Monday, April 22, 2013

Euro Conversion

One of the things I often do with this blog is to attempt to decipher some of the tougher concepts expressed by Another and FOA. I try to get into their heads and figure out what they really meant so that I can rephrase it in a way that (to me at least) is easier to understand.  This is one of those posts. 

The following question came to me via email from "Solitary Monk" who took his name from a comment left by Woland referring to the fact that he had "preserved our 'Library of Alexandria' from destruction" with the AFTER (THOUGHTS!)  archive. Another contribution from SM was the "threshold levels of understanding" concept which first appeared in this post and seems to be more relevant with each passing day:

I think that there are "threshold levels of understanding" required to 1) buy, 2) hold until the transition begins, and 3) hold through the transition. Each requires a greater level of understanding. I can see from your writings that you know some people will make it through 1) and 2), but not 3). I've been working for a long time to prepare myself to get through 3). Your blog posts are one way to help with that.

Even though he has not commented on the blog, Solitary Monk has been on the Gold Trail since 1998 (15 years now) and he obviously enjoys quiet contemplation followed by insightful emails which he leaves up to me to decide whether or not to use them on the blog. So I figured I'd go ahead and answer his email with a post.  I'm sure he won't mind.  ;D  His words are in red, FOA is in blue and I am in black:

There is one part of the gold trail that I have never fully understood. I do understand it conceptually, which is all that is really necessary, but it’s been bugging me for years. And now, it might not be that far away.

As we already clearly understand, paper gold markets tank, paper gold loses credibility, there is a rush for physical, and then there is no more physical available.

Next comes the part where I don’t completely understand the details. But conceptually it goes like this:

With no more physical available, there is a rush to exchange remaining dollar gold loans for euro gold loans which puts downward pressure on the dollar, upward pressure on the euro. The dollar exchange rate tanks. Hyperinflation here we come.

Perhaps you can enlighten me? And I’m sure your readers would find an FOFOA-style explanation of all this of value as well since it’s what’s coming right after gold goes into hiding.

Following are quotes from the trail regarding this. I have bolded certain parts and added some questions in red.
Solitary Monk

== == == ==
FOA: Perhaps, "this new gold supply", it was for the purchase of "time".

If oil was about to go off the "dollar reserve standard" and allow pricing in all currencies, and "the physical gold currency" was to be the most economical way to purchase, then I would say, "time was a valued purchase", yes? It is in this "purchased time", the world finds the creation of a "new reserve currency". The dollar, is today, strong in nature of a low gold price. Tomorrow, it will be the Euro that will find strength in a low gold price! Perhaps, these dollar "gold loans" will be called in to become "Euro gold loans"? "Gold priced in the thousands of USDs does not change this currency, it changes your perception of wealth"

SM: What makes a gold loan a dollar gold loan or a euro gold loan? My understanding is that you are owed gold. So, where do dollars and euros come in? As best I can figure it out, it means nothing other than the jurisdiction in which the loan was made. If it was initiated within a euro country, it’s a euro gold loan. Otherwise, it’s a dollar gold loan.
Also, note the use of “will be called in.” It’s not entirely clear to me who is demanding what. As best I can figure out, the holder is demanding gold, and the counterparty, aided by the powers that be in the US at least are saying “No, you cannot have gold and, in fact, we are going to force you to take dollars.”

Hello SM,

Great question for a post!  "Will be called in" tells me that the lender is calling in the loan to force immediate repayment, or in the impossibility of repayment, perhaps restructuring the terms of repayment.  Yes, the loans were denominated in gold ounces, that is to say that one troy ounce of gold (XAU) was the unit of account.  But what was actually lent was dollars, and what must be paid back in extremis is dollars.  It is a basic principle that you cannot force repayment of a physical item, just like the tractor analogy with the shuttered tractor factory.  Suppose a mine is destroyed by collapse or landslide, or it simply goes bankrupt.  Which brings us to who most of these gold-denominated debtors were. 

It was mostly the mines. The second largest group was hedge funds. But most of these loans are closed out now, while they were very common when FOA wrote the above. Even so, I think this "euro conversion" is worth exploring because it may still be applicable to the LBMA paper gold market, at least to its European customers. ;D 

The loans were from the BBs to the mines and the hedgefunds, and, on a much smaller scale, to the gold fabricators and industrial users. But in order to resell these notes to the East and to Oil who like their physical, the CBs stood behind them with their gold leases to the BBs. That guarantee gave the paper the credibility it needed for buyers who actually wanted the physical from the mines. A lot of those CB leases have been unwound now as well, although some do remain on the books.  So those could certainly be restructured with euro as the ultimate payment instead of dollars. 

Imagine we have the collapse of the paper gold market and the BBs still owe X tonnes to the CBs. In extremis, they can only pay back those loans at the cash equivalent of the price of gold.  But they were the ones who set that price of gold in their now-failed paper gold market. Do you think they can get away with paying back the CBs at the defunct low price of $200/oz. now that their market has failed to deliver? 

I don't think so. I think the CBs would reestablish a physical-only market pretty quickly and that market would establish the cash price at which the BBs could retire their obligation to the CBs.  Meanwhile, the dollar would be collapsing which, in reality, means an extreme shortage of dollars.  No matter how many dollars the BBs could get a hold of, the FPOG (Freegold price of gold) would be outrunning them, making repayment impossible and restructure or default the only remaining options. And with their creditor being their new overlord, restructure becomes the only option if they want to keep operating. 

So how is this good for the euro and bad for the dollar?  Well, if you need dollars to buy something or service a debt, this is usage demand, and this adds strength to the dollar, no?  Think of poor countries with IMF loans, and the effect of having oil and other commodities priced in dollars. These are both dollar-positive, are they not? And so through conversion, dollar demand is reduced while supply remains, which will be dollar-negative and euro-positive as the outward flow of dollars (from the US) turns inward. 

This will also be good for the BBs, because euro will be in plentiful supply while dollars will be in short supply (which is the case when a currency is collapsing in value), and gold will be stable in euros while it is anything but stable in dollars.  And the UoA for the loans is gold ounces, so that means the amount owed will be stable in euro while it was previously skyrocketing in scarce dollars.  A win-win for everyone involved.  Well, almost everyone.  ;D

== == == ==

One day soon, this "paper gold item" may lose it's "integrity from oil" by way of "competition" from a new reserve currency! In that day, "paper gold" will rush to become "physical gold" as "dollar gold contracts" rush to become "Euro gold contracts". You see, the value of the gold lost from the Euro CB sales will return in the form of a "Euro strong in gold". The "gold reserves" held for the EURO will offer strength, but it will be the total destruction of the dollar gold market that does make " this currency go home"!

I assume, but don’t know for sure, that “paper gold” means unallocated gold, and “gold contract” means a gold loan and a right to future delivery.

This paragraph seems to imply that this will lead to dollar spending in the US, but the mechanism isn’t clear to me.

I think that "integrity from oil" means that the GOR (gold oil ratio) will depart its 67-year range (of between 9 and 29) in dramatic fashion.  If we look back over 67 years, "paper gold" was simply dollars before 1971 and today it's mostly LBMA unallocated gold-ounce-denominated accounts.  And it is the convertability of this "paper gold" that has kept the GOR in its range. 

With convertibility gone, "this "paper gold item" may lose it's "integrity from oil" by way of "competition" from a new reserve currency [that offers the reestablishment of credible convertibility]."  Does that first sentence make more sense now? 

"In that day, "paper gold" will rush to become "physical gold"..."  This part is pretty self-explanatory.

" "dollar gold contracts" rush to become "Euro gold contracts"."  Just like I said above, if you are either party (creditor or debtor), you would rather have your loan payable in extremis in a stable, knowable amount than a crazily rising, impossible to achieve amount, no? 

And, once again, all of these dollar-denominated trading accounts outside of the US do require actual Realdollars (US base money, either cash or liabilities tied directly to the Fed or through a US bank with an account at the Fed) for clearing, even if not for every single transaction.  This principle lends strength to the flow that can be described as Realdollars heading outward from the US while real goods and services head inward, aka the trade deficit.  So the conversion of this need for dollars to, instead, a need for euros for clearing, will contribute to the reversal of that flow I just described. 

Think of every transaction as one side being the traded commodity and the other side being the money.  Even in currency trading, one currency is the traded commodity and the other is the money.  Today, the USD is the "money" (or the denominator) in most of the global markets.  This requires real US dollars for clearing.  So imagine the simple change of using a different money, and what impact that change will have on the flow I described above.  It will make the current glut of homeless dollars want to "go home" as FOA said.

Here's a short paragraph I found in a
tutorial that explains how the dollar is the main axis of most transactions today. This adds demand for dollars everywhere in the world:
In EUR-USD, the first currency which is Euro is the commodity and the second currency which is USD is the money. When you buy EUR-USD, in fact you pay USD to buy Euro. No matter in what currency your forex trading account is. You can have a trading account in USD, GBP, CAD or any other currency. When you want to buy EUR-USD, your broker changes your trading account capital into USD and then pays that USD to buy Euro. This is how it works. Any trade in forex market has to be done through USD. US dollar is the main currency and is the axis of all transactions in the forex market. Any currency pair that you buy or sell has to be done through USD. However, all of these process will be done automatically and you just need to click on the buy or sell buttons.

