This article is based on an interview with economic and precious metals analyst Grant Williams. He is portfolio and strategy advisor to Vulpes Investment management in Singapore and the editor of the respected newsletter Things That Make You Go Hmm (subscribe for free).
The gold and silver price have been trading in a quite counterintuitive way lately. It became very obvious after the US Fed announcement on December 13th which was a fundamentally bullish event for precious metals. Gold was trading above $1,700 an ounce but has been trading lower since then. The gold price tried only once to break above $1,700 but did not succeed. Which leaves a lot of believers and investors with the question how that is possible and if more of the same can be expected in the foreseeable future.
Grant Williams confirmed that both gold and silver have been trading in a counterintuitive way. However, the same “behavior” is detected in a lot of other markets for a long time. The reason seems obvious: government involvement. The greater the involvement, the greater the counterintuitive behavior. “The government is never a pure market force,” says Williams. “If you think about normally-functioning markets, they have minimal (and ideally zero) government involvement. The fact that we have the government as the biggest participant most notably in the bond market means that natural market forces are being corrupted.”
The government is not particularly a market participant that will be out of the markets short to medium term. Counterintuitive price behavior can be expected to continue, throughout (and very likely beyond) 2013.
Gold and silver are very thin markets, so it does not take too much effort and resources to control their direction (at least not for large investors). However, this is a double-edged sword. Because of their scale, these markets can easily reach a tipping point after which it becomes very easy for market forces to overwhelm intervention of any kind. Right now investors’ portfolio allocations in precious metals are approximately 0.5%. If that allocation would rise to 0.6% (a 20% increase) or 1% (a 100% increase), the markets would not be able to absorb those significant inflows of money without a significant upside move. “It is a question of being patient and waiting for the reality of the current situation to assert itself,” says Williams.
“You cannot expect markets always to go your way or, in fact, the way common sense or circumstance would dictate. Whether their action feels legitimate or illegitimate is besides the point. You have to check your logic for being long gold or silver and act accordingly. In my view, the case for being long precious metals has never been stronger. People should not let themselves get affected by the shadow of intervention and make the wrong decision regarding their investment holdings during periods of weakness.”
Central bank and Asia drive physical gold demand
Williams points to the importance of central bank buying. They were the biggest sellers during the first 7 years of the current bull run. Only the IMF sold more bullion, with numerous announcements of future sales in the past decade leading to sharp price drops. Nevertheless the price of gold has been rising steadily during that period. The biggest supplier of gold has, since 2009, turned into the biggest buyer and that is a hugely significant shift for any market.. “While things can look somewhat shaky in the COMEX markets at times, it’s important to understand that these prices are based on paper contracts – not physical bullion. Looking at the demand for physical metal would suggest that over time, these markets are poised to go a lot higher.” The premiums for gold and especially silver bars and coins in Asia (where Grant Williams lives) are at an all-time high.
In addition, readers should be aware that Western central banks hold between 70% and 80% of their reserves in gold. In contrast, Eastern central banks have much lower allocations. They are buying both continuously andaggressively in order to increase those allocations and decrease their exposure to fiat currency.
As discussed, small markets have difficulties in absorbing significant inflows. The supply of physical silver is already very tight, and it will not take a lot of inflows of money to cause delivery problems. Eric Sprott has witnessed this first-hand when he encountered significant delays in getting the silver delivered that he bought for his Physical Silver Trust (PSLV). In some cases, bars delivered were actually cast AFTER they were purchased. Looking at the stocks in the COMEX warehouses, it is fairly easy to see that any meaningful buying of silver futures which then stood for physical delivery would have a significant impact.
The trigger for a collapse in the confidence game
The level of government debt has become so huge that it is mathematically impossible to pay it back as we all know. Governments are desperately seeking to create inflation in order to “inflate their debts away.” Growth is absent in the economic powerhouses (Europe, UK, US). Even Asia has seen slowing growth over the past few years. Genuine growth has become a case of paying debts back through inflation.
Williams has a hard time to find positive economic statistics. Given these dire economic fundamentals, he sees many potential triggers for an economic breakdown. Such a trigger is likely to come from the bond market. Japan couldpotentially provide the tipping point, as early as 2013. With demographic imbalances, a debt to GDP ratio at an all-time high, increasing money printing from the new government, bond rates cannot go higher. The government is spending nearly 25% of all national revenue on debt service payments despite very low interest rates. With an interest rate rise to 2%, Japan would be paying roughly 50% of all government revenue on their interest alone.
The global bond market is so big and, currently, so overpriced that any kind of shift in sentiment will have ramifications across the entire investment spectrum. It will simply be a matter of time until the investment community realizes that all sovereigns are truly insolvent. “It is a confidence game in the true sense of the phrase,” says Williams. “At some point, however, confidence is going to be more inclined to look at the balance sheet.”
Suppose the Japanese bond market breaks down. The initial reaction from investors will probably be a quick move towards “safer” bond markets (like the German, UK or US). From that point, it would not require a huge leap of logic for investors to realize that Japan the canary in the coalmine. Precious metals will be positively impacted by any loss of confidence in the bond market as they are the only true safe havens left.
Since QE4, yields in the US and in Japan have started creeping higher, and the new year rally in equities has seen previous safe havens such as Germany and (surprisingly) France see sell-offs in their government bond markets as investors’ fear dissipates. These are the first signs that investors have begun adjusting their bond positions. However, as Grant Williams notes, “we are one panic away from getting everyone back in the bond market. From the governments’ perspective, should they start losing control over sovereign bond markets, all they have to do is engineer some kind of crisis of confidence and instantly people will jump back into the perceived safety of government bonds.” The political willpower is enormous and the head of the European Central Bank has explicitly stated that he will do “whatever it takes” to save the single currency and continue this confidence game.”
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