Gold’s undervaluation is extremeJul 1, 2013·Alasdair Macleod
The price of gold fell last week to the $1,200 level. The lemming sentiment in capital markets is uniformly bearish, yet every price-drop brings forth hungry buyers for physical gold from all over the world. Even hard-bitten gold bugs in the West are shaken and frightened to call a bottom, yet it is these conditions that accompany a selling climax.
This article concludes there is a high possibility that gold will go sharply higher from here. There are three loose ends to consider: valuation, economic and market fundamentals.
So far as I am aware nearly everyone is overlooking the obvious. You cannot consider the value of gold without taking account of the changes in the quantities of the currency and the above-ground stock of gold over time. The chart above shows the adjusted US dollar price of gold rebased to 100 in January 2005 when the gold price was $422. In 2005 dollars, using True Money Supply plus excess reserves as the currency adjustment, gold has risen only 13.9% to an equivalent price of $481.
TMS, or Austrian Money Supply, represents cash, checking accounts and savings deposits that can be redeemed for gold under a full convertibility regime. Excess reserves represent the funds deposited by banks at the Fed, which similarly can be redeemed for gold. The sum of TMS and excess reserves are therefore the comparable currency measure.
In 2005 we were in the sunny uplands of growing economic confidence, when systemic risk appeared to have been banished forever. We had recovered from a destabilising economic crisis the previous year, and both stock markets and house prices were rising. Today, eight years later governments are committed to monetary inflation from which there is no practical escape, yet at $1,200 gold is only 13.9% higher today.
The chart above is clear evidence that gold is mispriced to an exceptional degree given the deterioration in fundamental monetary and economic conditions.
Fundamental monetary and economic conditions
The recent episode about tapering, when it dawned on the big-wigs at the Fed that their plan to save the world was not working and that they were caught like rats in a trap with no exit, exposed an important truth. When you rely, credit cycle after credit cycle, on debasing the currency to stimulate economic recovery there comes a time when it fails to work completely, and instead you need to keep issuing new currency to avoid debt liquidation.
The Fed has begun to realise this truth applies today and is trying to find a way out of their mistake. Meanwhile prestigious economic and financial commentators, used to lapping up Fed policy statements, interpret the tapering episode as a “policy signal”, with which the Fed conditions the markets for monetary tightening. This optimistic view does not accord with a realistic assessment of economic prospects, the condition of the banking system and government financing requirements.
It has become clear in the last few months that the US economy is not recovering and if a realistic deflator is applied it is contracting in real terms. At the same time the largest economic area, the eurozone, is sinking into a deepening depression, Japan has resorted to printing yen just so the government can pay its bills, and the UK is in a similarly precarious position as the US.
The major economies have become hampered by too much debt, too much government and too much regulation. Their ability to recover and generate the tax revenues to rescue government finances and the profits to bail the banks out of their bad debts is therefore fatally impaired. It is this dawning realisation that has become every central banker’s worst nightmare.
Meanwhile, the global financial system was brought close to crisis by the mere whisper of higher interest rates, should the Fed try to reduce the pace of currency expansion. Markets were destabilised, and probably rescued only by exchange stability fund intervention.
The issue of rising interest rates is particularly sensitive because there are in Europe undercapitalised banks which cannot afford the losses on government debt from even a modest rise in bond yields, and are almost certain to collapse from the effect of unexpected interest rate increases on their interest rate swap exposure. Indeed, the parlous state of Europe’s banks was paraded before us only last week as the European Commission insensitively debated how to stick bondholders and depositors with the rescue costs.
The governments of the US, Japan and the UK have now become accustomed to financing their deficits by expanding the quantity of currency, and in the case of the eurozone, the expansion of bank credit to finance government debt. The dynamics of this debt trap on governments are concealed by manipulated and self-serving statistics misleading the governments themselves with respect to the true state of affairs. The four major currencies are now irretrievably committed to monetary hyperinflation, and this is illustrated in the chart below, using the example of USD True Money Supply plus excess reserves.