 == == == ==

Initially, they built the Euro with little talk of gold, all the while building a paper gold market that is dollar settlement based. By increasing the Gold Trading Market with paper gold, it not only drove the gold price down, but gave these contracts credibility as they could be settled in a strong dollar via gold. The hook came when they suddenly wanted gold as part of the reserves for the Euro! Now the BIS just stops supporting the London market with Central Bank gold loans and sales. By the time for the Euro to debut , gold starts to rise through the $360 area, there by breaking the entire dollar based paper gold market! Every oil state, and anyone else that is holding paper gold, will try to first exchange it for physical. After that guess who will be waiting with a brand new hard world reserve currency, ready made for converting dollar gold loans into Euro gold loans!

So, it sounds as if the euro block will facilitate / encourage this conversion. Just trying to be helpful?

Yes, it does sound like that's the plan!  Helpful?  Sure!  Why not?  To me, being "strong in gold" means being relatively stable in gold such that physical redemption/convertibility is possible anywhere, at any time, by anyone.  And, once again, most of these "dollar gold loans" are already closed out.  So now I'm thinking more about the massive amount of paper gold, backed by complex derivatives held by the BBs. 

Let's look at that last sentence a different way:

After that guess who will be waiting with a brand new hard world reserve currency, ready made for converting dollar gold liabilities/credits into Euro gold liabilities/credits!

As the paper gold market fails, the derivatives backing the BB's gold-ounce-denominated liabilities will fail to be able to bring in (buy) the metal required for redemption. Say the paper market stops trading at $250 per ounce.  There will be ounce-denominated liabilities that still exist, and they can now be settled for $250 instead of a real ounce because, like I said, in extremis you cannot force repayment of a physical item.  But will they all be closed out in exchange for USD250?  Perhaps not. 

Here's a better alternative for everyone involved.  Remember that if repayment becomes impossible, then the alternatives are restructuring or default.  And if the banks want to keep operating in the new system, restructuring becomes the only option.  So, even as the paper market dies at $250 per ounce, the real price of physical gold will be much higher, and the operators of the new system know this.  So perhaps they would rather not let the BBs cash everyone in a currency that gold is running away from when they could be cashed out in a currency that is "strong" (stable) in physical gold. 

The new gold price in dollar terms will be soaring as the USG is printing like mad, but the euro price for an ounce will be stable.  So even in the time it takes to cash everyone out in dollars, the amount of real gold each cashed-out customer could buy on the physical market is diminishing quickly. That's what happens when a currency collapses/hyperinflates.  On the other hand, you could lock in everyone's physical Freegold purchasing power on a moment's notice by converting all of those USD250 liabilities into EUR liabilities at the going exchange rate of that moment. 

Think of it like this:  The moment the paper market stops trading, physical gold is now $55,000 and you have 220 "ounces" in your BB trading account.  Each of those "ounces" is only worth $250 now.  If you could get that cash fast enough, you could buy one single ounce on the new physical market. But it takes time for them to cash everyone out and for everyone to go buy that physical. And during that time, the dollar is collapsing.  So your physical gold-denominated purchasing power is going to decline rapidly from a single ounce, to 3/4 of an ounce, to half an ounce and so on. 

If, on the other hand, the BIS/ECB and the BBs agreed to do the euro conversion, there would be no rush. You (as a BB customer) would still only get a single ounce of physical for your 220 "ounces" of BB credits, but at least you would now be locked into that full ounce and the BBs could cash everyone out at a more leisurely pace since I'm sure there will be plenty more pressing concerns at that moment. 

How could this conversion be facilitated by the ECB?  Easy!  Print the new euro for the banks in exchange for their derivative "assets" which are mostly dollar-denominated. The next step, I guess, would be to unwind and liquidate the derivatives.  The banks are getting a great deal here, so the ECB could easily instruct them to liquidate them on behalf of the ECB and return the proceeds in EUR. This would put further downward pressure on the dollar and upward pressure on the euro. 

Of course there would be some loss and the result would be a net-increase in euro base money.  But the ECB could easily mop that up with a small sale of Eurosystem gold.  Like I said, I have no idea what the actual stock of these BB ounce-denominated credits is, but let's say it's 10,000 "tonnes".  Divide that by 220 and you get 45 tonnes, and let's say the derivative loss is 50% from the time of the euro conversion until liquidation.  Divide 45 tonnes by 2 and the Eurosystem would have to sell about 23 tonnes to mop up the extra euro that were created by the conversion. 

Today the Eurosystem has about 10,800 tonnes, so the cost of the conversion would be about 0.2% of its gold, wholly absorbed in real terms by the revaluation.
== == == ==

Euro Zone based derivatives will be supported through limited gold delivery or with Euro cash. Both will be seen as a mountain of credibility in the storm that is coming. Let's face it, if you held a Euro gold contract for 100 ounces and only ten ounces plus Euro cash are delivered, that settlement will be worth a fortune in today's terms compared to a hyper dollar world.

I think I basically explained this one above.  But he does say "limited gold delivery" is an option in addition to Euro cash.  "Limited gold delivery" would mean paying off the BB liabilities in ounces rather than euro at the new Freegold rate, so in my back-of-the-envelope calculation above, that would mean 45 tonnes, half of which could hopefully be recouped by the liquidation of (what was previously) 10,000 "tonnes" of correlated derivatives. So it's essentially the same thing.

== == == ==

The modern financing tool we call the "gold carry trade" is now becoming the poison that will kill this market. The demands of gold lenders to return their "at risk" positions are creating an atmosphere where no amount of physical gold exists that can supply the outstanding paper claims. Great blocks of gold are now lent into the markets at 4% or greater, where once 1% was considered a good return. As each new group of lenders enter the market they are followed close behind by former lenders demanding their gold return. Fear begins to grip those who were once bullion owners as they now became paper pawns. Each new demand for "full allocation" creates yet further demands to borrow. The supply of new lenders grows smaller and smaller as the possibility of default increases.

The ECB moved to block any further erosion of the Euroland position.
[This was written just after the Washington Agreement. I think that is what this refers to but I’m not sure.] Most certainly, all world gold contracts denominated in dollars [denominated in dollars???????????????] would have gravitated towards Euro conversion to best advantage the EMCB gold stocks. Indeed, in a brilliant move they have blocked that escape and doomed the dollar gold market to collapse from non delivery. The ECB can now effectively support its gold commitments thru either bullion allocation or Euro settlement. By marking to the market their gold reserves they will contrast the advantage of a dollar gold market collapse no matter what form it takes. Weather discounting of paper gold from non delivery as derivatives are sold in mass (plunging dollar gold price) or a complete run for delivery (what we are seeing now) that leaves 95% of the market shut down and still holding paper demands ( paper gold priced in the many thousands. prior to lock up), the Euro will gain reserve backing.

Yes, I'd say he was definitely referring to the WAG.  He's talking about a chain reaction where, as one paper gold holder (creditor to the BBs, remember, paper gold is a BB liability) demands allocation, the BBs have to borrow physical from someone else, creating a new paper gold holder.  The CBs were the ultimate "lender of last resort" in this chain until the WAG. 
I think I explained well enough above what he meant by "denominated in dollars".  In extremis, cash is paid.  But what cash?  Any cash?  No, I think it is probably legally limited to the "money" that priced the commodity that was bought, sold, lent or borrowed.  This is no problem as long as all the various currencies are stable and freely tradable, just like the tutorial I quoted above said:
Any currency pair that you buy or sell has to be done through USD. However, all of these process will be done automatically and you just need to click on the buy or sell buttons.
But in a crisis where the markets aren't functioning properly, this ease of exchange will break down. At that point, if you don't have the physical gold, you're better off being owed "gold-ounces" to be paid out in euros rather than than in dollars, because the euro will be in full supply and stable in gold while the dollar will be in short supply and rapidly declining in gold. 
Now when he says they "doomed the dollar gold market to collapse from non delivery" he's talking about cutting off the lender of last resort.  So the chain reaction will simply continue until there's no more gold to be allocated.  And then he says that by marking their gold reserves to market they positioned themselves for the collapse of the dollar gold market.  The collapse being from non delivery.  Once it collapses, its price is no longer real.  So at that very moment, because of the ECB's MTM rule, the ECB's price of gold will be the physical price, whatever they say it is, because they can make that market! 
He says, at this point, "The ECB can now effectively support its gold commitments thru either bullion allocation or Euro settlement."  Of course this happens at the new physical price, because that's now the price!  And any "dollar gold liabilities" can be converted to "euro gold liabilities" at the current exchange rate between the currencies at that time which will lock these liabilities back into gold in real terms.  Sure, they will have devalued, but they won't continue falling in real terms along with the dollar. 
And finally, when he says "the Euro will gain reserve backing", I think he's simply referring to the natural strength and stability the euro will have versus both the dollar and gold.  Yes, the euro will devalue against gold, but that's not really a devaluation of the euro.  It's simply a revaluation of the gold reserves, and that is another way in which the euro will gain reserve backing.  Its reserves will have been revalued. 
Additionally, as I mentioned above, the Eurosystem will probably sell some gold into the market as part of this euro conversion process, and that will put downward pressure on the (newly revalued) price of gold which will make the euro stronger in gold. 

