Why Isn’t Gold Higher?

My colleague and erstwhile nemesis Gonzalo Lira posed the question above in a recent essay, and it is indeed a most puzzling one. Given that the world’s central banks — joined most recently by a shockingly reckless Switzerland — are waging all-out economic war by inflating their currencies, shouldn’t gold be soaring,? In fact, prices have continued to meander between $1500 and $1700 since September of 2011, when gold topped out at $1945 after a spectacular run-up from $728 in just three years.

Why Isn’t Gold Higher?

What could have caused the bull market to go lifeless since then, even as more and more countries appear hell-bent on devaluing their currencies to keep their exports competitive? The answer that Lira has offered is novel and engaging, but it did not persuade me, perhaps because the underlying conceit seems forced. For he has likened the current gold market to the one for credit default swaps (CDS) prior to the Great Financial Crash of 2008. Because swaps provided insurance against bond defaults, they rose in value as the crisis mounted. But then, suddenly, they ceased to appreciate, Lira says, because “the markets collectively realized that the counterparties to those CDS contracts might not be able to pay up.” This, Lira asserts, is exactly what is occurring in gold, as paper certificates have come to greatly exceed the supply of ingots held in vaults. The result, he says, is that “the global precious metals markets are essentially a game of musical chairs, with far fewer seats than players—far less gold than gold holders. And market participants collectively know this. Which is why they don’t trust their counterparties. Which is why gold isn’t rising like a shot.”

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I think there’s a more convincing explanation for why gold isn’t rising, and I will get to it in a moment. But first let me say that my intention is not to assail Lira or his ideas. Even though we had a nasty spat on the Web a couple of years ago over the inflation vs. deflation conundrum, I’ve always found his essays insightful, original and well wrought. Putting aside our differences over whether the inevitable collapse of the financial system will be brought on by hyperinflation or deflation, we probably agree on 90% of the things we write about.

‘Vague’ Insurance

This time, however, his logic would seem to equate apples and oranges. To begin with, the swaps he would compare to gold are a contractual form of insurance against default risks in certain types of financial instruments. As such, it is at least theoretically possible to calculate exactly how much risk is insured, even in a market as large as mortgage securities. Gold, on the other hand, and relative to inflation, offers only a vague kind of insurance. Moreover, unlike swaps, gold does not give its owner a claim on anything.

Lira’s argument might have been more persuasive if he had simply asserted that an effectively unlimited supply of “paper gold” has been absorbing enough demand to suppress the price of physical. But if, as he evidently believes, ruinous inflation, never mind hyperinflation, were immediately in prospect, then we should have expected to see the demand for bullion soar, pushing up paper gold no matter how large the supply.

Physical vs. Paper Gold

Lira lumps paper and physical together to argue that “the current spot price of gold is reflecting market uncertainty as to who has actual gold, and who has worthless paper certificates of gold.” Again, if this were so, then we should have expected uncertainty itself to have spiked the preference of investors for physical over paper, overwhelming carry-traders and other feather merchants playing gold from the short side. And if investors were indeed worried about whether the insurance they hold is properly matched to the endgame, would they be buying the Treasury paper of a country that owes so much more than it will ever be able to repay? In fact, the risk of a U.S. default is the last thing on their minds at the moment, and it will likely remain so until the day when events no one can predict cause creditors or debtors – it will have to be one or the other – to get stiffed.

In the meantime, whither gold? My own theory as to why prices aren’t bounding above $2000 is simply this: the central banks have so far failed to produce any meaningful inflation. The untold trillions worth of stimulus they have shot at this goal have barely kept deflation at bay. Granted, prices for groceries, health care and some other necessities have gone through the roof. But the inflationary impact of all of these things together is inconsequential in comparison to the deflationary down force of a quadrillion dollar financial edifice that remains in a state of incipient collapse.

Hyperinflation Scenario

Under the circumstances, I continue to believe that deflation, rather than hyperinflation, will wreck the global financial system. I did not, by the way, “switch sides” in this argument as Gary North asserted in an essay he wrote for LewRockwell.com. It was when the debate turned unendurably ugly that I was impelled to take a closer look at what some of the hyperinflationists were saying. Peter Schiff, for one. In his scenario – which, along with the running debate at FOFOA blogspot is the most persuasive case for hyperinflation that I’ve come across — a run on the dollar would force the Fed to absorb the entire supply of Treasury paper at auction. An unintended result, says Schiff, is that ostensibly unsupported bond markets such as corporates and municipals would collapse, forcing the Fed to extend open-ended buying to all fixed-income securities.

