Speculating On The Gold Supply

This is a guest post by Alhambra Partners. Go to the website for information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation.

What follows here, in the interest of full disclosure, is nothing more than speculative conjecture on my part. This is due mostly to the opacity that dominates gold “markets” and trading oddities that follow from it. My thoughts here are based on gut instinct about recent observations, but that is about as much to solidify any analysis as can be offered without tangible confirmation that just isn’t forthcoming.

The basic premise here is that there has been some kind of paradigm shift in gold markets in 2014, particularly in light of how gold behaved in 2013. Unlike last year, there are no highly evident and conspicuous events to confirm the presence of leasing and heavy appeals to gold as an alternate repo. And that is itself the most curious aspect of recent weeks as repo markets became quite unglued, starting at the outset of June.

Stress was beginning to appear in UST repo early on, with the 10-year repo rate almost at the 3% fail penalty (or a -3% rate) by June 4. The more “special” UST issues became, against that -3% effective rate, eventually counterparties found it economical to simply hoard collateral and pay the penalty rather than continue to take the other rehypothecated side or obtain further issues at an even more negative repo rate. That is why fails surged into the middle of June, once the 3% rate was close in hand without a realistic end to the shortage in sight (despite the theoretical “fix” offered by the regressionists of the FOMC and its Open Market Desk).

gold_prices_February_July_2014

Last year, each such repo mess was met by a cascade in gold prices, in more than one discrete episode. The mechanics of gold as collateral, which is called “leasing” but really is just another form of collateralized lending interbank, are very much price negative. So to see not only the absence of heavy leasing pressuring gold much lower but an actual and sharp rise in gold prices is more than suggestive of something far different.

To this point I have been somewhat reluctant to speculate on part of that equation, focusing more on what I think is a more solid deduction about the bid side – namely the buoyancy of gold driven by a bid for safety. It seems, given the quite durable range into which gold has clearly fallen, that perhaps an increase in bid for “tail risk” insurance in the near-certain absence of central bank “cover” in the coming months may be a balancing variable in prices.

That seems to be echoed by other more esoteric indications, particularly option skews, which show a more determined hedge appeal. Yet, I don’t think we are really at the point where enough fear, or even uncertainty, has really been “allowed” back into the collective investor psyche to be a match for leasing negativity. Gold as collateral operates not as a gentle nudge lower in price, but as a hammer that often shows up in quantity all at once (the leasing counterparty, the cash owner that is lending cash and receiving gold as collateral, pays little attention to price since they are simply trying to arb a spread and have likely been overcollateralized at the outset).

If that is right, then the only way to account for the lack of downward pressure on gold coincident to its usual collateral place is to surmise that the supply of gold as such may be interrupted. In terms of leasing and pricing, that is what we are really aiming for, as gold leasing is not simply the churn of physical metal from one hand to the next, but rather the addition of deep storage bullion, and largely from central banks. In other words, it is highly additive supply, as what was formerly “non-market” gold hits the “market” hard.

In April last year, amidst the gold bear jubilation of one such event, I recounted an “operation” whereby the light of accounting actually “caught” the BIS engaging in exactly this. The timing of these maneuvers leaves little to be doubted about how gold was ultimately being used; without much reservation the implication of this was collateral as certain European banks were undoubtedly reaching their funding limits in the months just prior to the ECB’s first systemic liquidity program:

Back in July 2010, the Wall Street Journal caused some commotion when it happened to notice in the annual report for the Bank for International Settlements the sudden appearance of gold swap operations to the tune of 346 tons. Subsequent investigation by media outlets, including the Financial Times, reported that the BIS had indeed swapped in 346 tons of gold holdings from ten European commercial banks. That was highly unusual in that gold swaps are typically conducted between and among central banks.

Included in that list of commercial banks were, according to the Financial Times, HSBC, BNP Paribas and Société Générale. The timing of the swaps was pinned down to sometime between December 2009 and January 2010 – just as the world was getting reacquainted with the Greek Republic.

That was just one episode that we know about, and was not likely done in isolation but probably as part of a coordinated operation (as they so often are post-2007).
If there is, however in 2014, an interruption in central bank “supplies” of gold for collateral, then that might offer a richer and more contoured explanation as to why there is seemingly no longer a link between repo problems and gold decay. And it is here where you head off into the truly speculative, trying to reason why the world’s central banks, or their own central bank (BIS), would suddenly be absent. The primary pools of deep storage gold that supply this collateral are either there or in unallocated storage pools of custodian banks.

That would seem to suggest, again in nothing more than unenlightened conjecture, that either central banks are hard pressed to release more deep storage (Germany asking for its metal, or Austria and Switzerland demanding more account?) or custodial bank customers are no longer as pliant about property exigencies (unallocated gold is property of the bank, with the customer holding nothing more than a financial claim), or some combination of the two. Whatever the case, the level of selling pressure in 2014 is quite the opposite of 2013. Given the constant of the repo variable (if nothing else, repo problems are noticeably worse this year) that points to a gold “supply” factor away from interbank necessities.

Seeing recent gold behavior, I cannot help but wonder if this is actually the case, with a supply side theory providing a more wide-ranging, but still highly circumstantial, explanation beyond just the bid side of safety.

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