== == == ==

What of all the gold contracts being settled in Euros? You bet! And the DRAW here, is that the ECB marks its gold market to market with the process, later, extending to using "official" gold deals as the market price, not the paper LBMA. When push comes to shove, they will settle
Euroland gold notes at the official gold price, "in EUROS"! They can do this because their currency holds exchange reserves in gold that adds value as gold rises. The extra Euros printed to supply this demand will only fill the dollar void and be represented with gold reserves. When the dollar "paper" price starts it's "final" dive into the pits by discounting it's present credibility, it will drag every contract holder with it. This risk is real and will fuel the drive that demands a new Euroland physical marketplace.

Here he mentions the "official gold deals" that will be used to MTM gold once the paper gold market fails to deliver.  And I think the most important thing to keep in mind is that, when he talks about paper gold that was formerly traded in dollars being settled in euros or physical, he's talking about the new Freegold price.  If you had paper gold of any kind, you will still lose due to the revaluation.  But with the euro conversion you will not lose any more than the amount of the revaluation, whereas if you are (in the US?) holding dollar paper gold it could easily go to near zero by the time you are cashed out in dollars and try to buy some gold with those dollars. 

Perhaps the LBMA will fail to deliver on demand at $1,200, or $907 instead of $250, and that becomes the settlement price.  Say it happens at $1,200 and the revaluation takes it to $55K in real terms.  If you thought you had 46 ounces, you'll be cashed out at about 1 ounce.  So why would the ECB want to do this rather than letting all Euroland paper gold holders suffer the fate of the dollar?  Well, gold is to be an important part of the new system, yes?  Need I say more?

== == == ==

This first run will be a benefit to Euroland as they will be called to cover the needs of many other nations that once depended on dollar based assets. But later, the world will have a reserve currency and gold to trade with and against each other. The Swiss must free up their gold by selling it for Euro reserves (in a round about way, I'm sure). In the end, weather they join the EMU or not, the ECB will eventually absorb most of the "need to sell gold" as stress becomes apparent. This settlement of many of the Euroland gold loans in Euros, will not in any way make gold less valuable. Indeed, it will keep gold liquid in the face of an initial "lock up" in contract settlement.

Perhaps this is why Euroland will facilitate conversion to euro gold loans?
Sure! Perhaps the "gold in hiding" period will be less than a day, at least in Euroland!  ;D

== == == ==

If you read my recent reply to Strad Master, then it should become apparent that William F. is not declaring war. Rather he is continuing a policy that will allow the US dollar to destroy itself. By inflating the paper gold markets into uselessness, the US has removed the only vehicle that added enough value to our dollar currency to keep oil prices in check. Now that the Euro is clearly separated from our dollar system and able to make good on its physical portion (convertible) of gold debt, we are off to the races. Oil will rise until one of the currency systems fail! With the weak nature of the US debt situation, real world price inflation will break the dollar economy first. It will also break the dollar gold system through physical demand. It will force a dollar cash settlement for failing gold banking contracts in place of physical delivery. This process will create a cascading default that literally shuts down all paper gold markets. In the meantime any perceived weakness in the Euro will be countered in a soaring physical gold price. This sudden strength in Euros will allow settlement of all optional (physical or non- physical) gold loans in Euro cash instead of dollar cash.

No question was included with this quote, so I'll just let it stand, except to remind you that this "optional" settlement in euros rather than dollars will be at the new Freegold price after converting  from gold to dollars at the crashed LBMA price, then from dollars to euros at the euro-dollar exchange rate at that time, then back to gold at the new Freegold price in euros. 

== == == ==

Your position is based on current context. This drama will appear different as it unfolds. US inflation will be driving upward, its economy slowing and our Fed printing like mad. This very trend is currently on track as we and others have been pointing out. No one thought that Allan would embark on such a confidence killing rout and it is the bankruptcy of American financial policy that is driving this. The dollar is at the end of its timeline and our expansion of derivatives was but an effort to save the system for a while.

Let's see; you have a gold loan on the books, physical supply dries up forcing a premium on metal over contract gold, the contract and futures markets freeze up and your asset in the form of loan paper is worth zero. Then the ECB in conjunction with the Euro faction of the BIS offers to restate the now worthless gold loans into Euro denominations and you are going to walk? Where? To the US?

In this context, the next reserve system is saving a portion of assets that were already destroyed by US special interest. US policy destroyed before the fact as much as the US printing presses destroyed the dollar gold ratios in 71. Think again, my friend.

Again, no question came with this quote, so I'll just make a comment.  I think it is unlikely that the paper gold market will trade all the way to zero.  Trading will have to be halted at some point and cash settlment executed to wind it all down.  We obviously don't know when or at what price this will occur.  But there are three main exchange rates that will come into play here. 

The first is the $POG at which trading is halted.  The second is the EUR-USD exchange rate at the time of any euro conversion of Euroland-based claims.  And the third is the new Freegold (revalued) price of physical in euros.  We could play with various guesses here and see how you Eurolander paper gold players will fare versus the ones elsewhere who'll be left dangling with dollars.  But if we just use my back-of-the-envelope calculations above, you Europeans could get somewhere between 1/40th and 1/220th of what you thought you had, as opposed to getting close to zero.  Not so great either way, which is why it's best to stick with physical, even in Europe! ;D

== == == ==
A process is in the works to change our dollar / gold relationship again, after derivatives were inflated beyond use. Now, even the price of gold can no longer be captured on a par basis between derivative gold paper and real physical gold as the preceived value of gold is soaring. Once a super currency inflation breeds super price inflation; the derivative markets will begin to fail their hedge purpose and their trading value. These asset themselves will become the real risk.

Dollar supporters have no choice but to "NET OUT" at even any derivative hedge that may risk the system. That is, "Net Out" in a way that completely voids their risk transferring purpose as they are settled in dollar cash "no matter what effect inflation is having on the currency's value or your other dollar assets! Remember, the financial world today turns on dollar assets that are hedged; not just pure bare holdings! Block the hedge markets from performing and the dollar itself is unseated.

Make no mistake, every official rule and regulation ever written for currency crisis management involves not only currency profile assets, but also gold profile assets. With this concept in grasp; it's easy to see, with gold derivatives so widely used in current dollar support functions today, why they will be impacted as part of the paper mass.

Modern derivative usage involves gold derivatives and a new evolving crisis policy management will function somewhat the same as in 1971. It will arrive as some "net out" policy directive and universally abrogate all gold delivery options as part of the package. Any gold derivative that is used to support dollar currency exchange rates will be reworked to implement cash settlement against all claims for international currency derivatives written for gold.

What is a “gold derivative that is used to support dollar currency exchange rates”? Any liability of a US bank, perhaps?

It seems to me like he's talking about gold derivatives used to hedge non-gold investments, perhaps even bonds whose value is tied to interest rates, as it has long been assumed that gold moves in the opposite direction.  If you buy a bunch of Treasury bonds at today's low interest rates (which supports the dollar exchange rate like when China buys Treasuries), you might be worried that interest rates could rise destroying the present value of your bonds. If that were to happen, you'd expect gold to rise, so you might hedge your large position in bonds with gold derivatives like COMEX futures options or something with a low cost and a high payout if the low-probability event happens. 

The problem is that those hedges can only perform like an FDIC sticker that gives you confidence in your position, but cannot perform in real terms if what you worry about actually happens.


Is it no wonder that Euro Banks have no fear from writing short gold paper. Because the entire Euro money profile is in the background for them. Running in parallel to and not in conjunction with the current dollar system. Any Fed policy that must break the risk transferring dynamic of derivatives, to protect our US banks, will open the door to the ECB's dumping IMF protocols and using the Euro alone as their sole reserve currency. This will immediately shift all dollar derivative plays onto the market, dynamically devaluing our dollar in the process. The ECB would then be cashing out holders of their gold loans in Euros as dollar physical gold prices spike and paper gold prices plunge.

I guess the "IMF protocols" must be at least part of the reason that dollars are the axis of most transactions today. So what he's saying is that if the Fed is forced to do anything that jeopardizes the hedging functionality of the derivative structure, the ECB will be forced to abandon this protocol and allow its banks to start using euros as the axis of transactions. And if this happens, then it would cause the unwinding and liquidation of all dollar derivatives as the banks frantically scramble to switch them to euros. As I already mentioned above, this would not only put downward pressure on the dollar, sending dollars "home", but it would do so "dynamically" as FOA so brilliantly put it.

