Sky Blue Monthly (July 2000)
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July 1, 2000
Gold Carry Trade
The following is an analysis on Mr. Martin Armstrong's paper "Gold: Manipulation or Exaggeration?" (http://www.pei-intl.com/TOPICS/GOLD0699.HTM) His paper is very thoughtful. We agree with most of his points, but we disagree with his analysis on Gold Carry Trade and we came to an opposite conclusion. The quotes from his paper will be printed bold and black. If we agree with Mr. Armstrong's points, our comments will be printed bold and blue. If we disagree with his points, our analyses will be printed bold and red. Here we go:
(This issue of Sky Blue Monthly is published online much earlier than usual due to high number of requests from our readers who were interested in this particular subject. The actual date of publication of this issue is June 8, 2000. The "official" date of publication is July 1, 2000 -- see above.)
A two-man army calling itself GATA has begun to besiege the media attempting to gain a lot of press on the platform that gold is being "manipulated" by a cartel of investment banks.
(GATA may have an overly high profile. However, in a democratic country, people can express what they believe freely. Actually, we will be pleased if both sides debate the issue openly because people will learn more about the market.)
They constantly point to what they call the huge "carry trade" in gold were there is far more gold sold than exists. The basic tenents of the commodity markets, be it cash or futures, is that every position is offset by an equal and opposite position. There cannot be more outstanding short positions than long positions, yet the total number of positions combined can far exceed the actual supply.
(Exactly! Mr. Armstrong did a good job on explaining the nature of commodity markets -- both cash and futures.)
However, the same thing can happen in S&P 500 futures or even US 30-year bond futures. That is the nature of the free markets. Those who own a commodity have the right to sell it, lend it or hedge it to someone else who is willing to take the other side for whatever reason, be it hedging a future use or betting on the next bull market.
Above all – this single misconception has been man’s greatest downfall! For during almost every great financial panic in history, government has launched intrusive investigations seeking to uncover that horrible short position that has manipulated the entire marketplace through its sheer ability to overpower it with size. Every investigation to date has begun with that misguided belief that a short position can be larger than a long position, failing to understand in the process that all positions must balance. In the wake of the Panic of 1907, short selling was declared a criminal act despite the fact that they never found that horrible person who overpowered the marketplace. Fortunately, the US Supreme Court struck down that law against short selling and the free market went on. The true cause of the decline was only finally revealed as a cash flow problem, which in turn gave birth to the Federal Reserve 6 years later.
(Again, Mr. Armstrong did a very good job here. We agree with his point completely. Actually, we had written something very similar: "We believe that every market crash in human history was caused, is caused, and will be caused by liquidation by the holders.")
An investigation was launched following the Crash of 1929 from which the SEC was born. People from all over the country were questioned by Congress and accused, without evidence, of somehow being short behind the scenes. The mere accusation made against people ruined their reputations and provided the basis that launched a thousand lawsuits. When the evidence was finally collected, all the famous names were found to have been long – not short. From Rockefeller on down, they all lost staggering amounts of money. The multimillion-dollar short position never surfaced once again. The same was true following the Crash of 1987. Those who should have been short as a hedge against their stock portfolios were in fact found to have been significantly under hedged. No massive short position ever surfaced from the 1987 investigation and they imposed circuit breakers that needed to be revised in 1997.
(Mr. Armstrong was on a roll. His analyses on 1929 and 1987 were excellent and right on the money. Another paper by Mr. Armstrong, titled "The Greatest Bull Market In History", is simply the best study on the Great Depression that we have ever read. This wonder piece can be found at PEI:http://www.pei-us.com/Research/GBM/GBM-MAST.HTM. We want to show our appreciation on PEI's generosity to make it available online.)
The "carry trade" in gold that has been the subject of much discussion is seriously misunderstood. There are those who would like to point to this position as the cause for the decline in gold. They are dead wrong. The "carry trade" in the OTC gold market has been around for years. The Arabs have used gold as a means to earn interest without calling it interest. Islam forbids the lending of money for interest known as the "sin of usury". The Arabs have used the carry trade in gold since the early 1980s. They buy spot and sell forward and collect the "carry" or premium on a back month. This premium is a reflection of the cost to "carry" a gold position. If you buy the current spot and sell the forward, you earn that net difference without being exposed to the price fluctuation of gold itself. In reality, the investment banks can book billions of dollars of such transactions that have NO impact or relevance to the gold market. Technically, the Arabs are not receiving interest but instead they are buying gold today and selling it for a few dollars more 3 months out. These profits are allowed under Islam, whereas normal interest earnings are forbidden.