This would most surely trigger a hyperinflation – would in fact be a hyperinflation. However, this scenario, and virtually every other hyperinflation scenario of which I am aware, envision hyperinflation occurring as a result of political decisions made, Fed actions taken and markets “rescued.” My gut feeling, however, is that the collapse of global markets will be so swift as to preclude intervention, let alone rescue. Pent-up forces will take their course, and the entire financial system will experience an instantaneous collapse for which the May 2010 Flash Crash will seem to have been just a warm-up.

Whatever we might predict about the outcome, one result that seems entirely likely is that banks in the U.S and elsewhere will not open for business the next day. Over the short-run — a few weeks, perhaps — this would be ruinously deflationary, since a hitherto inexhaustible supply of digital money will have become inaccessible via checks, ATMs or charge cards. The fragility of the clearing system that allows such money conduits to function will be tragically obvious by then, as will the distinction between cyber money and the real stuff. And you had better have some of the “real stuff” stashed away in your home, by the way, since, The Morning After, that’s the only kind of money Safeway cashiers and gas station attendants will understand. Nor should you expect them to be up to speed right away on the junk silver you’ve socked away, since, at the retail level, although perhaps not in barter circles, pre-1964 coins are likely to be treated the same as the pot-metal coins that have driven silver dimes, quarters, halfs and dollars into secure storage.

Gold Hoarders, Beware

A couple of caveats for gold hoarders. Don’t count on exchanging gold at $5000 an ounce for something with high intrinsic value, such as farmland. For all we know, supply-chain disruptions could be so severe that you’ll pay a Krugerrand just for a loaf of bread. And while it has always been possible in theory for short-squeeze pressures to push gold well above the $5000 level, this is most unlikely for reasons that Lira’s essay implicitly recognizes. Consider who is short all of that paper gold: carry-traders such as Morgan Stanley, J.P. Morgan, Goldman Sachs and other bullion bankers who have always been able to borrow gold for next to nothing. The likelihood of regulators forcing them to make good on their paper gold obligations can be dismissed in advance as negligible

Despite the seeming paradox of intrinsically worthless fiat money gaining traction in a post-apocalyptic economy, there will remain the possibility of a hyperinflationary spike. It could happen if, say, the Fed were to attempt a lump-sum pension payment to all government workers. For political reasons, this would have to be matched by similar windfall benefits to private-sector workers in the form of Social Security, welfare payments, unemployment compensation and food stamps. The Catch-22 of this approach is that any benefits in excess of what is needed to keep the economy functioning, if only barely, would touch off an inflationary spiral. Imagine how the world would react if someone in Congress merely mentioned that The Government was going to cover all of the obligations and liabilities of public and private pensions and health plans. If and when that day arrives, I will have no argument with Lira and the hyperinflationists about the likely outcome.

By Zerohedge

And gold could go to $10,000/oz

James Turk: Central Banks are Losing the War to Suppress Gold & Silver Prices

My guess is that 2013 and 2014 are going to be big up year for the precious metals, but we still have to contend with the central planners and the various government policies, which have been actively trying to keep the gold and silver prices from reaching fair value. The central planners are losing the war. They may win an occasional battle or two, but they’re losing the war, and eventually gold and silver are going to go higher.

So predicts James Turk, founder and Chairman of GoldMoney.com.

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From James’ perspective, gold is not an investment. It’s a sterile asset, meaning it does not generate income. What it is, is money. Its function is to store wealth.

But money, like investments, can be overvalued or undervalued. And what we’re witnessing on the world stage is a gross mispricing of money as central banks engage in depreciation of their fiat currencies via inflation (i.e., money printing).

The process causes a transfer of wealth from those holding overvalued money to those who hold undervalued money. That’s what’s been going on for the past decade as the price of gold has steadily marched upwards versus fiat currencies.

But this process is not efficient. Mass awareness of this wealth transfer is low, so confidence in paper currencies is still high, supporting their perceived value. Market intervention by central banks and other parties conspires to keep the prices of precious metals artificially low and suspect.

