What Does It All Mean?

July 12, 1999 – One of the most basic axioms of trading and investing is that every market has a story to tell. Traders, generally speaking, need to know what that story is telling us about the short-term prospects for a market. In contrast, investors are more concerned by the longer-term implications of that story.

Regardless whether one is looking at stocks, commodities, currencies, Gold or any other tradable instrument, that market story for any time horizon has three different outcomes. Prices can go up, go down or remain unchanged.

My job as an investor and trader and, most importantly, as an analyst who writes this letter for a wide and diverse audience ranging from novice investors to tested and seasoned professionals, is to use my knowledge, experience and intuition to accurately interpret the facts impacting upon a market. From this analysis I can then make hopefully accurate basic conclusions about the trend of prices as well as hopefully useful specific recommendations for the traders and investors who read these letters.

This task of correctly interpreting markets and forecasting price direction is never easy, and as I get older and wiser, ironically this job gets harder. I suppose this job becomes harder because as I get older I understand better not what I know, but rather, what I don’t know. And that knowledge about one’s limitations is a very humbling and daunting realization. But as daunting as that may be, something even greater is intimidating me at the moment.

Never before have I seen such a confluence of inexplicable and incongruent events impacting the Gold market with such an unexplainable result. The Gold price continues to head lower in the face of what historically have proven to be very bullish facts. For example, look at bullish consensus figures.

By the rule of contrary opinion, when sentiment in any given market is preponderantly bullish, it is time to sell, and conversely, it is time to buy when market sentiment is extremely bearish. The logic of this methodology is that all buy orders have been filled when the market is extremely bullish, so any orders to sell will cause prices to fall. The opposite occurs when market sentiment is extremely bearish. The selling has reached a frenzied climax, and any buy order will cause prices to rise because at that point in time, buying power will be stronger than selling pressure.

Bearish sentiment has set new records in the Gold market over the past four weeks. However, rather than resulting in even a weak rally that would relieve at least some of the selling pressure – the expected event in the normal course of any market – the Gold price continues to make new lows.

Another indicator of sentiment is the huge short position in Gold. Historically, when such an extreme level of shorts has appeared in the market, the Gold price rallies, if even a little, as nervous shorts run for cover. But not this time, at least not yet, even though shorts are near record highs. Moreover, a surge in Comex open interest in recent days suggests that the total short position may in fact now be at a new record high. The current condition will be made known when the next Commitment of Traders update is released on July 16th.

Another area that is out-of-whack is the supply/demand statistics. Throughout this decade, the weight of Gold fabricated into its various uses has annually exceeded the supply of newly mined Gold, and salvaged Gold that has been put back into the market for recycling. While these so-called deficits can last for some time because they can be filled by the dishoarding from those who own some of the aboveground stock of Gold, the size of these annual deficits and the cumulative total weight of the deficit that has been built up this decade is unprecedented.

The Fear Index reflects another inexplicable fact about the Gold market today. Historically, when the Fear Index dropped below 2.6%, it was an important signal to begin accumulating Gold before the next upturn, which always followed. The previous historic low in the Fear Index was 1.63% in October 1971. That level was broken in August 1997, and defying all previous experience, the Fear Index has continued to head lower, last month reaching a new record low of 1.12%.

Finally, consider what I believe to be the most outlandish example of the abnormal conditions prevailing in the Gold market at the moment – interest rates.

History shows that the normal interest rate for Gold is about 30-50 basis points for 3-month to 6-month money. In other words, a triple-A borrower can borrow Gold for six months at a rate of ½ % per annum. Presently, 6-month borrowing rates are 1.80%, a rate far above natural market conditions.

Normally, such high rates would result in higher Gold prices. The reason is that a higher price is needed to induce owners of Gold to part with their metal, thus freeing up the weight of Gold available for lending. Metal is very tight right now, as evidenced by the relatively low Comex stocks. Also, the high interest rate itself reflects these tight conditions. But the Gold price has continued to fall nonetheless.

