Turning Up the Heat

January 31, 2000 – In recent letters I have referred time and again to the predicament of the shorts, and more specifically, to those short physical Gold. I keep getting a lot of questions on this point, so I would like to explain why the shorts are vulnerable. I will then go on to also explain why the parties behind these short positions are causing what I believe to be the on-going manipulation of the Gold price, a manipulation which is now becoming more obvious with each passing day.

In order to explain the predicament of those short physical Gold, we have to distinguish between the two types of shorts. These are the ‘physical’ shorts as opposed to the ‘paper’ shorts. Looking first at the paper shorts, we can see the duality of the opposing players who trade paper, a process that is often referred to as a zero-sum game. The futures market is typical of this type of situation.

For example, there are two sides to every futures contract, of which about 140,000 are now outstanding on the Comex. Each contract represents a commitment for 100 ounces of Gold, so in essence, persons willing to take the price risk that Gold will go higher in the future are short futures on 14 million ounces. Conversely, persons willing to take the price risk that Gold will go lower in the future are long futures on those same 14 million ounces of Gold.

This duality explains the zero-sum nature of futures contracts. If the price of Gold rises, the aggregate loss incurred by those short the futures contracts on 14 million ounces of Gold is equal to the profit gained by everyone long those same 14 million ounces.

The fact that very few contracts on the Comex actually make it to maturity – when the short is obligated to make delivery and the long is obligated to take delivery – only highlights the zero-sum nature of this game played in the ‘paper’ market. The longs benefit from the shorts or vice versa depending on the movement in the Gold price. One group’s loss is the other group’s gain, excluding commissions of course. And the final reconciliation to account for these gains and losses at close-out of the trading positions is handled with Dollars, not the physical delivery of metal (except a few instances). But now compare the obligation of these paper shorts to those short physical metal.

The shorts in the physical market not only have a price risk, but they also have a delivery risk. As opposed to just making some bet as to what the price of Gold may be at some future date, which is the essence of the ‘paper’ market, these shorts have borrowed Gold. Consequently, they are obligated to repay Gold at the maturity date.

Compare this situation of the physical shorts to borrowers of Dollars. When someone borrows Dollars, the borrower need not worry about there being enough Dollars in existence to make repayment. First of all, the Dollar market is vast, and no one borrower or group of borrowers would likely need to repay their obligations at the same time.

Secondly, even if a shortage were somehow to develop, new Dollars could simply be created out of thin air. After all, Dollars are only some fanciful bookkeeping item, more conceptual than real. But not so with Gold. Borrowers of physical Gold have to repay physical Gold. An example will help illustrate this very important point.

Suppose you borrow your brother-in-law’s Chevy. He says you can use it for three months, but after that date he wants it back. So you borrow the Chevy, and when three months are up, you return it with a fee. If you still need a car, you can go out and borrow someone else’s, but your brother-in-law gets his car back. It is a real item that cannot be created from some fanciful bookkeeping. The same principle applies to borrowing Gold.

Borrowed Gold must be repaid when due to avoid default. The borrower must get the Gold from somewhere in order to return it to the lender at the due date. Of course, he may find another lender, and this newly borrowed Gold can then be used to repay the originally borrowed Gold. Or the borrower may try to go into the market and purchase the Gold he requires, but this action may exacerbate his price risk.

If buying in the market the Gold that he needs to return to his lender causes the price to go up, more Dollars are required. These additional Dollars are a cost to the borrower, so it is clear that the borrower has a dilemma. Fulfilling his obligation to deliver may cause the borrower to lose money because of his price risk. So what’s a borrower to do?

If you are an ordinary borrower you suffer the consequences of your decision to borrow Gold. However, if you are a bank, you change the rules of the game to your advantage.