Higher still; we climb

Of course, the big difference is that Euroland will encourage a physical only market price that, in turn, also floats Euro gold values to the sky. All in an well balanced effort to replace the massive dollar asset base it lost. In this; the Euro will become the first currency block that functions as a local reserve, yet under scores its image with huge non- monetary gold assets. Is it no wonder that EuroLand citizens will be buying gold as much for its prospects to rise as for its ability to be a wealth savings. In this it will hedge the future remains of a dollar failure and its impact on the world system.
Great paragraph!  I hope someone in particular is paying attention. ;D  

If Mr. Huge EuroLand bank owes the ECB system gold worth 100 million in current gold deals;
[why does the bank owe these to the ECB system?] with each 1,000 euro rise in gold he finds himself able to settle in less received physical gold. In a true "cashed out" transition of currency reserve hedges, each ounce of contracted gold owed could be reduced many times. Every player in the gold system, that is caught with their pants down, will rush to be a part of any Euro workout. Indeed, for every major player that was long the gold loan system, for the purpose of buying gold, cash outs in Euros will offer the only return. Official players in the oil sector would eventually be receiving American gold (but that is Another story).

SM asked why the bank would owe gold to the ECB system.  This would be a bullion bank that had leased gold from one of the Eurosystem CBs.  As I mentioned earlier, there are probably less of these leases outstanding today than there were when FOA wrote that, but we can't know for sure since they removed the lease cap from the 2009 WAG renewal.

And here, in this last paragraph, he makes it clear that "any Euro workout," any "cashouts in Euros will offer the only return."  It won't be a great return, because you will have missed out on a once-in-a-thousand-years revaluation and the opportunity of a lifetime, but it will still be better than holding a "dollar gold contract" while the dollar circles the drain.  ;D


Wednesday, April 10, 2013

Open (Window?) Forum

Hello, and sorry I've been gone so long. I've been taking a little time away from the blog to get a few things done around the house. You know, Spring cleaning and stuff like that! ;D

So let's see what's been going on… ah, yes… Cyprus! I consumed a lot of popcorn watching that blockbuster! It sure seems like something big changed in the Eurozone; almost like they're now willing to let the chips fall where they may. And, of course, we had another Snapshot day and MTM Party. Here's the result, and here are the last five snapshots to put it into context:

3/29/13 - €1,251.464
1/4/13 - €1,261.179
9/28/12 - €1,377.417
6/29/12 - €1,246.624
3/30/12 - €1,243.449

That's right, we're back where we were a year ago! In fact, we're currently at €1,213, well below a year ago, and we even dipped below €1,200 for a few hours on MTM Party day.

Meanwhile, GLD has been spilling its guts. Down to just 1,200.37 tonnes from its peak of 1,353.35 exactly four months ago. I wonder where those 153 tonnes went. Remember: for every seller there is also a buyer. And for every sale, there must be a purchase. So when you hear someone saying "sale", think "purchase", and if they're trying to say that the sale of physical from GLD explains (or is explained by) the price decline, just remember that there's much more paper being sold than physical. ;D

This is an open forum, but I'm going to give you a couple of recent discussions that I had in private to set the mood. These are topics that came up in the last thread of comments, which is why I decided to publish them here. The first one is my personal view of GLD, and the second one is about the GOR or the gold:oil ratio.

Do you remember this lead-in from FOA on 10/10/01?

"(pulling a cloth from my pocket and cleaning my glasses while talking)

On most parts of this Trail, I could walk with my eyes closed; while in other areas I would need six maps and two GPSs units just to know north! Right now, I can tell ya what's most likely out there, but in those strange areas; not really sure?"

That's kind of what this post is. While the two topics below will seem like they could each be their own post, there's a good reason why I dumped them here in an open forum. My blog is a tribute to the thoughts of Another and FOA, and these discussions fall a little bit outside the scope of the archives they left behind. So they are a little more speculative, more like my view, as opposed to theirs, but still my view as it has developed with a constant focus on their view. So take it for what it is, and that means with a grain of salt. ;D

In this first discussion, I attempted to explain my view of GLD to a friend. I am well aware of the consensus view or standard explanation of how GLD operates. I am also aware that it is considered indisputable and even fact by most industry professionals. The consensus view is basically that GLD buys and sells bullion based on an arb that the Authorized Participants (APs) take advantage of. If sellers beat GLD so hard that it trades below spot (i.e., below its Net Asset Value or NAV), the APs will buy GLD shares and redeem them for metal which they then sell and make the spread between the GLD price and the spot price. The same works in reverse when GLD trades above spot and the AP buys physical, puts it in GLD and sells the shares earning the spread. This is how GLD "tracks" the metal over time, or at least that's the consensus view assumed by most everyone to be indisputable fact.

My view is a little different. It is not a conspiracy theory, simply a different view. If you can entertain it, even without accepting it, then perhaps you can judge for yourself which of the two views does a better job explaining what we see happening in reality, what actually is indisputable fact.

GLD – The Coat-Check Room View

Hello Michael,

Re: "I currently have a gap in my understanding of how the BBs would acquire the shares of GLD necessary to drain the fund's inventory when they are in need of physical gold."

It looks like the pukes all fit comfortably inside their day's trading volume. So if the BBs need some physical fast, they should be able to just buy the shares as long as they are OK paying above the NAV to get it. But perhaps they don't even need to. Here's a paragraph taken right out of the GLD prospectus. Read it carefully and then tell me what you think. Seems to me that any AP can withdraw any amount of physical up to that which its own clients are holding in GLD shares:


Individual certificates will not be issued for the Shares. Instead, global certificates are deposited by the Trustee with DTC and registered in the name of Cede & Co., as nominee for DTC. The global certificates evidence all of the Shares outstanding at any time. Under the Trust Indenture, Shareholders are limited to: (1) DTC Participants; (2) those who maintain, either directly or indirectly, a custodial relationship with a DTC Participant, or Indirect Participants; and (3) those banks, brokers, dealers, trust companies and others who hold interests in the Shares through DTC Participants or Indirect Participants. The Shares are only transferable through the book-entry system of DTC. Shareholders who are not DTC Participants may transfer their Shares through DTC by instructing the DTC Participant holding their Shares (or by instructing the Indirect Participant or other entity through which their Shares are held) to transfer the Shares. Transfers are made in accordance with standard securities industry practice.

As far as the Trustee is concerned, all of the GLD shares are registered "in street name" which means "Cede & Co.", the nominee for DTC. And as far as DTC is concerned, the shares are shuffled around electronically on the DTC "books" between the banks and broker dealers, many of whom are also Authorized Participants in GLD.

Now please just think about this for a while. And then think about it in light of what Randy Strauss wrote, which I quoted in Who is Draining GLD:

"These are NOT actively managed funds whose gold inventory is tweaked to ebb and flow based on public sentiment in the shares. Instead, the ETFs are more like a central coat-check room in which the various bullion banks have temporarily hung out their own inventories (i.e., meaning, their unallocated stock which they hold loosely on behalf of their depositors). And whereas the claim tickets (ETF shares) may freely circulate on the open market, any significant outflow of physical inventory is simply and primarily indicative of a bullion bank reclaiming the original inventory based on a heightened need or desire for physical metal in a tightening market — for example, to meet the demands emerging from Asia."

That post was a popular one, but even to this day, more than two years later, I don't think that 99% of the people that read it understood my main point. It requires a slight shift in perspective, and I think that with this shift, a lot of what we've been discussing recently will come into focus. And after you've given this "coat check room perspective" some thought, consider these emails from Ari which I used in The View: A Classic Bank Run. I think they will help tie it all together in a comprehensive view of the BBs and their unique position at the center of the universe for all things forex, XAU, "gold", Gold and even GLD:

"A bank can be "populated" with unallocated gold accounts in two primary ways. It can either be done as a physical deposit by a silly person or by another corporate entity, or else it can occur completely in the non-physical realm as a cashflow event whereby a customer with a surplus account of forex calls up and requests to exchange some or all of it for gold units, whereupon the bank acts as a broker/dealer to cover the deal – occurring and residing on the books as an accounting event among counterparties rather than as any sort of physical purchase. No bread, no breadcrumbs, only a paper trail and metal of the mind. This is how the LBMA can report its mere subset of clearing volumes averaging in the neighborhood of 18 million ounces PER DAY. Just a whole lot of "unallocated gold" digital activity as an ongoing counterparty-squaring exercise.

It is here that I offer the eurodollar market as a very good parallel to the bullion sector of banking. While not a perfect parallel (for all the most obvious reasons) it provides a remarkably good bridge to help anyone who has a good footing on modern commercial banking to successfully cross over to that seemingly unfamiliar territory of "bullion banking". In fact, they need do little more to successfully cross over than to simply think of bullion banking ops as though they were eurodollar banking ops – the difference being that whereas eurodollar banking makes extra-sovereign use of the U.S. dollar as its accounting basis in international banking activities (thus outflanking New York's purview and restrictions), bullion banking engages in similar "extra-sovereign" use of gold ounces within its operational/accounting basis (thus outflanking and overrunning Mother Earth's domain and tangible restrictions).

