May 14th, 2013
by Peter Krauth, Money Morning
In mid-April, a black swan crash-landed on the gold market.
Over just two trading days, gold futures prices shed 13%, falling from $1,575 to $1,375.
That $200 cliff dive was the largest two-day drop in 33 years.
Gold prices already had been in steady consolidation mode for 18 months. But the magnitude and swiftness of this dramatic move were rare...to the point of suspicion.
How did markets react? Unlike almost anyone expected.
What caused such a landslide, and who may be behind it? More importantly, what are the implications for the precious metals markets moving forward?
The conclusions will surprise you - and help you invest more wisely.
Past As Prologue
To understand what happened, we need to first dissect the circumstances surrounding the event.
The gold futures selloff were so extreme, it's difficult not to conclude that whoever may have initiated this effort achieved exactly what was intended: a gold panic.
However, the law of unintended consequences tells us that some actions have unanticipated effects. And given the reaction in the physical gold markets, it appears the perpetrators of a gold panic (if they indeed exist) will find it difficult to achieve their goals in the future.
A number of bearish news stories were released in the days and weeks leading into the selloff.
First came word that infamous hedge fund manager George Soros had dramatically cut his fund's gold ETF holdings by 55% in 4Q 2012. But having already dumped (as a group) a total of 140 tons just in 1Q this year, gold ETFs were already suffering a bloodletting.
Three days before the initial selloff, the Fed's Open Market Committee minutes were leaked a day early. They revealed that some members were in favor of slowing the Fed's monthly purchases of $85 billion worth of mortgage-backed securities and Treasuries.
Was Goldman prescient, lucky, or did they know what was coming?
The Plot Thickens
The very next day, news broke that Cyprus may be pressured by Europe to sell 10 of its 14 tons of gold reserves, worth some $400 million euros, in order to meet its bank bailout obligations. This was initially denied by Cypriot officials, then later confirmed.
But worry quickly spread that other debt-strapped euro members could be forced down the same path, potentially flooding the market with the Midas metal.
Further pressuring negative sentiment, the Commitment of Traders Report published by the COMEX showed that large speculators had become less bullish. As a group, they typically move with the market, and they'd recently become their least bullish in four years. What's more, their sheer size is enough to sway the gold futures markets in either direction.
It's anyone's guess whether any or all of these events contributed to the gold price crash. But it's impossible to imagine that what happened next did not. In fact, this single overwhelming factor was likely enough to smash the paper gold markets all on its own.
April 12 saw what I'd generously categorize as very conspicuous activity: The futures markets were simply deluged by two massive trades, perhaps the largest ever.
First an order to sell futures contracts for 100 tons was placed, almost as if to "test the waters." Then, about an hour later, a second order of 300 tons hit the offer.
Now here's a little perspective; 1 ton is the equivalent of 32,000 ounces, so 400 tons is 12.8 million ounces. That's $19.8 billion worth of gold at $1,550 per ounce. The equivalent of 20% of total world annual gold production was put up for sale within a few short hours!
Response in the gold futures markets wasn't surprising.
Paper Gold Reaction
Hit by an atomic bomb, gold futures sold off ... dramatically.
The initial selling pressure was enough to push gold below its technically important $1,540, a make-or-break level it hadn't crossed in all of 2012.
An enormous move like this has a tendency to trigger stop losses. That in turn can become a vicious downward spiral with even lower stops being triggered. Margin calls are issued, and many positions are forced to liquidate. And that can lead to a panic, where traders essentially try to stampede out.
Exacerbating the situation, margin requirements are increased as futures contracts lose value. On April 15, after gold's largest two-day drop in 33 years, the CME Group pushed up margin requirements on gold futures by 19% and on silver futures by 16%.
Traders were then forced to post more cash, or sell at least a portion of their holdings just to meet the new higher margin requirements. Naturally, this helped to push prices even lower still.
But that's just half the story.
Physical Gold Reaction
Response in the physical gold markets was astonishing.
In the immediate aftermath of the selloff for both gold and silver, demand for physical bullion simply exploded. It appears there was substantial pent up demand waiting for an important price drop in order to buy. It also appears that the swift and unpredictable downward price action in the futures market spooked gold buyers into wanting nothing less than physical gold in their hands.
Numerous gold buyers saw the price drop as an opportunity to get into the gold market. What they hadn't anticipated was how many others were thinking the exact same thing at precisely the same time.
Premiums on physical gold and silver went ballistic. There are countless reports of physical bar and coin shortages at bullion dealers in both the Western and Eastern hemispheres.
China saw 15-month highs for gold premiums. The Financial Times reported the president of the Hong Kong Gold & Silver Exchange Society, Haywood Cheung, as saying that -
"in terms of volume, I haven't seen this gold rush for over 20 years. Older members who have been in the business for 50 years haven't seen such a thing."
