Why Physical Gold is Headed for a Liquidity Crisis

What would happen if the market found out that the world's central banks have been leasing out far more gold than they actually own? Would the conditions of a massive jump in the gold price be in place? According to my friend Greg Canavan, the answer is also the reason gold could jump to anywhere between $2,000 and $5,000 an ounce very quickly in the near future. In the following sit down session, Greg explains why talk of a gold bubble is nonsense, reveals a startling fact about the unfolding precious metals bull, highlights a new danger of owning 'paper gold'...and outlines what he's advising his readers to do right now...

Dan Denning: The gold price eased back to around $1,400 an ounce last week. But for ten years gold has gone up in pretty much every currency. You're starting to see talk that gold is now in a financial bubble, akin to the dotcom one. What's your take on that?

Greg Canavan: It's foolish, and pretty uninformed. A financial bubble is when greedy speculators buy something based on no fundamental reason...just on the assumption there will be a 'greater fool' to sell it to at a higher future price. Firstly it assumes that gold is over-owned. But if you look at the data it's still actually a very under-owned asset class. Eric Sprott of Sprott Asset Management makes the point perfectly. He cites from the Gold Yearbook 2010 that gold held by private investors in 1968 made up 5% of global financial assets. Last year, ten years into the recent gold boom, gold comprised just 0.7% of global financial assets. Most people don't own gold. It's that simple. You can't have a bubble in something until most people own it. I know the line of thinking you're referencing...the idea that gold has 'crossed over' into the mainstream imagination. But it hasn't. Gold is still decidedly fringe.

DD: Bill Bonner says the same thing. But are you sure gold hasn't gone mainstream? These days you see articles on gold everywhere, from the New York Times to the New Zealand Herald.
GC: Sure you do...in the finance pages. An asset can't trend upwards for 10 years and not get attention from the business press. They can't ignore gold any more. Usually they disparage it. That kind of attention is a lot different than gold entering the mainstream press in a positive way. In December 1999 Time Magazine ran a cover announcing Amazon founder Jeff Bezos as 'Person of the Year'. Try and find it on the Internet, it's perhaps the quintessential example of 'bubble-think'. Around the time it was published, an Amazon share cost you a hundred bucks. Fast-forward a year to December 2000 and you could pick one up for $15. When you see a golden bull with his nostrils flared on the cover of Time...or the CEO of Newcrest Mining starts buying Rugby League teams and doing interviews on This Morning...then you could say gold is in a bubble.

DD: How high could the gold price go?

GC: This relates to one more thing that damages the gold bubble argument. Unlike dotcoms or apartments or tulips, gold is a barometer for the global financial system. When the system is well-managed, gold keeps quiet. When interest rates are held too low, creating a mismatch between the demand for funds and real savings, gold sounds the alarm and its price rises. As long as central banks keep printing money, as long as we have a financial system built on debt, and as long as gold is allowed to freely float, its price will keep going up. I think you'll see gold at $5,000 an ounce when this bull market is over. Although defining what 'over' means is not easy.

DD: Why?

GC: Well, I think we both know there has to be some kind of endgame here. It's just really hard to picture what it might look like. Ben Bernanke's quantitative easing has done a bang-up job so far at propping up asset markets in the face of the Japan disaster, a deepening crisis in the Middle East and ongoing Eurozone troubles. But he can't keep it up forever. QE2 is scheduled to end in June. QE3 could happen, but it's not a given. The truth is, if you make investment decisions on predictions of what central banks might do, you will probably lose money. With so many uncertainties, gold is the only thing you can rely on right now. I bought my first bullion in 2003...but I'm convinced I haven't come close to seeing the biggest gains.

DD: Your most recent report had a great expose on what you called "The Great Gold Swindle." Can you explain what you mean by that?

GC: I've been researching this recently. To tell you the truth, what I've found is pretty incredible...and more than a little unsettling. To cut a very long story short...for several decades now central banks have been 'leasing' gold to the market. They've been doing this to keep the gold price low...so they could keep conducting loose monetary policy. According to the World Gold Council, total official central bank gold reserves at December 2010 are around 30,000 tonnes. If the figures I have are accurate, well over 15,000 tonnes of gold has been lent out by central banks.

DD: Half the official reserves have been leased onto the market?

GC: Yes.

DD: What does that mean?

GC: It means that central banks are now 'short' a heck of a lot of gold! And this is where things get really interesting. As I explain in the latest issue of Sound Money, Sound Investments, this 'lent gold' is the real reason gold is going to go much higher in the next few years...provided central banks stick to an irresponsible monetary policy.

DD: Why?

GC: Well, without giving away too much of the report, we basically now have a paper gold market operating alongside the physical one. In fact it's MUCH BIGGER than the physical one. All this lent gold means that investors can get 'exposure' to gold without owning it, in the form of derivatives. Trading that takes place is settled in cash rather than gold. So the derivatives market is a way of trading gold out of all proportion to the actual amount of physical gold available.

DD: Well, to play the Devil's Advocate, so what? That's what derivatives markets are…a way of gaining exposure or managing risk without having to own the physical commodity. What's the problem?

GC: Yeah, true, but as I keep saying today - gold is different. Gold IS money. You own gold because you want to protect your wealth from currency debasement, stemming from monetary mismanagement. Owning physical gold means you have no counterparty risk. It's a way of putting a portion of your wealth outside the currently flawed banking system. Owning gold derivatives comes with counterparty risk. In a benign monetary environment counterparty risk is no big deal. But in an impaired system, which is what we have now, it can become a major issue very quickly.

DD: Okay. But if you're right and more gold has been leased than central banks actually have, what happens next? What's the catalyst for gold soaring above $2,000 and beyond?

GC: Again, I cover that in detail in my recent report. Simply put: we are nearing a point where physical hoarding of gold by wealth-protecting individuals and countries is going to cause a liquidity crisis in physical gold. When that happens, much higher prices will be required to lure gold away from hoarders and back onto the physical market. Only a sharp increase in interest rates by the Federal Reserve would prevent this from happening...and entice me to sell some gold. And, frankly, I don't see that happening anytime soon.

DD: What is your specific investment recommendation?

GC: Buy gold.

DD: Anything a little more specific?

GC: You can find out the specific allocation of gold in the Sound Money, Sound Investments portfolio...plus the five precious metal stocks I have my readers in by taking a risk-free look at the latest issue of Sound Money, Sound Investments. There's another important take-away from this: now more than ever it's important you own precious metals themselves as well as just a paper claim to them. Take a trial of Sound Money and you'll find some information in the Member's area on the best ways of buying physical gold.

DD: What else can new readers expect in your report?

GC: Like you, I'm very bullish on energy. But that's not to say that, from a value perspective, there are good energy stocks to buy right now. A month ago I looked at the top 4 listed oil and gas producers and concluded there wasn't a great deal of value around. I'd like to have some energy exposure in the portfolio, but based on my analysis the four largest companies are priced to deliver an uninspiring long-term return. In a recent issue I took a look at the next ten largest oil and gas plays, ranging from Aurora Oil & Gas with a market cap of around $1.2bn, down to New Zealand Oil and Gas at just over $250m. And I've found three you should put on your watch-list immediately.