And just to be sure we're on the same page, the eurodollar is not to be in any way confused with the euro, but rather stands to mean the artificial supply of "U.S. dollars" that "exist" as accounting units in off-shore banks, having originally been authentic deposits of New York's finest export, but which were then subsequently lent on – fractionalized and derivatized into a vast amorphous mass as only a network of cooperating banks can do best."

I'd like to draw your attention to two phrases Ari used in those emails I posted:

"…an ongoing counterparty-squaring exercise…

…a vast amorphous mass as only a network of cooperating banks can do best."

I think it's best to think of the banks' primary job as being that of a middleman, bringing buyers and sellers together, more so than to think of the banks as the direct counterparty their customers. And like banks do maturity transformation in traditional banking, these banks can also do "other kinds of" transformation in their "ongoing counterparty-squaring exercise" which, if you could see it all laid bare, would look like "a vast amorphous mass as only a network of cooperating banks can do best."


The APs are market makers. Your "ownership" of a GLD share is recorded in their books (or your broker's books and then your broker is listed in the AP's book). It is your credit and their liability. As far as the GLD Trust is concerned, the APs own the baskets which means they own the gold. Kind of like saying a bank "owns" its reserves. It's not a scam. It's not a conspiracy. It's just the way it is. If you can adjust your view, this will all start to make sense. I'll send you more as time allows, because this is one of those things that has been bugging me for two years… that no one seemed to understand the implication of that post.


Re: "They do need the shares to redeem the basket right?"

They already have the shares. The shares are already in their name at the DTC. So they can put in physical or take it out as needed. It is a choice they make. And it is not a choice based on the gold price, the discount or premium to the NAV or the popularity of GLD as is the common explanation for pukes and additions.

"These are NOT actively managed funds whose gold inventory is tweaked to ebb and flow based on public sentiment in the shares. Instead, the ETFs are more like a central coat-check room in which the various bullion banks have temporarily hung out their own inventories…"


Underneath this "amorphous mass" the BBs have a second job—managing the flow of physical gold. This flow has incoming and outgoing. Incoming includes supply from refineries, mints, mines and scrap supply as well as any physical gold deposits. Physical deposits are what Ari referred to as "a physical deposit by a silly person or by another corporate entity." ANOTHER put it like this: "In the beginning the CBs didn't sell their own gold. They ( thru third party ) found someone else who had bullion." So physical deposits are essentially someone giving up their allocated in exchange for unallocated (tradable) credits. That's the incoming.

The outgoing is the allocation and shipments of real physical gold. Here's how I clumsily explained it two years ago in The View: A Classic Bank Run:

"So, imagine two "gold windows" at the Bullion Bank. One is marked "incoming" and the other is marked "outgoing." At the "incoming window" you have "the West" lined up to turn in their physical gold for exchange-tradable paper liabilities. And right around the corner you have "oil" lined up taking delivery or allocation. It is this flow that allowed the oil for gold deal to go on as long as it did. But then something happened.

The thing was, the incoming flow from the mines was not exploding as hoped and expected. And the overall flow from the mines combined with the Western gold bugs puking up their private stashes was nothing compared to the sheer volume of the "oil" wealth in line around the corner. At the current price there was literally unlimited demand at the "outgoing" window and a limited supply coming in. This is what Another meant when he wrote that the oil states had already (almost inadvertently) cornered the gold market by 1997."

The BB's "second job" of managing this flow is not unlike a regular commercial bank in 1933 managing its gold coin reserves. If the reserves get too low, it needs to find more. Normally it does this by borrowing them from its central bank. But in a general bank run, even the central bank doesn't have enough reserves, which is when the people get a "bank holiday". At least that was the case before 1934.

The idea of central banking grew out of the need to pool excess reserves to avoid the unnecessary hassle of having to shop around for reserves when they are needed. A central bank is a kind of a gentleman's club or trade union in which the member banks are actually the owners and users. And in this way, GLD is very much like the central bank of the BBs in a pre-1934 sort of environment.

Unlike the physical gold that I like to buy which has a subjective value, GLD shares have a decidedly objective value. That objective value is the NAV (net asset value) ÷ the number of shares outstanding as reported (and revised) by the Trustee. The NAV is simple. It is the dollar price of an ounce of paper gold times the number of ounces held in the Trust. So if I, as a bullion bank, remove some physical from the Trust, this reduces both the number of ounces in there and the number of shares outstanding as reported by the Trustee. The market price or value of a share doesn't change. But the real value of a share changes because I have some inside information that the shareholders don't have.

Do I need to report any new short sales of these shares? Nope. No one has short sold any shares. And yet I now know that there are more shared on my books than I have in reserve. So the price isn't too high, just the number of shares believed to be held by my clients is too high. And those "shares" are actually my liabilities of GLD shares to my clients. In other words, my GLD share liabilities to my clients now exceed my GLD share reserves.

What I have to do now is buy back those excess liabilities and, as a market maker supplying a bid and offer spread to my clients, I might just be able to accomplish my goal entirely in-house simply by accommodating more sales than buys over a few days. In the meantime, I can offset my price exposure by incorporating it into my hedging operations for my much larger OTC (FOREX/XAU) side of the business.

Here's how I clumsily explained the objective value of GLD two years ago in Who is Draining GLD:

"GLD is designed to track the price of gold. It is not actively managed to track the price of gold. Instead, it does so through opportunities that arise whenever it doesn't. Imagine GLD as a big lump of gold just sitting there in Town Square. The price of gold is "discovered" elsewhere and shares in this big lump just trade based on that elsewhere-discovered price. If the share price is too high, then an opportunity exists to sell your share and buy "gold" elsewhere. Likewise, if it is too low, there is an opportunity to sell elsewhere and buy into this lump on display."

I find it useful to think of the flow of physical gold (i.e., the physical portion of the overall gold market) as separate from the paper gold market. Not that it's a separate market with a separate price—parity must be maintained—but that it's simply a flow that must be maintained and it is not an integral part of the price discovery mechanism that we call the overall gold market.

The reason price parity must be maintained is because without it the paper gold market won't function for its majority users, the "FDIC sticker" crowd. Here's where that reference comes from:

FOA: "What doesn't seem to be obvious is the "why for" the paper market grew so large. It grew to dominate because worldwide dollar expansion reached its "non-hedged" peak. In other words, the dollar's timeline was ending as its ability to produce non price inflationary economic gains came into sight.

In order to push dollar holdings further, international players needed and purchased "paper financial hedges" to balance their risk. Within their total mix of derivative hedges were found "paper gold price hedges"; modern gold derivatives. The important thing to remember is that these positions are not and never will be used to demand physical gold. They are held to buffer financial and currency risk associated with holding any form of dollar based asset. To work these items don't need to really perform "dollar price movements" in the holders favor as much as they are present in the portfolio to act as insurance stickers.

In that truth, these paper gold positions act like FDIC insurance at our banks. It can and will manage only a small determined portion of bank runs,,,,, not a full scale failure of the banking system. In a real full banking failure we would all get, perhaps, 80% of our covered $100,000 and 10% of the rest.

The same is true for these gold position's performance; real gold delivery along with true price performance, matching real bullion trading, would be only for the very few. For that matter, an actual functioning paper gold marketplace would be for the very few, too! But, in the same way a bank account owner understands the credibility of FDIC insurance when times are good; the international dollar asset owner will not grasp that modern paper gold hedges cannot be allowed to work until after a real serious price inflationary run begins."

The reason I view the physical portion of the gold market as something separate from the overall gold market is because demand for physical exerts the opposite effect on the overall market as demand for paper gold. Demand for paper gold supports the cohesion of the overall gold market and demand for physical stresses it, IMO.

What I picture in my mind is like a subterranean stream. This stream is the flow of physical gold from the mines and refiners (and all other physical gold inputs combined) into the BBs and then on to the East, "oil" and the old world Giants. With the BBs in the middle, there is always some flow coming in and some going out. And during whatever time the gold spends (or "eddies") in the possession of the BBs on its journey, it could be considered the BB's reserves (the slack in their rope). The rest of us trading paper gold look at that swirling "eddy" of BB gold and believe we have a valid bid ticket for our portion of it, even though 20 others believe the same thing. We think, "all I have to do is bid a little higher and take it! Insane, but that's what is going on! Somehow, the BIS and the major private gold holders know the total claims, as does Another. The Euro group is going to force those claims into real bids instead of just claims!" (FOA)

Over time (say, through the 80s and 90s), the size of the BBs' eddy of gold will stabilize, and then it will appear to just sit there. Everyone can look at it and say, "wow, look at all the gold those BBs have!" In fact, the very same pieces (bars) may lie very still in the same place for years and decades even, creating the illusion that they are no longer part of the subterranean flow. Once stabilized, the incoming gold is simply matched up with the outgoing and the eddy appears almost separate from the stream. But it is not.