Anxious gold buyers formed long lines in Beijing outside gold retailers. The Gold Exchange in Shanghai saw its contracts exceed 150 metric tons in the week of April 15 alone.
According to a Mineweb report, some Dubai gold merchants boosted their premiums by 750% above normal levels. And trading on the Dubai Gold and Commodities Exchange hit a volume record on April 16.
On April 17, the U.S. Mint sold a record 63,500 ounces (or roughly 2 tons) of gold coins. By April 19, year-to-date sales had already reached 62% of total 2012 sales.
In the physical silver markets premiums shot up from pre-selloff around 8% to post-selloff up to 37%. That totally negated the effect of the price crash, with silver bullion selling at the same price as before the selloff, near $31/ounce.
In the first three months of 2013, the U.S. Mint sold more than 15 million American Silver Eagle bullion coins. That's the first time ever the Mint has sold this many coins so early in the year, setting a record in the 27-year history of the series.
Coin dealers across the U.S. have been swamped with demand, regularly selling out of their inventories, desperate to get new allocations.
Some buyers waited in long lineups with the intent of buying silver coins. When they reached the wicket, only large bars at high premiums were left, which many bought nonetheless just so not to leave empty-handed.
This reaction indicates that the physical gold and silver markets appear to be at a crossroads. We may have seen the defining moment where physical markets begin to divorce themselves from the paper futures markets.
A quick internet search for gold and silver coins on Ebay or at bullion dealers easily confirms that futures prices may no longer be able to dictate physical precious metals prices.
Plunge Precipitation Team?
The gold selloff conspiracy question begs the question: "Who would do this and why?"
Experienced traders with a large order to execute, such as the mammoth 400 tons, know to spread these out into numerous orders over time. That allows the market to absorb smaller individual sales with much less dramatic downward price pressure, allowing for higher proceeds from each sale.
No one selling this much gold in such a large transaction is stupid enough not to foresee the immediate consequences. They have to have known that the gold price would get crushed. The seller was either desperate to unload it, or deliberately wanted a much lower price.
And there is a point at which evidence becomes so compelling that it's nearly impossible not to suspect some of the largest stakeholders in this market.
There have been a number of suggestions by well-informed market observers that a few large speculators have been manipulating the gold and silver futures markets for years. This recent sale of 400 tons in a single day looks and smells like a concerted effort to push the gold price way down in short order.
Who could pull this off? The most likely perpetrators would be either Western central banks or large bullion banks (large speculators), or perhaps the two groups in concert.
The price of gold is a gauge of inflation, which is the result of printing fiat money. Central banks benefit from a lower gold price as it gives the impression that they are not dropping cash from helicopters.
On the other hand, a high and rising gold price signals concern for inflation as ever-increasing quantities of fiat currency are pumped into the money supply. Gold acts as the proverbial canary in the coal mine.
Large bullion banks, for their part, can benefit from the sheer size of their net long or short positions. If bullion banks choose to build up large short positions, and then initiate a gold price crash (as we may have just witnessed), they benefit by cashing in on their short positions. Once the dust settles, these nimble speculators can also profit from the likely bounce that almost always follows the selloff by going long.
However, let's not forget the law of unintended consequences. It now appears the perpetrators of the gold panic may find it increasingly difficult to achieve any future manipulations.
Law of Unintended Consequences
Back in March ABN Amro, one of Holland's largest banks, told its clients that it would no longer be delivering physical gold. All accounts with gold holdings would be settled in cash rather than bullion, whereas clients previously could have taken delivery.
This naturally raises suspicion that the custodian simply doesn't have sufficient gold to deliver on all accounts.
It's been suggested that as much as 100 times the amount of physically delivered gold is traded in the form of paper gold on futures exchanges.
The trigger for ending potential gold price manipulation could come from a default in the futures markets.
All it would take is for too many holders of gold futures contracts to demand physical delivery simultaneously. This would overwhelm the exchange, forcing it to settle in cash for lack of sufficient physical bullion. And that would instantly call into question the integrity of the exchange, much like Bear Stearns, Lehman, and AIG did to the financial system.
The news from ABN Amro, followed by the mid-April gold price crash, look like the first rains warning of an approaching hurricane.
A major default in the futures markets could remove the last shackles holding back a true free market gold price naturally set by supply and demand. Based on recent price action in the physical gold market, it appears we've taken a big step toward that outcome.
We may soon be on the cusp of a brand new gold paradigm, one where prices are set by the physical markets rather than the futures markets. That will make for interesting times.
Would-be manipulators beware: your job just got tougher.
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