1 Apr 2013

Why Isn’t Gold Higher?

Hint: Because it’s the Credit Default Swap of the Next Financial Crisis

Why isn’t gold higher? Two of the three reserve currencies of the world—the dollar and the yen—are on a relentless race to the bottom, and only recently have the Europeans figured out that they’d better start kicking the euro down, before they price themselves out of the global markets. 

With this general fiat currency devaluation, you would think that gold would be much-much higher than it is now. 

But gold isn’t higher—it’s drifting. Consider this chart of gold, over the last decade: 

Click to enlarge.
Gold was on a relentless climb after the 2008 Global Financial Crisis—with good reason: The markets collectively deduced that the central banks of the world would devalue their currencies, in order to get out from under the mountain of private, consumer and sovereign debt. 

Individuals might have decided to buy gold for different reasons—a hedge against volatile equities markets, worries about a run on sovereign debt instruments, etc.—but collectively the market participants all acted the same way: They bought gold as a hedge. (In fact, gold has no value except as a hedge.)

Thus the steady climb in the price of gold from $750 to $1900 in a little less than three years. 

So far, so good. 

But then starting in September of 2011, gold prices zoned out between $1,900 and $1,600. Instead of continuing on to $2,000 an ounce, $3,000, Infinity and Beyond, gold just drifted like a lobotomized patient spending some quiet time in a rubber room. 

Gold has not outperformed anything since September 2011. 

The conspiracy-minded claim it’s a conspiracy, natch. The Rothschilds, the CIA, and the little green men from Mars are all conspiring to down-price gold, to the detriment of the gold-buggers. 

But I’m not one for conspiracies, not since I learned in grade school that a secret between two people is never a secret for long, and a secret between three or more people is no secret at all—just ask Lance Armstrong. If there’s a conspiracy, someone’s bound to talk. Since no one’s talking, my guess is, no one in any position of power has any more clue as to this drifting in the price of gold than any arm-chair conspiracy weenie. 

So if we’re discounting conspiracies, that leaves us with the numbers—and the markets. 

And an idea I have: What if the price of gold is drifting not because the markets don’t trust the world’s reserve currencies to continue to devalue, but because the market doesn’t trust gold?

Which reminds me of credit default swaps. 

(Yes, I know: My brain seems fairly odd in its associations. Bear with me as I untangle the mess in my head.)

Remember CDS’s? They were essentially insurance contracts taken out to hedge against a particular bond defaulting. In the run-up to the Global Financial Crisis of 2008, credit default swaps rose in value—sometimes exponentially—as investors concluded that a lot of the triple-A rated bonds were actually junk, and would soon default like junk. 

Credit default swaps were the insurance—the hedge—against exactly what happened in 2008: Bonds threatened to default, during the Global Financial Crisis. So the CDS’s insuring those bonds rose in value like a mofo— 

—until suddenly, they didn’t: CDS’s stopped rising in value just when the markets collectively realized that the counterparties to those CDS contracts might not be able to pay up. 

Because remember, an insurance policy is only as good as the counterparty’s ability to pay it off. 

When all those mortgage backed bonds started to default in 2008, all those credit default swaps started to rise in value and/or needed to be paid off. This huge exposure to credit default swaps sent insurance giant AIG to bankruptcy, and credibly threatened to wipe out the entire global financial system in September of ’08. 

When that point came, credit default swaps no longer were rising in price. Rather, they were jagging up and down, like the monitor readings of a heart-attack patient—which made perfect sense: Some market participants expected the CDS’s they were holding to be paid in full, while others weren’t sure that AIG or whatever other counterparty they were working with would be able to honor the CDS’s once the bonds they were insuring went bust. 

So price discovery of the CDS’s was impossible while the crisis was raging. The prices of credit default swaps ran up relentlessly, as it became obvious that what they were hedging again—bonds defaulting—was going to happen. But then CDS prices went jagged immediately before and during the crisis itself, when no one was sure if the contracts would be honored. 

In its shape, it’s identical to what’s been happening with gold: A relentless climb in price during the run-up period to the crisis—then jagged drifting right before the crisis. 

We all know and understand what’s going on with the global economies and the fiat currency system: The global overindebtedness is forcing central banks around the world to devalue their currencies, so as to make the debt burden less onerous. 

Many people—and I happen to be one of them—believe that this policy will lead to an inflationary crisis, which will spiral into an uncontrollable hyperinflation event. The key assumption in this scenario is that the only cure for runaway inflation—raising interest rates higher, and hard, like Paul Volcker did in ’79—will never be implemented by the world’s central banks, because they believe (with some justification) that higher rates will shove the global economies into a deflationary death spiral. 

Thus a spike in inflation will bleed into hyperinflation, and by the time the central banks wake up and raise interest rates to stop it, it’ll be too late. 

In such a case, gold would be the perfect hedge against inflation and eventual hyperinflation. In fact, even better than a hedge, gold would be the perfect investment, an investment that would outpace all other asset classes, because market participants would anticipate this inflation scenario, and thus pile into gold so fast and in such numbers that gold prices would spike parabolically, far outpacing the fiat currency devaluation. 

Since everyone with any sense realizes that this is the endgame of the current race to the bottom, gold ought to be rising dramatically. 

But that is not happening. Gold rose steady and strong from 2000 through September 2011—but since then it’s been drifting jaggedly. 

So why would gold—which is an actual, physical commodity—be acting like credit default swaps did right before the 2008 crisis?

For the same reason: Gold buyers don’t trust the counterparties selling gold. 

Because after all, most gold markets are paper markets, not bullion markets

The various gold ETF’s, gold certificates, etc.—they are all based on the trustworthiness of the counterparty issuing the paper. The gold bullion is stored in vaults, and paper receipts against it are being issued. 

But as more than one precious metals commentator has pointed out, there is more paper issuance of gold than actual gold bullion.

What does this mean? It means that the global precious metals markets are essentially a game of musical chairs, with far fewer seats than players—far less gold than gold holders. 

And market participants collectively know this. Which is why they don’t trust their counterparties. Which is why gold isn’t rising like a shot. 

There is only one market in gold, not two. There is no way to segregate gold bullion holders from gold certificate holders, and thus create two markets, one for the real thing, one for the paper thing. 

Thus the current spot price of gold is reflecting market uncertainty as to who has actual gold, and who has worthless paper certificates of gold. 

Do recall: The prices of credit default swaps quickly reached their market prices after the 2008 crisis had passed. They reached those actual market prices once the insolvent counterparties, like AIG, had been identified and isolated. 

But before and during the crisis? When it wasn’ clear which credit default swap would be honored and which wouldn’t? CDS prices were jagged—like gold’s is today. 

In the long run, assuming that central banks don’t manage to raise rates in time to prevent high- or hyperinflation, gold prices will go parabolic. But between now and then, gold prices will continue to drift, because the markets don’t really know whose gold is real, and whose is worthless paper. 

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