr. Dizard tries to distinguish goldbugs from mere gold bulls: "The most significant difference would be the goldbugs' firm conviction that the gold price has been manipulated by a cabal of western governments, gold dealers, and bankers." Although not buying the bugs' thesis, Mr. Dizard nevertheless attributed special significance to the changing of the guard at the U.S. Treasury:
It may not entirely be a coincidence that the cyclical gold peak was just past when Hank Paulson was appointed U.S. treasury secretary. This, one can be sure, was not the president's idea. There is a range of opinions of Mr. Paulson, but nobody thinks of him as only another front man, which is what the political world was expecting. Someone -- or, rather, a lot of people -- grimly informed the White House that it was time to get serious. Forget the cheerleaders.
Keeping Them Honest. So far at least, Wall Street does not seem to be on Anderson Cooper's beat. Should the mainstream financial press ever seriously try to keep the world's central bankers and finance ministers honest, it would quickly discover -- to paraphrase Churchill -- that the truth about gold and gold derivatives is so "precious" that it must be shielded by "a bodyguard of lies."
Recently the International Monetary Fund has effectively conceded what GATA has maintained for several years: total official gold reserves as reported by the IMF are significantly overstated due to double-counting of gold loans and deposits by many central banks. H. Takeda, IMF Statistics Department, Treatment of Gold Swaps and Gold Deposits (Loans) (Issue Paper (RESTEG) # 11, April 2006). See Statistics Department, International Monetary Fund, The Macroeconomic Statistical Treatment of Reverse Transactions (Thirteenth Meeting of the IMF Committee on Balance of Payments Statistics, Washington, D.C., October 23-27, 2000).
Information about activities in the gold market, including the reporting of gold derivatives to the BIS, may face additional official distortion. Having been successfully invoked to support curtailment of various civil liberties, the "War on Terror" may now be used to justify less than candid financial reporting by companies recruited to help prosecute it. See D. Kopecki, Intelligence Czar Can Waive SEC Rules, BusinessWeek(online) (May 23, 2006) (alternate link); and The Spy Chief's New Financial Power (June 5, 2006).
Stories on gold in the British press are frequently more entertaining than enlightening, so it was not surprising that higher gold prices triggered numerous articles bemoaning the "losses" incurred by Chancellor Brown's untimely gold sales. See, e.g., B. Jamieson, Brown's gold sale losses pile up as bullion price surges, The Scotsman.com (November 28, 2005); A. Evans-Pritchard, Brown's great bullion sale has cost us £1.6bn, Telegraph.co.uk (December 1, 2005); G. Rozenburg, Chancellor under fire for gold sale as price nears $600, The Times (London) Online (March 25, 2006); J. Nissé, Chancellor's losses hit $6.6 billion as gold touches record high, The Independent (May 14, 2006).
Although suggesting that these sales might somehow have been directed at supporting the fledgling euro or later easing British entry into the euro bloc, none of these stories reflected any real effort to investigate the true reasons for the sales, notwithstanding that Mr. Brown now looks to be the next occupant of 10 Downing Street. In fact, the British sales replaced planned IMF sales that fell through, contributed a lot more to dollar than to euro strength, were carried out in a manner designed to hammer gold prices, and depressed gold prices sufficiently to anger the European central banks into the first Washington Agreement on Gold. See Two Bills: Scandal and Opportunity in Gold? (2/1/2000); Cycles of Manipulation: COMEX Option Expiration Days and BOE Auctions (1/18/2001); Complaint, ¶¶ 42-43).
Outside of Mr. Brown and perhaps a few other high officials, no one seems to know the real motivation for the British gold sales. In retrospect, if they were directed at prolonging the Anglo-American hegemony in international monetary affairs until the underlying political weaknesses of the euro could manifest themselves, the sales might be regarded as a policy success albeit a rather expensive one. See A. Evans-Pritchard, Outgoing euro chief warns of 'tensions', Telegraph.co.uk (May 31, 2006).
Rube Goldberg Money. Today the real job of central banks and finance ministries is not to secure sound money, but to finance governments. In a recent issue of The Privateer (no. 554, mid-June 2006), Bill Buckler summarized their modus operandi (at p. 10):
This they do, not by “fighting” inflation, but by FUELLING it by means of interest rate manipulation and credit expansion. To do this successfully, central banks do not strive to control inflation, they strive to control “inflationary expectations”. [Emphasis supplied.]
