The price of gold crashed from $1565 to $1355 (14 percent) from the close April 11 to the low April 16. What prompted this statistically rare move and is it the end of the 12-year bull market?
It is possible to find an answer to what caused the biggest two-day drop in 30 years. The inner workings of the financial system and interdependence of different asset classes provide some clues. In this case, a strong move in Japanese bond yields likely triggered the sell-off in gold.
The Bank of Japan spooked markets in the beginning of April by announcing a record quantitative easing (money printing) program, which targets asset purchases of 60 trillion -70 trillion yen ($610 billion to $710 billion) per year.
The surprise announcement, which initially weakened the yen and boosted Japanese stock prices, had some negative side effects, however. After a quick drop in 30- year Japanese bond yields to 1.04 percent, yields rallied right back to 1.60 percent over the course of 10 days. Measuring only 0.56 percent the move took markets by surprise as it would statistically occur on only one of 15,700 occasions.
According to an analysis by Zerohedge, this increase in volatility or erratic price movement in Japanese bonds led leveraged investors to sell gold to satisfy margin requirements for bonds. Increasing volatility and a falling price mean that investors who bought bonds on margin have to post more cash as collateral with their counterparties.
Given the $14 trillion size of the Japanese government bond market, there is a large pool of potentials victims.
Gold is very liquid and one of the first things that investors can sell if they need cash, as it also happened during the panic of 2008. U.S. treasury bonds and other commodities likewise fell in a bid to raise cash over the two day period and the yen strengthened as Japanese investors sold overseas assets to bring home cash.
Investor George Soros earlier told Bloomberg about this phenomenon: “If people needed to sell something, they could sell gold. Therefore they sold gold. So gold went down together with everything else.”
400 Ton Selling Smacks Market on Friday
While the distress in Japanese bonds was a good fundamental reason for gold to go down, forced selling on Friday at the New York Comex future exchange was the trigger for the cataclysmic collapse.
According to industry expert Ross Norman, a hedge fund was responsible for a “shock and awe” selling of 13.4 million ounces, or 420 tons (15 percent of annual production) and likely did it on purpose.
“This was clearly not a case of disappointed longs leaving the market—it had the hallmarks of a concerted ’short sale,' … driving prices sharply lower,” he writes on the website of London bullion dealer Sharps Pixley.
A short seller makes money if prices fall and can benefit from a cascade of selling as other investors panic. In this case, the tactic worked, as stop-losses were taken out and gold kept on falling until Monday.
Difference Between Paper and Physical Key to Understand Market
In fact, this example illustrates a curious feature of the way the gold market works. Most people, including central banks, buy gold in physical form as bars or coins. But the price of the physical metal takes the spot price on the future exchange as a main input.
It merely adds the costs of shipping, storage and insurance plus a fee for the dealer, which results in physical prices that are “above spot.” Spot is the futures contract with the closest delivery date. Most buyers of physical pay cash and don’t use any margin.
Futures, on the other hand are leveraged financial contracts traded and regulated on an exchange, in gold’s case the New York Comex. These contracts have the option of converting them into physical metal upon expiry, which is rarely used; instead, they are settled in cash.
Buying or selling one contract is the equivalent of buying or selling 100 ounces of gold, worth $139,000 at April 17 prices. To do that, you only have to put up 5 percent or $7000 dollars as a deposit, the rest is controlled on margin.
Once the contract expires, you can either settle your gain or loss in cash or as a buyer, demand physical delivery of the metal. Only then would you need to pay the full price. As a seller you are only then obliged to deliver the 100 ounces.
To put this mechanic into perspective, the 420 ton seller from Friday only had to post $1 billion with the exchange to sell around $20 billion worth of gold. On Monday, 2300 tons of gold exchanged hands—on paper—equaling 80 percent of world production. Inventories in the Comex warehouses, used to settle trades only make up 286 tons, however.
And while leveraged paper investors have to sell to meet margin calls, cash-buyers of physical are piling in at reduced prices. According to German bullion dealer Pro Aurum, individual buyers still outnumber sellers 9 to 1 in its stores in Germany.
“If demand stays or even rises, it is likely that physical gold will become scarce and there will be delivery delays,” Principal Robert Hartman states on the company’s website. Media reports confirm similar behavior in Japan, China and Australia.
Central banks, who also deal in physical, added 14.8 million ounces over 2012, according to Casey Research. “Central banks as a group have been net buyers for at least two years now. But the 2012 data trickling out shows that the amount of tonnage being added is breaking records,” Jeff Clark of Casey Research writes in the company’s newsletter.
So while future traders are largely looking for the quick buck, long term investors still think the fundamentals for gold to go up are intact.
Nothing Has Changed
Physical buyers regard gold as an insurance against financial turmoil that can hurt other assets such as bonds, stocks, as well as paper currencies and bank deposits.
Negative real interest rates and dividend yields, an undercapitalized banking system as well as unprecedented central bank money printing were and are a good reason to keep investing in physical gold, according to Dan Oliver, principal at Myrmikan Capital in New York.
“Those familiar with Austrian economics understand that not just money printing but accelerating money printing is required to keep a credit boom going,” he writes in a note to clients. According to him, slumping commodity prices are signaling worsening economic conditions that have to be met with more money printing, ultimately benefitting gold.
“In 2008 the economic forces that lowered gold from $1000 to $700 prompted the Fed to implement policies that drove it to $1929. It may well be that a decline of a similar magnitude, to $1350, will correspond with the actions necessary to drive gold to $4000. “
As long as the physical gold price is set by futures trading, it will be a bumpy ride.