This maintains an arbitrage for individuals to buy gold and silver at a discount to true value, which James believes will be slowly realized in full over the next several years as the bull market in precious metals approaches its third and final phase.

A factor in this rise will be the increasing fragmentation of coordination among the central banks. Increasingly, central banks outside the influence of the U.S. Federal Reserve are treating the precious metals as true money, and becoming net buyers of bullion for their reserves.

Ultimately, Turk predicts the price of gold will move to somewhere between $8,000-10,000/oz and that we’ll see even higher price appreciation in silver.

The way markets normally work is, after you do have a big move, you get a correction. Even over the past 12 years, if you look at gold, you had big moves in 2005, 2006, and 2007 where you were in some years generating over 20% appreciation in gold. Then you had the correction in 2008. Even though that was a correction, gold was still up that year. Then, in 2009 and 2010 and the earlier part of 2011, you had again big moves. Then you had the correction where basically they moved sideways. My guess is that 2013 and 2014 are going to be big moves on the upside, because what’s important here is not so much the price of gold, but whether it’s a good value.

The proper way to manage a portfolio is, you move assets that are overvalued out of your portfolio and you concentrate on assets that are undervalued. That’s true regardless of whether you’re talking about investments or money. You want undervalued forms of money. You want undervalued investments. I use a couple of mathematical formulas which I’ve written a lot about, one being the Fear index and the other being the Gold money index; by both of those measures, gold is still very, very undervalued, as is silver, for that matter. Silver is even more undervalued than gold. My expectation is that these undervalued assets will continue to rise in price, because the market doesn’t like levels of overvaluation or undervaluation. The market is always constantly changing, moving money out of overvalued assets and moving into undervalued ones. And that’s what we’re basically seeing in the precious metals: people are moving out of overvalued fiat currencies and moving into undervalued gold and silver.

My guess is that 2013 and 2014 are going to be big up years, but we still have to contend with the central planners and the various government policies, which have been actively trying to keep the gold and silver prices from reaching fair value. The central planners are losing the war. They may win an occasional battle or two, but they’re losing the war, and eventually gold and silver are going to go higher – assuming that governments and central planners and central banks still continue to follow these same policies that they’ve been doing, which is defacing fiat currencies.

An interesting thing is that when we saw the price drop in gold and silver at the end of 2012, the demand for physical metal rose tremendously because people recognized that these assets are undervalued, and if they’re going to be sold down to such cheap prices, they may as well just pick them up and continue to accumulate them. So it certainly has a perverse affect when the central banks intervene. In fact, as we’ve noted, gold has risen 12 years in a row against the U.S. dollar – double-digit rates of appreciation. But I guess the best way is using an analogy. If you’ve got a pot of water boiling on the stove and it’s bubbling away, every once in a while you have to release or pull off the lid to let a little bit of steam out, and then you put the lid back on.

That’s sort of what the central planners are doing. Every year they release the lid, and gold on average has risen over the last 12 years by 16.8%. Then they put the lid back on. One of these days they’re not going to be able to put the lid back on, and you’re going to go into the third stage of a bull market where gold just keeps rising and rising and rising because confidence will be lost in the currency. I think that’s what we have to be focusing on.

I can’t say that trust between central banks is waning, but you have to recognize that there are two categories of central banks: There are central banks that are in the U.S. circle of control and dominance, and then there are central banks outside the circle of U.S. control and dominance. The ones that are outside of the U.S. control and dominance are accumulating physical gold. The ones within the U.S. control tend not to do that, although it’s interesting that Germany, Netherlands, and now Austria, too, are talking about bringing their gold back.

It’s quite clear that a lot of promises have been made, particularly by politicians and most governments around the world, and those promises cannot possibly be fulfilled. A lot of those promises are going to be broken. Particularly when it comes to the area of gold, a lot of central banks are relying on the promises of other central banks. Oh, yeah, we’ll be good for the gold if you ever ask for it. Those promises are likely to be broken as well, as the demand for physical metal continues to grow. Whether it’s going to accelerate in 2013, 2014, I don’t know. But, my guess is the demand for physical metal is indeed going to accelerate over the next couple of years, because I’m looking for serious financial problems to be hitting.

Via: Peakprosperity