Official suppression of gold prices constituted the key -- if not the only -- active ingredient in the strong dollar/low interest rate policy put in place by the Greenspan/Rubin/Summers economic team in the early 1990's. See The Greatest Con: The Rubin Dollar (2/8/2000). The theoretical necessity for this manipulation is explained by Gibson's Paradox, which holds that gold prices in a free market should move inversely to real long-term interest rates. See Gibson's Paradox Revisited: Professor Summers Analyzes Gold Prices (8/13/2001).
That essay was illustrated by a chart prepared by Nick Laird, the proprietor of www.sharelynx.net, who has kindly updated it for this commentary. Note that the gold price is inverted, so that prices and interest rates should be moving in roughly the same directions on the chart gold assuming, of course, that Gibson's Paradox is operative. Also, the 13-week T-bill is shown as well as the 30-year T-bond.
As the chart shows, the relationship described by Gibson's Paradox seemed to falter during much of the 1990's, but started to reappear around 2001-2002 as gold prices rallied from a double bottom while real rates on the T-bond entered a period of sharp decline.
Most striking, however, is what this year's spike in gold prices augurs for interest rates. Not since 1980 have gold prices displayed such dramatic strength. At that time they were not turned around until the U.S. Federal Reserve under Paul Volcker let the markets impose punishing real rates that also brought on the worst recession since the Great Depression. See Fiat's Reprieve: Saving the System, 1979-1987 (8/21/2004).
Gibson's Paradox is a phenomenon first observed under the classical gold standard, when long-term interest rates moved in tandem with the general price level. It was a paradox precisely because rates moved with actual prices rather than inflationary expectations. In a similar vein, recent research makes the case that actual gold prices are a far better predictor of interest rates and inflation than other more frequently used measures. D. Ranson, Why gold, not oil is the superior predictor of inflation, (H.C. Wainwright & Co. Economics study, published by World Gold Council, November 2005).
Precisely because it anticipates inflation so well, gold is also a powerful predictor of nominal interest interest rates, both long and short. This, in fact, is a more rigorous test of the relative powers of gold and oil, because bond market performance is an objective indicator, and is free from many of the errors of measurement that bedevil the official indices of inflation. In similar research on short-term interest rates we have obtained very similar results.
Our calculations show that the time frame that yields the optimum correlation (0.73) between changes in the price of gold and changes in the 10-year T-bond rate is about twelve months. ... These results reveal two respects in which the information in the gold price is superior [to oil prices]: gold provides a much earlier warning, and the correlation with interest rates is significantly tighter regardless of the time frame.
* * * * * The investment applications of gold are numerous, but not widely recognized. Analysts often try to anticipate where the price of gold is heading; however, knowing where it has already been is far more fruitful. Despite growing recognition of gold's forecasting power, investors schooled to believe that gold is a "barbarous relic" with no modern role to play or "just another commodity," often resist using it in their investment strategy. Others are concerned that gold is buffeted by many bottom-up factors such as South African politics, Chinese demand, central-bank dumping and so forth, which can distort its price. But its forecasting power proves that such distortions do not last long. [Emphasis supplied.]
Central bankers and finance ministers know their enemy. They are as aware of gold's predictive powers as Mr. Ranson. For that very reason, if a rising gold price is shouting for higher real rates that would poison the economy, they have strong incentive to suppress its price and distort its message. What is more, they have a powerful weapon that Mr. Ranson did not mention: gold derivatives.
In Goldman We Trust. On Tuesday, May 30, gold closed in London at $660, the same day that President Bush nominated Henry K. Paulson, CEO of Goldman Sachs, to replace John Snow as Secretary of the U.S. Treasury. Mr. Paulson had agreed to take the job in a meeting with the President ten days earlier. See "Mr. Risk Goes to Washington," Business Week (June 12, 2006). Noting that "Goldman actually has leveraged up faster than the U.S. government in recent years," the article reports:
Goldman, under Paulson's leadership, became one of the greatest and most profitable risk-taking machines ever built. ... Paulson stresses Goldman's willingness to take risks along with clients in the latest annual report: "Investment banks are expected to commit more of their own capital when executing transactions."