Now picture this eddy bubbling up to a surface pool, visible to all. From the paper gold surface it appears to be a pool of still water (a hoard of physical gold lying still), but what is unseen is that the pool is actually connected to a subterranean stream deep below the surface. From time to time the level of the pool rises and falls, revealing that there's something going on under the surface, though few understand what is actually happening down there.

To most eyes, this is simply a large hoard of gold just sitting there. And there is a time value to such a hoard. Gold bars don't generate offspring, but dollars do. Enter the "coat check room idea" c.2004.

That gold "hoard" wasn't "sold to the public" as it wasn't actually owned by the BBs in the first place. It was simply their reserves, the slack in the flow, that portion of the flow of physical from one owner to its next owner that is in the temporary possession of the BBs at any given time. If enough of the global flow passes through the BBs, and if that flow is big enough, and if the portion in their possession can be stabilized, then it can appear to lie still and be "owned" by GLD investors even as it is really only an illusion of the management of the slack in the flow. This is the "coat check room" view.

I think the utility of a view or a perspective is in how it explains or clarifies what we see, and how it helps us understand events as they unfold. It is like a lens that we can look through, and it is possible to have multiple lenses in order to check the focus and field of view of one versus the other. Yet most people simply pick one lens, usually one that was handed to them or the one that everyone else seems to be using, and stick with it and it alone. It's like buying an SLR camera with an interchangeable lens and only ever using the lens that came in the box, never trying a wide angle or a really long lens.

FOA: "I (we) expect none of you to consider anything said here as credible. Everything is given as I understand it. If you came with a notion that I am someone who sees the future, grab the children and run far away. For these Thoughts, and my ongoing commentary, are meant to impact exactly as the "gentleman" said they would. People hear them, and whether believed or not, the words leave a mark. A mental mark on the trail, if you will. And later, after the world turns, our little "stacks of rocks" will be easier to understand next time you are passing this way. In fact, your ability to find your own way will forever be enhanced for having seen this path in a different light."

I just love that quote because it explains this concept of the lens in a way that disarms the critics. It's like, "here's a lens, stick it in your bag, and then maybe someday when you can't make sense of what you are seeing you'll try it on again and everything will suddenly come into focus." He's not saying, "here's the right lens for all situations, so you might as well throw away yours and superglue this one onto your camera." But like I said, it's tough to get some people to even understand that the lens that came with the camera is even removable/interchangeable.


So back to our "coat check room" lens. When I put this lens on my camera, some funny-looking things come into focus. For example, if this view is correct, then one implication is that these pukes or redemptions could actually be happening in the exact opposite direction or chain of events than the standard explanation implies (e.g., physical delivery or allocation in excess of the incoming flow is promised to someone, then it is "removed" from the Trust through a technical basket redemption, then the BB's GLD share liabilities are bought back from the public). You see this. I can tell from your replies. And yet you are still looking for some arb mechanism or some link that maintains the parity between paper and physical. What I see is that none is necessary. What I see is all that is necessary to maintain parity on the surface is that the subterranean stream doesn't run dry.

Now there are two separate things here. There is what the view reveals, the picture I see, and then there are the unseen things going on behind the scene that I can only speculate about. For those things unseen, I try to come up with a plausible explanation that fits. That doesn't necessarily mean the unseen is happening exactly that way, but it lends its plausibility to the picture and to the lens. Above, I said that redemptions could be happening in the opposite direction. But that doesn't mean that ALL redemptions MUST be happening that way for the view to be correct. Some could be happening in the standard explanation direction as well. So with this view we could say that the lens that came with your camera is not necessarily lying to you, it just isn't showing you the whole picture [if the "coat check room" view is correct].

My blog is a tribute to A/FOA, so they are my primary lens for all things within their field of view. Unfortunately GLD didn't even exist when they were writing, so I can't claim that this "coat check room" lens is precisely the same lens. In fact, it would be a mistake to assume that I give the "coat check room" view equal weighting to the A/FOA view. I certainly try to avoid giving that impression. So if I seem a little hesitant to write more extensively about the GLD pukes, or if I seem to hold back a bit of my view when I do, that is why.

Ari is my closest proxy to A/FOA, and I know through email exchanges that he shares this view of GLD which gives me additional confidence in it. Plus, of all the competing GLD lenses (I can think of two or three others if I count the ones that say there's no actual physical in the ETF), I think this one fits best with the A/FOA view, and I think it explains what we are seeing better than the others.

Anyway, the point I'm trying to get to is that fitting this view with the A/FOA view and the big picture of what we see happening today leaves me with two primary mysteries. The first is why and how a trend developed such that Lance Lewis picked up on it and even gave it a name. And the second mystery is how and why the subterranean stream hasn't frozen up yet, seeing as it was essentially cornered by the East back in 1997.

The best, simplest and most fitting explanations that I have found for these two mysteries come from Ari and Another respectively. When I add them to the big picture, I have a full view (perspective) on what is happening today that suddenly makes more sense than anything else I've seen. Whether it is exactly what is happening today is uncertain, but I have yet to see another view that even comes close to explaining everything we see.

The first mystery is why and how the price of gold tends to rise for a period after large GLD redemptions. Lance labeled it as an indication of a "significant bottom" in gold. But I'm not sure that is correct. As you pointed out, we had some large redemptions (pukes) in August 2011 near the peak. So if it's not a bottom symptom, what is it? Could it be a stress symptom? Could it simply be the visible symptom that the outgoing flow of physical suddenly overwhelmed the incoming supply?

Now it generally happens after a drop in the price of gold, even though that's not what happened in 2011. So, with my view, that would indicate a lack of demand for paper gold. In Aug. 2011 there was plenty of demand for paper gold, and then it suddenly dropped off a cliff. One explanation for that could be that the tremendous build-up of XAU paper we saw in Q1 of 2011 on the survey had to be unwound when the demand suddenly fell. Perhaps too much paper was created in Q1, preventing the price from exploding during that quarter, then when paper demand suddenly fell, the price rise seen in July and August couldn't (and didn't need to be) maintained (levitated) artificially.

But, perhaps, when the price drops in the absence of a prior large paper expansion and a subsequent (almost parabolic) price run-up, a drop in XAU paper demand (like we saw in May 2012) is more threatening to the physical flow and some sort of official support is needed at that point to prevent it from spiraling out of control. I'm talking about the combination of overwhelming physical demand which stresses the cohesion of the overall gold market combined with low paper demand giving it no support. See my posts The Two-Legged Dog and Legs for more of my thoughts about "official support" for paper gold.

As I mentioned earlier, I think that the BBs can manage "too much paper demand" on their own. They can normally keep the price from rising too fast in the face of more buy orders than sell orders by simply expanding the paper supply and delta hedging their exposure in another part of the gold market or even in correlated markets. But I think they have less control when the bottom drops out of the demand for their paper (more sell orders and very few or no buy orders). When that happens, if "artificial support" is required (for whatever reason), I think it must come from an external source with a motivation other than profit from the trade, like a CB.

And this is where Ari's "Snapshot day" theory comes into play. If that view is correct, then why not on pukes too? Perhaps (and this is just a guess), ever since late 2008 there have been two main times when the CBs step in and buy up some paper XAU on the exchanges to fill in the lack of public demand: for Snapshot days (but only when needed) and for GLD Pukes (when needed). We could call this the "official support" explanation. And, if you can accept it as plausible, I think it explains the trend better, more simply and more completely than the other explanations.

Now back to that subterranean stream. Even with the pukes, there must be some explanation as to how and why it's still flowing. If the demand was as high as Another says it was in the late 90s, and now the mine supply is roughly the same while the mines are no longer hedging 10 years out and the CBs are no longer "primary suppliers" then where is all the gold coming from to keep it flowing? This is the second mystery, and I believe that Another gave us the answer. It may be just as hard to swallow as "official support", "coat check room" and "snapshot day" for mainstream analysts who can't afford to utilize these lens, but if you accept it as plausible then it becomes the final missing piece of the puzzle. And that answer is gold *IN SIZE* being traded at a huge premium to spot and a discount to the expected revaluation price.

When Another said that the flow of physical gold was cornered, the attribution of the corner went to the Giants, both Asian (Big Trader) and Middle Eastern oil (the Saudis). If you can just satisfy these two players then the flow from the mines must be enough, as evidenced by the fact that the LBMA continues functioning today.

Earlier I mentioned that I like to think of the banks as middlemen, pairing buyers with sellers (buyers and sellers who may never meet each other), rather than the banks being the direct counterparty to each of their clients. And this view extends to the BIS brokering these *IN SIZE* deals as far as I'm concerned.

So imagine that the CBs (aka the BIS), working through a "third party" who would be the broker, finds people with gold *IN SIZE* who would be willing to part with it at a HUGE premium to the LBMA price, and they match these sellers with the Giant buyers on the other side. Both sides are getting a deal in the present, but the Giant buy side would have to be given some assurance of an inevitable revaluation. That's the catch that I can see. There must be a credible promise given. The alternative is that the Eastern Giant simply buys paper gold, as much as he wants, but for a Giant that wants physical, there must be an assurance of some kind.

