Central banks and the gold price

2011-SEP-11

Last week the Swiss National Bank suddenly announced that it was “no longer going to tolerate a EUR/CHF exchange rate below the minimum rate of CHF1.20”. Just before the announcement the franc had been trading at CHF1.10, so it represented a devaluation of about 9%. The Swiss Franc had been as strong as parity about a month before the move, so the decision appears to have been based on more than simple currency over-valuation.

The SNB definitely has a problem. Switzerland is a successful economy surrounded by nations in a currency union that threatens to disintegrate. Essentially, Switzerland’s success is out of step with the rest of Europe. This is obvious, but the motivations for central banks are rarely stated plainly, and there is usually more to an action such as this than meets the eye.

It was gold’s reaction to the news that surprised everyone, because gold fell $60 from its high at the time of the announcement, when the SNB’s action was expected to be good for gold. Half the fall in the gold price occurred in the few minutes ahead of the SNB’s announcement at 10.00am European time, so it appears that the gold price was getting some guidance from the central banks. Furthermore, very late that evening US time, when trade is thin and Europe was asleep someone dumped 4,000 futures contracts, driving the price down over $50 to $1,816. The first trade was on privileged information, while the second was clearly timed for maximum effect.

Rarely do we see such a public determination to hit the gold price. Indeed, the promptness of the action suggests that the move on the Swiss franc was designed to get the gold price down as much as it was the franc itself. If this is the case, then there must be a good reason, and we should bear in mind that the central banks have it in their interest to reduce volatility in bullion markets as well as currencies.

In common with dealers and market makers in all markets, bullion traders run short positions in bull markets. The turnover on the bullion markets is massive, and a dealer active on behalf of its customers and its own trading book can make substantial dealing profits. So long as those profits exceed the losses on their short positions, all is well. This is why the greatest threat to the bullion market is not the bull market itself, but prices rising too rapidly.

In the last two months, the market for gold has been particularly strong, erasing trading profits for many bullion dealers. Central bankers see this as the result of financial flows building due to the difficulties in the euro area. The targets for these flows out of the euro are the Swiss franc and gold, so the SNB’s move is designed to take the heat out of both of them.

Attempts to keep the price of gold down are unlikely to succeed for long. Westerners who buy gold may be unhelpful to the central banks, but you cannot stop a few hundred million Chinese and Indians from protecting their hard-earned savings. And the Chinese are busy developing their bullion markets, taking control away from the Western central banking cartel.