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From http://www.goldensextant.com/ on June 23, 2006 By Reginald Howe
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CURRENT COMMENTARIES
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.