The dotted black line is the exponential rate of growth, which is the maximum rate at which TMS can grow without destabilising the monetary system. Since the Lehman crisis the rate of growth has become hyperinflationary. Another way to consider this issue is that to revert to a stable exponential rate approximately $3 trillion would have to be withdrawn from circulation by the Fed. A monetary contraction on this scale is inconceivable, even if it is spread out over a number of years, not least because it would almost certainly collapse the whole monetary system.
The world is now committed to monetary hyperinflation, yet since 2005 gold at $1,200 today has only risen by $59 in adjusted terms.
In my preview of 2013 published by GoldMoney six months ago, I identified silver markets as a systemic danger, with the potential to create problems for gold. The problem appears to have been understood by both the central and bullion banks and partially deferred through what can only have been an engineered price slump.
Today the bullion banks have now balanced their gold derivative books on the US futures market, with the four largest actually long by 25,782 contracts on 25 June, and most probably more so on the last price fall. They have achieved this remarkable feat through a combination of increased short positions to record levels in the managed money category (hedge funds), and by producers in the Commercials category selling gold forward to protect themselves from falling prices. The extreme managed money short position is shown in the next chart, and last Friday the level of short contracts was probably even more extreme reflecting the most recent price falls.
Hedge funds’ short positions amount to about 240 tonnes, which is unprecedented.
In the last six months on the US futures market, the bullion banks – with the assistance of hedge funds – have booked enormous profits by closing their shorts and have virtually eliminated their exposure to systemic risk from rising gold prices. This can be seen in the chart below.
Silver, which I originally identified as the likely trigger point for a systemic crisis, has not been so easy to deal with and is an entirely different situation. The largest four traders (bullion banks) are still short by 18,846 contracts, but nevertheless have reduced a highly dangerous short position in illiquid conditions.
The problem in silver is that manufacturers are running long positions. Mindful of silver’s volatility they are locking in low silver prices to secure their operating margins. Nevertheless, the bullion banks have managed to stick it to the managed money category, whose short position is truly extreme.
Think about it for a moment: here is a bunch of amateurish hedge funds which has sold expecting lower silver prices and is now short of 133,000,000 ounces in an illiquid market, where the manufacturers cannot get enough physical at current prices.
Meanwhile physical is disappearing fast
If ever there was proof that gold is under-priced, it is the remarkable appetite low prices have developed for physical delivery. This is now so great, particularly from China and India, that not even the liquidation of ETF holdings has been enough to make up the difference. I wrote about this two weeks ago where I demonstrated that the western central banks must be supplying the market with bullion. Their motivation is clear: to avert a developing market crisis which was evident last year as a combination of ETF, Chinese and Indian buying led to persistent bullion shortages.
The acceleration of Asian demand from China and India alone last April and May increased the global shortage of physical bullion to record levels, requiring an increased supply to the market from central banks.
The important point to note is that it is erroneously believed in the capital markets that with respect to physical supply ETF liquidation has been sufficient to match increased Asian demand. An examination of the facts shows this to be untrue: the fall in prices has generated global demand on such a scale ETF liquidation is only a minor part of the whole supply picture, and the balance of supply can only have come from western central banks.
This is now the missing piece in the jigsaw: how much more gold will be fed into the markets by central banks? We don’t know how much they have left. We don’t know how short the bullion banks in Europe are, nor do we know the true positions of other members of the London Bullion Market. But we do know central banks are panicking, as evidenced by the tapering episode. We can surmise that they expected to quash the gold price by their actions, only to find that record and unexpected levels of global demand were generated instead.
The conditions are in place for a spectacular price readjustment on valuation and economic grounds alone. Furthermore, the short positions on Comex have been transferred to the hedge funds, leaving the bullion banks less exposed to escalating systemic risks. It is now in the latters’ interests to keep their gold and silver books as level as possible as a bear squeeze on the market shorts gets under way and starts the revaluation process.