This result is even more bizarre when considering that Gold interest rates are presently inverted. One-month borrowing rates are around 2.20%, and three-month rates are 1.90%. In other words, even though it is becoming increasingly expensive (and therefore, unattractive) to borrow Gold, the demand for borrowed Gold remains high. I understand that notwithstanding the hoard of central bank Gold available for lending, the supply of lendable Gold is in short supply, so interest rates remain unusually high.

These are bizarre conditions. Any one of the above matters is enough to raise eyebrows and cause one to wonder what is going on. But taken together, these conditions are astounding, and it forces one to ask the question, what does it all mean? And to be honest, I don’t have the answer, and I’m pretty sure that no one else does either. They may think they do, but given this set of unusual and unprecedented circumstances, I would be willing to bet that they don’t. If anyone accurately guesses the outcome from here, it would in my view be luck. It couldn’t be experience because no one has ever before experienced this confluence of bizarre conditions.

Nevertheless, it is my job to try making some sense out of what is happening at the moment, and to explain these odd events. So here goes my interpretation on what I think is happening in the Gold market.

The center of attention for me is Gold’s interest rate. These high rates I believe mean that a banking crisis is brewing. Not a commercial banking crisis, though, but rather, a bullion banking crisis. A crisis is brewing for those banks that borrow Gold and take bullion deposits – metal then used to make Gold loans.

The history of banking in general shows recurring panics and crises. While the trigger for each of these many crises is usually very different, the crisis arises because of one common theme – banks borrow short and lend long. In other words, banks take 3-6 month deposits, and then lend this money out for 5, 10 or more years. There is a mismatch between bank assets and liabilities.

Normally this mismatch is ignored. But eventually, some bank loans inevitably go sour because of imprudent credit extensions during the good times. These bad loans in turn create nervousness about bank solvency, which consequently leads to panic. The banks then go hat-in-hand to the central banks as the lender of last resort, because only the central bank has the ability to turn the illiquid long-term bank assets into newly created national currency. The central bank buys these illiquid assets from the banks in exchange for the newly created currency, which is then used to repay depositors until the deposit outflow stops.

This same process does not occur with the bullion banks because there is no lender of last resort. No one stands ready to buy the long-term Gold loans made by the bullion banks for metal, which can then be used to repay deposits. Instead, if deposits start flowing out of the bullion banks, they have to keep bidding up Gold interest rates in order to reach a rate high enough to entice some one holding the metal to lend it.

I think this process has already begun, which explains the inordinately high Gold borrowing rate. One or more bullion banks are experiencing a run on their deposits. Depositors are asking for their metal back, placing safety of capital above return on capital as their immediate objective. Bullion banks are borrowing the metal to remain liquid and solvent, and are being forced to borrow at ever higher rates, the typical warning sign that a crisis has begun.

Other than this jump in interest rates, my conclusion so far is based more on anecdotal evidence and the deductive elimination of the other possibilities that could explain the high interest rates, rather than any hard facts to grab onto at the moment. Nevertheless, if I’m right and the bullion banks are indeed ‘feeling the heat’, when the Gold market turns, it will be a rocket shot. But when will the Gold market turn?

Unfortunately, neither I nor anyone else on the face of this earth knows when that will happen, or from what price level the reversal back up will begin. And right now, Gold remains in a short-term and long-term downtrend.

However, when the Gold price does start rallying – and a lot of technical evidence says it should already be rallying – the rally should be something to behold as shorts cover, the bullion banks scramble for metal, the central banks try to retrieve their deposits to prevent losses, and investors and speculators start buying the metal because they see what’s happening. If I’m right and a run on the bullion banks has already begun, we should see this turn of events soon, probably within one or two months. Banking crises don’t smolder long; the flames ignite rapidly, generally even before the depositors can smell any smoke.

Finally, if a developing bullion banking crises does not explain the abnormal conditions prevailing in the Gold market, I would still expect to learn the answers as to what is causing these peculiar conditions within a short period of time. Market anomalies are rare, and are not long-lasting. This current anomaly in Gold should not be long-lasting either, so watch Gold interest rates carefully here. Continued upward pressure means a bullion banking crisis is deepening.