(These gold trades by the Arabs are not dynamic in nature, according to our unique Far-from-equilibrium Macro Economic Theory (FFEE). Therefore, Mr. Armstrong was right again on his analysis. Nevertheless, if any dynamic factor is present, the analysis must be done differently by applying FFEE on the causes and effects of any dynamic factor. More on this as we move on.)
The Japanese are also involved in the "carry trade" in gold. Public futures funds in Japan are still regulated under the commodity acts even if they trade Nikkei or S&P500 futures. Since the definition of ALL futures funds remains that of a "commodity" fund according to Japanese regulation, there is a strict investment guideline. ALL futures funds must be invested 50% at all times in commodities. Hence, the Japanese futures funds are also using the gold "carry trade" in order to meet the crazy requirement that the fund must be invested 50% in commodities at all times. Again, gold is purchased on the spot and sold forward without risk. Again, this becomes a paper transaction where a bank will certify that there is a trade on their books thus allowing the fund to meet its requirements for being invested 50% in commodities at all times. The balance of the fund then CANNOT be invested in commodities and off they go into the financial futures world trading Nikkei, JGBs, S&P500 and the like.
(These gold trades by the Japanese are not dynamic in nature, according to our FFEE. Mr. Armstrong was right on this one again.)
Of course, the last type of this "carry trade" involves the mining companies. Here, gold is sold forward in order for a company to plan its operating expenses. A budget can be established only if there is some assured return for their production. Others may borrow gold on an interest rate differential. In this case, a gold loan comes with a lower interest rate. The gold is sold on the spot and the loan is repaid from future production. It is a cheap means of acquiring financing. Interest on gold loans tend to be lower because it is a dead asset on the books of its owners since there is no income and often there is storage and insurance costs. Consumers of such loans are typically mining companies or manufacturers. The granter of gold loans are holders including central banks. Holding gold without lending can be very costly, but by lending the gold a holder retains ownership since the borrower is committed to repay the loan in gold plus interest thereby reducing the holding costs.
(We spot a dynamic factor in this type of carry trade. Let us refer this type of carry trade involving the gold mining companies and other traders who borrow gold on an interest rate differential as the "Gold Carry Trade". Gold Carry Trade occurs because of the forward selling by the gold mining industry. To hedge against potential price swings in gold, gold producers have been doing forward selling against their gold mines (still in the ground). By accelerating future supply, the gold mining industry has exacerbated its woes. In trying to protect against the downside, hedgers have magnified it. Wait a minute... What about the delivery when futures contract reaches expiration? Shorts must deliver gold and buyers must take the delivery. Gold still in the ground doesn't count. So, gold mining firms (or those who do the forward selling for the producers) borrow gold from central banks (and pay interest for this gold lease, of course) and deliver it. Some "bright" traders can actually do this Gold Carry Trade themselves -- borrow gold at a low interest rate (lease rate) from central banks, then sell gold at the market, after that, use the acquired USD to buy T-Bond. As the Gold Carry Trade and the forward selling of gold continue, gold price is becoming weaker and weaker. This makes Gold Carry Trade even more profitable. (This Gold Carry Trade is dynamic: Forward selling of gold in the market --> Gold price declines --> Gold Carry Trade becomes more profitable --> More traders decide to do the Gold Carry Trade --> More forward selling of gold in the market --> Gold price declines even further --> Gold Carry Trade becomes even more profitable --> Even more traders decide to do the Gold Carry Trade --> …) Since this factor is dynamic, there will be no equilibrium. In fact, as time passes, Gold Carry Trade is strengthening and as a result, we are moving further away from the equilibrium and gold price simply collapses. As long as the interest rate for gold leasing is lower than the yield of T-Bond, this "looks" like "free money". But there is one big potential risk. The cost of Gold Carry Trade is expressed in the price of gold, while the profit of Gold Carry Trade is calculated in US Dollar. If the price of gold goes up against USD, the profit will sink and the cost will skyrocket. In other words, if the price of gold rises against USD, this Gold Carry Trade has to be unwound. And those who have been doing Gold Carry Trade will be in deep financial trouble. Gold Carry Trade will not last forever, simply because central banks don't have unlimited amount of gold to lease. The beginning and the end of a Carry Trade are not symmetrical because, at the formation of a Carry Trade, the volume is at a minimum; at the time when a Carry Trade is unwound, the volume is at a maximum. We had better use an analogy here: Imagine that you are at a theatre. Before the show, few are in the theatre and some are just coming in. If fire breaks out, these guys, of course, head toward the exit doors and no one gets hurt. During the show, the theatre is packed. If fire breaks out, the crowd rush to the exits. Because there are so many people trying to escape through a few doors, some are trapped inside the theatre. Hence, tragedy occurs. Same thing happens when a Carry Trade is unwound. We believe that every market crash in human history was caused, is caused, and will be caused by liquidation by the holders. Due to the huge volume, the unwinding of a Carry Trade will be compressed within a very short time frame. The consequence will be catastrophic. We expect the end of Gold Carry Trade will not be an exception.)
