YGGDRASIL

Central Bank Gold Sales

Jan. 16, 1998

Note 1:

If you believe the published demand numbers, we are all intimately familiar with the 800 pound gorilla.

For the gorilla is - women! That's right - women!

New mine production and central bank sales this year are estimated by CPM Group to equal about 100 million ounces, or about 31 billion dollars worth at current prices. Central bank sales will equal 17.5 million ounces this year.

Thus the gold market - including central bank sales - is actually relatively small. One good January of Mutual fund sales can come close to equaling gold sales for an entire year.

Investment demand accounts for only 8.7 million ounces this year. Jewelry purchases account for over 50 million ounces. Industrial (computer) uses account for the rest.

The Russian central bank is acquiring a large monetary supply of gold as everyone else is selling. They plan to acquire 64.3 million ounces, and have 14.23 million ounces right now.

Thus, Russia is a close as you will come to identifying a single 800 pound gorilla.

Total above ground supply is estimated at 130,000 tons. (A ton equals 32,272 ounces.) This supply - three quarters of which is in private hands - has a market value at current prices of about 1.31 trillion. Total U.S. debt (all sectors) now numbers 20 trillions.

Central bank gold holdings of 32,000 tons have a current market value of about 322 billions. The U.S. M-1 money stock (cash plus checkable deposits) is now 1.1 trillion. M-2 is 4 trillion.

I do not know what the world M-1 is, but it must be close to 10 trillion. Central bank gold at current prices is going to equal a much smaller fraction of World M-1 than 10%.

But as you can see, in a crisis the supply of gold is quite inelastic. If Bill Gates decided to buy $30 billion worth in a single year, he would risk doubling the price. In reality, if central banks suddenly decide to follow Russia's lead, it is going to take monster prices to coax the gold away from the necks of women in India, Thailand and Italy. (But in truth, as to that remaining 3/4 of the supply, we have no idea where it is. All we know is that it is not in the hands of hedge funds or momentum players ready to sell!)

Hence my guess at $5000 an ounce in a monetary crisis.

Note 2:

Read your web site. Excellent analysis.

BTW, I don't put much credit in the sources of demand for gold ginned up by the analysts such as CPM group.

I strongly suspect that there is an economic war going on out there, and that someone is stockpiling the stuff in anticipation of a generalized currency collapse.

Can't prove it, but it just has that "feel" about it.

If I had to guess, I would pick the house of Saud. But given the size of the market, an Emir could easily do it too, but not out of petty cash.

Given the relative thinness of the gold market, a large buyer would be foolish to do anything other than identify himself as a "jewelry fabricator" and try to blend in with the crowd.

Note 3:

The gold market fascinates me because it represents the clash of wildly conflicting belief systems.

Given these conflicting belief systems, it is a market that is ripe for conspiracy theories.

My friends who are mining engineers all think (and were taught at places like the Colorado School of Mines) that holding precious metals is crazy. "There is just too much of the stuff in the ground." Prices will always go down, forever. The quicker you can sell it the better. If you can sell the stuff three years before you mine it, that is even better still!

This explains why management of the gold mining companies has sold forward at least three years of mine production.

The belief system that motivates investors generally is "momentum" or MO. There is no reason to hold an investment unless it is going up RIGHT NOW. With the internet and faster, cheaper information at the fingertips of individuals, why would anyone buy on contrary opinion and wait? If your intellect tells you something is undervalued you take two aspirin and buy something else that is going up now! If it ain't got MO, it doesn't exist!

This explains lack of interest by ordinary investors, and the falling price trend for gold and gold stocks. After all, if the insiders are so negative on the stuff, why buy it?

But the buyer of all these forward sales?

Ah, there's the rub!

Rather than just buy on the open market, and drive up price, the buyer pays a central bank the current price to deliver physical gold right now. The central bank earns interest on the proceeds until it pays these proceeds to a mining company that has promised to deliver an equivalent number of tons years later at today's price. In the meantime, the central bank treats the piece of paper from the mine as if it were physical gold in its vaults.