Or maybe they didn't need to find Giant sellers. Maybe the ~2,100 tonnes sold by the European CBs (including the BOE) since 1999 was enough at the right price. I don't know and I don't even pretend to know. But that only takes care of the supply side. The demand side, if Another was right about gold being cornered, must have received a credible promise of some kind. And this implies a plan which implies a target date for "assertively rolling forth the freegold paradigm" as Ari wrote in 2010.

When I put all of these pieces together, they fit together like a puzzle and present a clear picture even in the absence of A/FOA's guidance for the last 11 years. The fact that it all fits together while remaining logically consistent, as well as consistent with A/FOA and what we see happening, is the best evidence I have that it is the correct view. That, and also the fact that I have yet to see another lens that explains everything plausibly and comprehensively.

Everything fits, especially Ari's read of the central bank discussions around 2005 that seemed to be pointing to 2010 as the next window. And then pushing it back after the financial crisis in 2008. And assuming that no one wants to intentionally crash the current system, which I do assume, then they must be confident that the removal of support is all it will take. And they would know this because they would also know the level of support they had been providing. The more support necessary to prop something up, the more confidence you'd have that the mere removal of support would bring it down, enough confidence, perhaps, to make assurances that would be credible enough that they would actually work to prolong the system until your targeted window. Which brings us to today.

In addition to Ari's intuition and the January 4th snapshot day, we now also have a significant string of GLD redemptions without the timely (mysterious) levitation we've grown used to seeing in the past. As Victor has been pointing out, if this time was to follow the pattern of last time (March 2012), then we should have seen a $100 increase in the $PoG by March 4. That would have been at least $1,675, instead it went nowhere. I'm not making a prediction here, just pointing out the obvious signs.

Michael, you wrote:

"My gut feeling is that 60 tonnes/week is stressful but not at the limit, and that the limit would be more like 150 tonnes in a week, and that would about hold whether it occurs in a day or evenly distributed through 5 days. But another sign of stress would be if GLD gets drained at a slow but steady and continuous rate such that its inventory drops below the 1200-1300 range. Below 1070 would be my first level to watch, and below 700 would be trouble."

I view the pukes as a visible symptom of stress under the surface. I doubt that we can accurately judge the level of stress by what we see. I think we can only know that there is stress.

Unlike a well-made, good quality glass lens, a crystal ball provides only a highly distorted, bubbly-looking image. When I look through my crystal ball right now, what I see is that we won't get to see GLD whittled down even to those ranges you mentioned. As I said above, these redemptions could be happening in a chain of events that is the reverse of what you'd normally expect. First the gold is promised to someone, then it is taken out. And if this is the case, then I'd expect at some point it all gets "promised" at once and then the music stops, the "price" is frozen and the shareholders cashed out. From my old post, The Waterfall Effect:

"The Waterfall Effect describes the "overnight" collapse of a complex system, without even the forewarning of a run up (like gold in 1980 or the dot com run up). The following two graphs demonstrate this effect as seen in the collapse of Roman money in the 3rd century AD…"

"…Entropy is the amount of chaos, disorder or unknowable elements in any system. A system has low entropy when it is highly organized, ordered, controlled, contained, and all the elements are known. A system has high entropy when it is disordered, chaotic, out of control, and many elements cannot be known. Science teaches us that everything in the universe ultimately ends in absolute entropy (chaos) through the passage of time. In other words, ashes to ashes and dust to dust.

One thing that can affect the natural progression of entropy along the way is adding energy into a system. In certain closed systems with a high degree of order and control, adding energy can actually reduce entropy, increasing organization and order. This can be seen in the wonders of life and reproduction. In the closed system of a baby, we add energy (food) and watch it grow. Ultimately, though, entropy wins out and we return to dust.

But adding energy to a system usually has the opposite effect. It speeds up the journey to absolute entropy. This can be seen in an explosion. A bomb can take an entire building from low entropy to high entropy in a fraction of a second…"

The point of mentioning this concept from an old post is that I imagine the graph of GLD inventory will ultimately look more like a waterfall than a gently-sloping stream.

You also wrote:

"FOFOA, if I understand you correctly, you are saying that GLD will always track the XAU price, and only the XAU price. Thus, GLD would be entirely drained of gold before the gold-XAU parity is broken."

A few things here… First, why is there any discussion about GLD tracking the price of gold? It tracks the price of gold because it has an objective value that includes the price of gold in its calculation formula. It tracks the price of gold because an arbitrage opportunity arises when it doesn't. An arbitrage opportunity arises because arbitrageurs believe an arbitrage opportunity arises, simple as that. It is either an actively managed fund or it is not. I think it is not. And I think the arb that keeps it close to the Comex POG is an all-paper arb simply because people (arbitrageurs) believe the opportunity is real and therefore make it real.

Second, yes, I think GLD would be de facto drained and trading stopped before parity is broken. And I expect that would all happen while you are asleep. From Unambiguous Wealth 2:

"And this is a key difference between the average guy and the big money. Big money isn't used to being kept waiting. Big money owns the "bus company". They know the buses aren't going to run before the little guy. They panic early. There was an electronic bank run around the time of the Lehman collapse. That was one of the reasons why governments around the world stepped in with fresh deposit guarantees. But there were no lines outside the banks to alert the average guy to what the Giants were up to…

There's only one way to beat the Giants to the gold, and that is to run in front of them."

Lastly, keep in mind that the price you see is a derivative (the product) of sales that already happened in the past. To us shrimps it appears to be the price of the immediate future, that is, it is the price we'll pay right now if we choose to execute our purchase. But this is only a shrimp illusion. In reality the quoted price (bid and offer—it's actually a spread and not one price) is the result of sales that already transpired.

Imagine you are a hypothetical Giant with a few billion in your briefcase and you want a lot of gold. So you fly to London and somehow get yourself in to observe the daily fix. You are waiting, calculator in hand, to hear them quote you the price you will pay for your gold, since the fix is supposedly the cash price of physical. So they call out the AM fix and you immediately step up with your cash to take advantage of this awesome deal. What do you think happens next?

Or let's say you don't care to fly to London, so you just phone up the bullion desk at JP Morgan where you've got $5B cash sitting in your account after you just liquidated your APPL shares and BTC. Let's assume you get the bullion desk on the phone just based on your name without the guy actually looking at what's in your cash account. You ask him to quote you a price for gold. He asks, "are you buying or selling." You're a clever guy so you ask, "what does it matter?" He says, "OK" and proceeds to quote you two prices, one for buying and one for selling. You immediately say, "I'll take 100 tonnes, allocated." What do you think happens next?

Let's say you're really clever and figure out how to get a lot of physical all at a good price, rather than buying over time as most Giants do. You're a little late to the big game and you need to play catch-up! Let's say you read FOFOA, you understand Freegold, and you believe my bellwether who says the technicals suggest the $PoG is heading to somewhere between $1,050 and $1,250 by the end of 2013 (he actually predicted that). Just to be safe, you figure that a price of $1,450 for all of it will make you happy!! So how would you do it?

Well, the way to do it is to lock in your price on the FOREX. If you can buy paper gold at $1,450, then you can take your time buying physical wherever you can get it, at any price, and then sell off your XAUUSD position in bits and pieces concurrent with your physical acquisitions. Even if the price skyrockets to $2K you'll still be getting it for $1,450 because the paper you'll sell will be $2K at the time you sell it. You've locked in your price!

The first problem you will encounter is that your "footprint" is too large, even for the FOREX. Your limit order of 100 tonnes at $1,450 will only be partially filled and then the price will skyrocket. You see, as the price hits $1,450 it is only a reflection of past sales. Sure, it is an offer price, but all you will get is whatever has already been offered by sellers on that exchange at $1,450. And that's just paper!

Anyway, enough hypotheticals. But I will note that it seems paper gold is used in this way to accumulate some physical. Once you own paper gold, even XAUUSD, you can either ask to have it allocated by the bullion bank and find out what they say, or you can simply use it as a locked-in price and sell it off as you buy your physical closer to home, on a slower timeline, without worrying about price changes.

I guess my point is that the price we see is always the price of the past, it is never the price of the future. And also that there are many ways the physical flow can be stressed even if the BIS has the biggest Giants in check. If enough "clever" small giants were doing this, I could imagine it would tug on the LBMA through the dealers' network. Then again, I'm sure that none of these "small giants" read FOFOA or understand Freegold, so it's probably just something else that's stressing the subterranean flow right now. Perhaps official support has been withdrawn.

Alright, I think that's enough of "my view" for today. ;D


GOR – The Gold Oil Ratio

Two years ago I started thinking about the GOR (gold oil ratio) and how it has been relatively constant ever since an American oil company first struck oil in Saudi Arabia. (Read more here. See also US Mints ‘Gold Disks’ for Oil Payments to Saudi Arabia.) Then about a year ago, while I was working on Peak Exorbitant Privilege, I noticed a correlation between the GOR and "the privilege". (Important: Always keep in mind that correlation does not necessarily imply causation.)