Are you surprised by this comment? You shouldn’t be because the history of banking is the history of banks not meeting their obligations. This is not the time to go into an explanation of the nature of fractional reserve banking, which is a pernicious process that in essence renders every bank insolvent and causes recurring bank crises. But that is what fractional reserve banking does. And when the insolvency of the banks becomes apparent in some crisis, the banks go hat in hand to the government for a bail-out.

The nature of bail-outs have changed over the 300-year history of fractional reserve banking. Under the classical Gold Standard, government relieved the banks of their obligation to redeem currency (Dollars in the US, Pounds in Britain, Francs in France, etc.) for Gold.

More recently, bail-outs have come in the form of cash infusion from taxpayers (e.g., the Resolution Trust Company). But modern banks are also bailed-out in other ways.

Ten years ago when the banking industry was going through one of its periodic crises, the Federal Reserve manipulated interest rates to the banks’ benefit. The Fed dropped short-term rates, while holding up medium-term rates, widening the spread between these two maturities to an unusual level. Banks then borrowed short-term money at the artificially low rates and purchased medium-term government paper, earning the spread. These induced profits were then taken into the banks bottom line, helping them to charge off their bad loans without significantly impairing earnings. In short, the banks were bailed-out.

Today the banks are again getting bailed out. Banks are short Gold, which they have borrowed at low interest rates, in order to fund their higher interest Dollar portfolios.

Of course, not all banks are short Gold. Many bankers were wise enough not to get themselves into the predicament of owing physical Gold that they cannot return to their lenders (i.e., the central banks) without causing the price to skyrocket. But those banks who were foolish enough to get themselves stuck in this predicament (i.e., the big US and European money center banks), do what the big banks always do when they get into trouble. They go hat in hand to their respective government and to that government’s captive central bank in order to get bailed-out.

This time the bail-out is occurring not just in the US. It is clear that several countries are involved. And this time the bail-out is not a visible cash infusion nor is it a not-so-visible manipulation of interest rates. Rather, it is a manipulation of the Gold price that is becoming more obvious with each passing day.

As an example of some suspicious market action, here is a quote from Murray Pollitt, who I have often quoted in these letters. This is from Murray’s January 18th letter to his brokerage clients:

“Last Friday call options on over 5 million ounces expired worthless…yet three months ago they were a quarter of a billion in the money. This is a sum dealers don’t like to leave on the table and the decline to $284 on expiry day conveniently solved the problem.“

Eventually all manipulations come to an end. The on-going manipulation of the Gold price is no different. It will also end. It’s only a question of when, not if.

The banks that are short physical bullion do not have an end-game. They cannot come up with the thousands of tonnesof Gold they need to repay their loans (at least not at any price anywhere near current levels), so they just keep borrowing Gold and digging themselves into a deeper hole. Eventually the walls will collapse on them, turning that hole into a grave.

We saw briefly in September and October the upside potential that is possible when the banks momentarily lost control. Presently, palladium and platinum are relentlessly climbing higher. Silver looks ready to join them in a new uptrend, but poor ol’ Gold just keeps getting lambasted.

To put this relative performance of these different precious metals into perspective, palladium is now flirting with $500 per ounce, with Gold stuck here in the $280’s. Yet only three short years ago, Gold was at $380 and palladium was in the $130’s. Yes, that is nearly a fourfold increase in the price of palladium at a time while Gold headed south. During the same period, platinum has just about doubled.

Now admittedly, similar commodities (e.g., these four precious metals) don’t always move the same way. They do occasionally move in different ways with different trends. But the length of this disparity, as well as the magnitude of their divergence, is noteworthy.

I am making this observation about this relative performance not to discourage you about Gold’s bleak performance. Rather, it is to provide some examples of what will eventually happen to Gold. A dramatic increase in the price of Gold is coming, and it will no less spectacular than the recent moves in platinum, or perhaps even palladium.

It is not easy to continue accumulating an asset out of value. It requires stamina and will power. So I highlight this price appreciation in palladium and platinum as examples of what is possible in Gold and Silver when the manipulators of the Gold price eventually and inevitably lose control.