The subject has become an obsession at Goldman: how to find profitable risks, how to control them, and how to avoid the catastrophic missteps that can bring down whole companies. That means taking on more debt: $100 billion in long-term debt in 2005, compared with about $20 billion in 1999. It means placing big bets on all sorts of exotic derivatives and other securities. And it means holding almost $50 billion in the piggy bank, enough cash and liquid securities to keep the firm going in the event of a financial crisis.
Goldman is also known for fostering a culture of public service. See, e.g., J. Weber, "The Leadership Factory," Business Week (June 12, 2006); M. Lynn, Goldman Sachs Has Gained Too Much Political Power, Bloomberg (June 5, 2006). Mr. Paulson is the third Treasury secretary since World War II with ties to the firm. Former Goldman co-head Robert Rubin held the post for much of the Clinton administration, and Henry H. ("Joe") Fowler served under President Johnson from 1965 to 1968, before leaving the Treasury to become a Goldman partner.
Mr. Fowler had to deal with French demands for U.S. gold under President de Gaulle and the collapse of the London Gold Pool, which ushered in the two-tier gold market and marked as a practical matter the birth of the global paper currency system. He also successfully shepherded through the IMF the proposal to create Special Drawing Rights, "the first nonnational, nonmetallic universal asset." M. Mayer, The Fate of the Dollar (Times Books, 1980), p. 126.
While Mr. Paulson's appointment was in the works, one of GATA's many well-connected informants learned through a U.S. senator (Dem., Wash.) that the U.S. government had "ordered the price of gold down as $700+ gold was freaking them out." Midas at Le Metropole Cafe (6/06 and 6/13). Question: To whom does the government direct such an order?
Since the 1987 stock market crash, derivatives have become the tool of choice for manipulating markets. See, e.g., J. Crudele, Paulson's Other Job as Wall St.. Plunge Protector, New York Post (June 8, 2006).When it comes to derivatives generally, and to gold derivatives in particular, no firm is more experienced or more knowledgeable than Goldman. Its former head of derivatives and risk strategies, Emanuel Derman, ranks among the world's top two or three experts. See Gold Derivatives: Skewing the World (6/15/2005). In 1999, Goldman played the roles of both architect and savior in Ashanti Gold's hedge book debacle. See, e.g., L. Barber et al., "How Goldman Sachs Helped Ruin and then Dismember Ashanti Gold," Financial Times (London), Dec. 2, 1999 (alternate link).
The orchestration of gold's recent crash is detailed in D. Norcini, Remarkable Development in the Gold Market, Le Metropole Cafe (June 16, 2006) (alternate link) and J. Turk, Was Someone 'Piling On'?, GoldMoney (June 18, 2006). In this connection, it is worth noting that all price fluctuation limits on COMEX contracts, which include gold and silver, were eliminated on June 5. The stated purpose, according to the press release, was "to better facilitate the core functions of price discovery and hedging provided by COMEX products."
Whatever the reason, the limits were not in place to moderate gold's $40 rout on Tuesday, June 13. The only other time that COMEX gold has fallen as much in one day occurred in March 1980 after its record high. As the chart above shows, that event not only corresponded with record low real interest rates, but also marked their reversal toward much higher levels while gold prices continued to soften.
Last November, as reported in E. Thornton, "Inside Wall Street's Culture of Risk," Business Week (June 12, 2006)), Mr. Paulson "was asked to talk about his readiness for a big blow to the financial system."
Paulson issued a litany of warnings. The main risk measure Goldman discloses, VAR, "always assumes that the future is going to be like the past," he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from. "The one thing we do know," Paulson said, "is [that] if and when another there is another shock, things you hope wouldn't correlate [or trade in tandem] are going to correlate."
Save possibly for American politicians of both parties, no group has benefited more from the global paper currency system than Goldman's partners and top executives. Whatever tax advantages Mr. Paulson may secure if confirmed by the Senate (see J. Holtzer, A Loophole For Poor Mr. Paulson, Forbes.com (June 2. 2006)), neither tax breaks nor any other perquisites of the job were likely the determining factors in his decision to move from Wall Street to Washington.
His mission is nothing less than to save the dollar's franchise. But high real rates are no longer a politically viable option, nor one favored by Wall Street's large investment banks. American power and Wall Street's profits depend on Mr. Paulson's ability to outwit the gold market. If he cannot, the dollar is likely to fall like Humpty Dumpty, and all the derivatives that the investment banks can invent will not restore it to the world's monetary throne, which will then be reclaimed by its rightful occupant: gold.