Gold is no more being manipulated today in some grand conspiracy than it was going into the 1980 high.
(If you agree with our analysis above, you will also agree with Mr. Armstrong's point that gold is not being manipulated. But, this does not mean that gold is at equilibrium. Because of the dynamic factor that we studied above, gold is now far from equilibrium. You can say that gold is under-valued due to the dynamic nature of Gold Carry Trade. However, you can't say that gold is manipulated, UNLESS you can prove that gold lease rates are kept artificially low by the central banks. We won't try to prove that. That's your job if you believe the conspiracy theory.)
(The rest of the article is not essential to the study of Gold Carry Trade -- Some were Mr. Armstrong's forecasting records; some were his price projections on gold on June 10, 1999; and others were simply off topic. Therefore, we won't comment further. One thing, however, caught our attention. Mr. Armstrong wrote: "if one wants to discuss manipulations, the gold standard was the biggest manipulation of all by keeping the value of gold fixed while the supply of money increased. Gold was NOT money; it was merely a store of wealth in which money was expressed. This is why the gold standard collapsed."
We believe that he was right in a strange way. Theoretically, gold standard is not a manipulation. But, in reality, governments linked their currencies and gold prices at a fix rate but could not help increasing money supply. Then, it became a manipulation. Soviet Union did something very similar. First, Soviet Union fixed its currency -- "1 Soviet Ruble = 1 US Dollar". Then, it could not help increasing money supply to pump up their inefficient industries. After that, a black market came into existence: one Soviet Ruble only worth a tiny fraction of one US Dollar. Same thing occurred on gold in late 1960's. Due to the increasing money supply, one US Dollar really did not worth 1/35 ounce of gold. If you had been the boss of a gold mining firm in 1960's, would you have gone out to invest big time to search for a new gold mine or to speed up your gold mining production? Would you? Of course not! You would have lost money doing that because money supply was increasing faster than what the gold standard allowed. There was no incentive to go into the gold business. Hence, supply declined and this set up the great bull gold market in late 1970's. Therefore, Mr. Armstrong was right that gold was manipulated under gold standard because governments didn't follow the rule.
Mr. Armstrong also wrote that "Gold was NOT money; it was merely a store of wealth in which money was expressed." Was gold money? We need the definition of money before we can move on. The definition and function of money are: "Money is anything that is widely accepted as a medium of exchange. It serves as a means of payment for almost all goods and services; hence, it reduces the transaction cost of exchange and simplifies the process of exchange." Before Bretton Woods system (1947-1971) collapsed, gold was money, of course. After its collapse, we guess Mr. Armstrong can argue that gold has not been "money" because gold has not been used as a medium of exchange since 1971. (We don't know if this was his intention.) This is "unusual" in human history and it is something new.)
We hope this issue of Sky Blue Monthly can clarify the Gold Carry Trade. If you want to prove that there has been a conspiracy in the gold market, you have to prove that central banks have kept Gold Lease Rates artificially low. This is the subject that should be left for the experts in precious metals. (Translation: We won't even try to take on this Gold Lease Rates issue.)
Important: The structure of Sky Blue Monthly has changed. We launched our e-mail hotline on April 11, 2000. This new e-mail hotline is named Sky Blue Express. To keep up with the latest developments in stock, bond and currency markets, we have to update our analyses as new events unfold; and we use our e-mail hotline (Sky Blue Express) to inform our readers. Therefore, most of our outlooks, forecasts, and analyses are moved from Sky Blue Monthly to Sky Blue Express. Sky Blue Express is written irregularly -- it depends on when and if new economic events occur. To subscribe Sky Blue Express, simply send an e-mail to email@example.com. Sky Blue Express, like Sky Blue Monthly, is free. We have written 2 papers for Sky Blue Express subscribers: (1) "Economic History According to FFEE" and (2) "The Effects of Excessive Money Creation & Credit Expansion". These 2 papers contain a lot of basic economic concepts that will help you understand both Sky Blue Express and Sky Blue Monthly.
August 2000 issue of Sky Blue Monthly will be available by August 14, 2000.
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