Debtor's Prison

Greetings fellow inmates,

Previously, on Gold: a detailed look at demand we reported in some detail how gold demand is distributed amongst certain sectors as well as total demand statistics per quarter. Originally, the focus of our first post on gold was concerning its worth as a store of wealth, especially under the scenario of a broad fiat currency devaluation. As you might be aware, we believe that such a fiat crisis will in fact take place sometime in the next three years. Uncles Benny and Merv, together with other reserve currency central bankers have rampantly inflated their balance sheets, monetizing bad debt. For those of you unfamiliar with this term: the toxic debt is now being “aggregated” into the very backing of the currency. Eventually, this gargantuan game of musical chairs to the tune of le Ponzi will come to an end. Naturally then, the question arises of what will substitute this system. As the story goes, it seems a single world currency, perhaps in the form of an SDR or hybrid thereof, is the most likely scenario. In between the now and the then, there will ensue a period of very high volatility in currency exchange rates. The USD will plummet (at least versus commodities). Rational investors are well advised to prepare for this event, or at the very least diversify and hedge against the possibility with whatever collection of instruments found to be most suitable. Therefore, it is definitely important to pay close attention to the gold markets before the super tsunami.

As always, we begin with the data, courtesy of the World Gold Council. We highly recommend signing up for a free membership in order to get all the data and reports. For now, we have condensed the data in the following tables. In general, demand in the first quarter was up a strong 38% versus a year earlier levels. There are three main components of gold demand: jewellery, industrial and investment and they have behaved differently during the Great Credit Catastrophe (GCC). Jewellery and industrial demand have been extremely weak while safe-haven demand went through the roof. As you can see from the table, jewellery demand dropped from 550 tonnes to 340 in Q1. Industrial and Dental dropped by 20 tonnes to 90. This is a very clear indication yet again that the industrial and productive segment of the world economy continues to slump and structurally contract. These are what we call brown shoots. Investment demand however continued to skyrocket going up roughly 36% from an already strong 440 tonnes to 600 tonnes in the first quarter. Investment demand has been on a tear during the GCC, especially from Q2 to Q3 ’08 when we saw a huge spike of 180%. Within the investment category, the single biggest jump came from ETF demand which surged from 95 tonnes to 465! This is a very strong indication of the flight into gold, since it means many retail investors are getting heavily into the game of wealth preservation from gold. We do caution strongly against believing that investing in a gold ETF is the same thing as investment in gold, they are decidedly NOT the same thing, more on this below.

The rise investment demand has been so strong that something fundamental has changed since we last discussed the subject. Previously, we postulated that many people held an erroneous belief that gold demand was mostly investment-driven when, in fact, jewellery provided most of the demand. The situation has reversed, and investment demand now composes almost 60% of total demand, at least in the first quarter. Even as late as 2007, investment demand was a mere 19% of total demand. At the end of 2008, with the strong surge in investment demand, it still composed only 31% of total demand. Now, it is by far the largest component at 60%. No wonder that you see so many commercials on TV asking you to part with your jewellery, simultaneously with commercials selling you the re-melted jewellery in the form of official coins. Again, this screams out that prices of gold (which we are conspicuously avoiding discussing) will be increasingly determined by its use as an investment device. Historically, it has been used as a hedge against inflation, but also more generally as a safe-haven in times of panic. This surge in investment demand is likely associated with some of these uses and perhaps others. Maybe, this could even be taken as an uptick in inflation expectations, who knows. Our purpose with this post was to explore the gold data, not speculate.

On a related note, one thing that concerns us about the gold markets is the overloaded nature of some of its infrastructure. For starters, it is important to understand that a lot more gold exists in futures that can be delivered. Of course, this traditionally isn’t viewed as problematic since most contracts get settled in cash and there is this widespread faith that clearinghouses can’t fail. Indulge in a thought experiment for the moment. Imagine one of the big-five banks or other systemically important counterparties, who are able to enter into any number of short contracts as they please, referencing much more gold than they could ever deliver. Then, imagine one of those counterparties goes under or defaults on the contracts. The consequences of this would be quite dramatic to say the least. A clearinghouse itself might fail, a huge run on gold like nothing else, a breakdown in segments of some commodity trading are all scenarios that could come about. Specifically, one of our pet peeves here at DP is the blind belief that a clearinghouse can’t fail. If there is a lesson from the GCC is that nothing is to big to fail. We are on the verge of an era when even a large central bank might fail, just as Dr. Doomsayer Nouriel Roubini. Surely a clearinghouse can fail. We are not saying it will, but simply that it can.

In spite of the low likelihood of this extreme event at the moment, it is intellectually lazy and foolhardy to not at least consider its repercussions. Seriously, the belief that FAT DARK WINGS (in the probability distribution) can’t happen should be wiped from any rational mind. They can, and they will, especially now. With gold in particular there are a few things that point our attention in this direction. The growth in investment demand has been spectacular and likely to continue. If a fiat currency collapse does come about, expect this demand to skyrocket again, some more. Already, a huge proportion of a fixed supply of gold is being sucked by financial and investment reasons, even into shaky products like ETFs. If you count all the gold derivative markets and even the gold lease markets, then there is the possibility that at some point physical demand (so to speak) might exceed physical supply. This is similar to the huge mountain of debt that served to collapse of financial structures previously believed to be indestructible. A mountain large enough will collapse any structure. The possibility of this event causing some major systemic crisis is non-negligible over the next three years. We will do a post in the near future about the gold derivative markets, but for now we bid you adieu!

May your capital be safe and your investments prosperous,

MAAA