I don't pretend to know if the USG "wants" oil prices higher or lower. There's an argument that high oil prices support the strong dollar and the perpetual US(G) deficit, but it's a double-edged sword. What I do know is that the dollar reserve system needs oil and gold to remain correlated commodities as they have been for the last 67 years. So I think the $PoG is kind of stuck where it is right now. If gold rises, oil needs to rise in tandem or else it's curtains for the dollar reserve system. But if oil rises too much, then it's probably curtains for the dollar anyway. And if paper gold falls, well, you know what I think about that. It's what I call a Catch-22. A no-win situation for the dollar at present. It can't afford a big movement of either in either direction, IMO.

The GOR ranged from 9 up to 29 for the last 67 years. What I noticed while writing Peak Exorbitant Privilege was that the extremes of that GOR range correlated with times when the US exorbitant privilege apparently retreated quite a bit. It seems that somewhere around 15 in the GOR is the sweet spot for the $IMFS, and dropping below 9 or up to almost 30 was somehow stressful on the $IMFS (or at least indicative of stress) and something had to give. Of course, if you understand ANOTHER (which I think I do), the GOR will gap up or phase shift from this range to around 1,000 when gold is revalued in real terms. But maybe we should call that the FGOR since comparing it to the GOR is like comparing apples to oranges. Anyway, I guess I am expecting the GOR to plunge from 16 down to around 9 in the final moments before revaluation. That could either be the paper gold price falling below $900 or the oil price rising to $200. Either way, I think it will portend imminent transition to the new Freegold paradigm.

Here's the GOR data going back to 1946, the very time the world's largest oil refinery first went into production as a joint operation between the Saudis and the American oil companies (Saudi Aramco):

Annual Average

Gold and Crude Price

# of bbl Oil 1 OZ Gold will buy
Year Average $/bbl Average $/oz Ave bbl / oz
1946 $1.63 $34.71 21.294
1947 $2.16 $34.71 16.069
1948 $2.77 $34.71 12.531
1949 $2.77 $31.69 11.440
1950 $2.77 $34.72 12.534
1951 $2.77 $34.72 12.534
1952 $2.77 $34.60 12.491
1953 $2.92 $34.84 11.932
1954 $2.99 $35.04 11.719
1955 $2.93 $35.03 11.956
1956 $2.94 $34.99 11.901
1957 $3.00 $34.95 11.650
1958 $3.01 $35.10 11.661
1959 $3.00 $35.10 11.700
1960 $2.91 $35.27 12.120
1961 $2.85 $35.25 12.368
1962 $2.85 $35.23 12.361
1963 $3.00 $35.09 11.697
1964 $2.88 $35.10 12.188
1965 $3.01 $35.12 11.668
1966 $3.10 $35.13 11.332
1967 $3.12 $34.95 11.202
1968 $3.18 $39.31 12.362
1969 $3.32 $41.28 12.434
1970 $3.39 $36.02 10.625
1971 $3.60 $40.62 11.283
1972 $3.60 $58.42 16.228
1973 $4.75 $97.39 20.503
1974 $9.35 $154.00 16.471
1975 $7.67 $160.86 20.973
1976 $13.10 $124.74 9.522
1977 $14.40 $147.84 10.267
1978 $14.95 $193.40 12.936
1979 $25.10 $306.00 12.191
1980 $37.42 $615.00 16.435
1981 $35.75 $460.00 12.867
1982 $31.83 $376.00 11.813
1983 $29.08 $424.00 14.580
1984 $28.75 $361.00 12.557
1985 $26.92 $317.00 11.776
1986 $14.64 $368.00 25.137
1987 $17.50 $447.00 25.543
1988 $14.87 $437.00 29.388
1989 $18.33 $381.00 20.786
1990 $23.19 $383.51 16.538
1991 $20.19 $362.11 17.935
1992 $19.25 $343.82 17.861
1993 $16.74 $359.77 21.492
1994 $15.66 $384.00 24.521
1995 $16.75 $383.79 22.913
1996 $20.46 $387.81 18.955
1997 $18.97 $331.02 17.450
1998 $11.91 $294.24 24.705
1999 $16.55 $278.98 16.857
2000 $27.40 $279.11 10.186
2001 $23.00 $271.04 11.784
2002 $22.81 $309.73 13.579
2003 $27.69 $363.38 13.123
2004 $37.41 $409.72 10.952
2005 $50.04 $444.74 8.888
2006 $58.30 $603.46 10.351
2007 $64.20 $695.39 10.832
2008 $91.48 $871.96 9.532
2009 $53.48 $972.35 18.180
2010 $71.21 $1,224.53 17.196
2011 $87.04 $1,571.52 18.055
Average 14.771

Consider that the GOR peaked at 29.388 in 1988. That peak correlates with a dramatic drop-off in the US trade deficit from more than 30% of total trade in 1987 down to only 5% by 1991:

Here's the data from that exorbitant privilege chart which was explained in Peak Exorbitant Privilege as the percentage of US imports paid for with paper promises rather than actual exports:

1970 -4.14%
1975 -10.32%



What drew this correlation to my attention was that there is also a dramatic drop-off in the US trade deficit that corresponds with the two times the GOR hit the bottom of its range as well. So I’m considering whether both extremes might be somehow tough on the $IMFS (or at least indicative of stress—an effect or a cause of the stress?). In 1976 the GOR hit 9.522, its lowest point in 30 years, and the US trade deficit subsequently fell from 15% in 1977 down to 5% in 1981. And then in 2005 the GOR hit its lowest point ever at 8.888 which preceded a drop in the trade deficit from 35% in 2005 to 19% in 2009:

Is it possible that the correlation may have something to do with the ability of our trading partners to save their surplus production revenue? If you think about the oil price as, in general, a representation of or proxy for the general price level of goods flowing to the West, and the (paper) gold price as the determinant of the eastward flow of physical relative to the westward flow of gold, it starts to make a little sense.

With a low GOR, general prices are relatively high providing a high income to the producers, but with a low paper price for gold, the underlying physical flow might be relatively tight. So while the net-producer can get more gold by weight with his relatively higher surpluses, the Superproducer finds it difficult to get the larger quantities of physical his currency profits are telling him that he should be able to get. Notice I'm not talking just about oil Superproducers. With a low GOR everyone will have higher profits in real (gold) terms.

Look at the prices of oil and gold in 1976 and 2005 above. Oil was very high relative to gold, so oil currency profits should have brought in massive amounts of gold (by weight). But if that massive tonnage of physical gold was not readily available, this would stress the system and something might have to give, like, say, the US exorbitant privilege.

With a high GOR, on the other hand, the general price level is relatively low and, presumably, paper profits are also relatively smaller (at least relative to gold by weight). So while the Superproducers face no problem getting all the physical their paper profits say they should be able to get, they are also concerned that they are getting relatively less gold (by weight) and that, *once the (paper) GOR reverts back down to its mean*, their foregone purchasing power during that high GOR period will have been cut in half. So, perhaps, they spend more of those overseas dollars in the present which then make their way back to the US, raising the general price level and decreasing the US trade deficit.

The bottom line is that our international monetary system has needed a revaluation in the real price of gold (not just the nominal price) ever since WWI (see Once Upon a Time for more on what happened in the 1920s). That’s a monetary revaluation of gold and a monetary devaluation of the dollar (as opposed to devaluing the dollar against everything else). In 1971 they opted instead to raise the price of oil and everything else for reasons we now know (thanks to ANOTHER). But today the problem is a bit more complicated. Today they really need a gold revaluation (only physical gold revalues and nothing else).

As I have said in the past, every ounce of physical gold in the world is owned by somebody. Even the gold in the ground is ultimately owned by the sovereign of that land (in extremis). So, in essence, every last bit of physical gold in the world represents a counterpartyless asset. What this means is that a revaluation of physical does not increase anyone's liabilities. Paper gold is another story.

If paper gold were to be revalued along with physical, the increase in the nominal (meaning in terms of dollars) liabilities of the bullion banks would break the system. But what about a gradual rise in paper gold to, say, $3,500 per ounce? At a GOR of 15 that means an oil price of $233 per barrel. At a GOR of 30, oil would still be almost $20 higher than it is today and then something would have to give.

This view fits with everything else that I expect to ultimately unfold. So it seems like today's (quote-unquote) "gold" can't go much higher or lower without ushering in the new financial architecture. Sometimes I wonder if that's why we've been stuck here at $1,600 for a year and a half now. If I was supporting the current system, that's where I'd want it to stay, since any big move in either direction will be very stressful.

FOA (08/09/01; 10:27:19MT - msg#93)
"everything to do with a gold bull market"

This not only has "everything to do with a gold bull market", it has everything to do with a changing world financial architecture. And I have to admit: if you hated our last one, you will no doubt hate this new one, too. However, everyone that is positioned in physical gold will carry this storm in fantastic shape. This is because the ECB has no intentions of backing their currency with gold and every intention of using gold as a "free trading" financial reserve. None of the other metals will play a part in this.


The first time I used this song was more than three years ago, and I still feel it, more now than ever! ;)