The buyer apparently wants physical gold right now, and also apparently finds the paper promise from a mining company, which the buyer could procure more cheaply without the presence of a central bank in the transaction, unacceptable.

It is the classic maneuver of a purchaser and seller both fearing that their transaction will move the price, but fearing movement in opposite directions and for wildly opposing reasons. Each wishes to have his price set by market players (principally jewelry buyers) clearing much smaller volumes.

Now what does the structure of the transaction tell us about the beliefs of the buyer?

Most investors want to move the price up. If price doesn't move up (ideally, at the end of the acquisition program) how do you sell at a profit?

If you believe in the value of the dollar - or more accurately - the ability of central banks to maintain the value of currencies in general for very long periods of time, then gold has essentially zero long term investment value.

On the other hand, if you believe that our modern currencies will, given enough time, collapse, then gold is worth a large multiple of its current price. Thus we have the spectacle of a market that values gold at $310 per ounce, when we know that it is either essentially worthless, or worth many times its current market price.

The structure of the forward sale tells us the purchaser does not expect to profit immediately and he does not expect to profit from an increase in jewelry demand. The fact that the deal results in immediate physical delivery clearly indicates that the buyer expects a generalized currency collapse or a collapse of the dollar but thinks (i) the timing of that event impossible to predict and (ii) that momentum investors simply will not have time to react.

Having gold will then allow him to issue a solid currency, or to back his existing currency, thereby leveraging his initial cheap investment by whatever multiple of gold backing the market will then accept.

It is a bearish long term bet on our modern "computer cipher" currencies.

Note 4:

The players with an obvious and intense interest in low gold prices are the central banks themselves.

Faith in the CPI is essential to keep savers believing that you can get a real yield on a 6% bond. Plus the CPI is used to index tax rates and to index Old Age benefits.

A low CPI increases taxes (by slowing the expansion of income brackets taxed at the lower marginal rates) while it contains the growth in the government's major liability, Social Security Old Age benefits.

Grumps like myself argue about the quality adjustments. A new Camaro that cost $2800 in 1967 costs only $7950 in our U.S. CPI. Never mind that a dealer will want $21,000! The dealer obviously doesn't understand "quality improvements"!

But more fun than quality improvements are the "substitution adjustments." As the price of steak rises to the point that 20% of people switch to chicken, the weighting of steak in the CPI is reduced by 20%! Ingenious! Just wait till we all switch to soybean meal! That will sure make inflation go down!

In any event, the carping of common sense cannot withstand the market message of gold, which is depressed.

Fact is that the central banks cannot let the price of gold rise on a sustained basis, because then it will have MO! And you know how intensely attracted our baby boomers are to MO! It is one thing to allow stock prices to surge in a parabolic bubble, but it is quite another to allow gold to do this. Rising gold would trigger an exodus out of all the fake currencies, putting downward pressure on their prices while casting suspicion on the CPI. Such behavior by the peasants would badly damage their governments!

Beginning in 1988, the central banks began selling. At first they did it quietly. Now they are trying to jawbone the price down.

In order for the threat of sales to be credible, you must have gold to sell. The central banks have 12% less now than they did 9 years ago.

Over the last 4 years it has taken an accelerating amount of sales to keep the price down. The central banks can keep this up for quite a few years, but as soon as the market notices that the absolute size of the sales is declining (as it must to maintain the threat), the market is likely to test the resolve of the central banks on the upside.

Gold is nothing more than a competing currency.

Gold sales allow central banks to gun their money supplies while maintaining confidence and rate arbitrage opportunities for their financial elites.

Are Arabs happy to exchange cheap oil for cheap gold? Sure! At the margins they are! But well over 90% of their oil revenues are spent on goods and services denominated in currencies. Only a tiny fraction of what is left is spent on cheap gold.

However, (the anonymous poster) is right to point out that the resource rich countries (Arabia and Russia) do not have any real interest in defending the belief systems we call "currencies." Arabia and Russia are concerned only that there be a medium of exchange that allows the oil consuming nations to buy. It is the consuming nations that have an intense interest in defending currency values and in selling gold to do it.

The important thing to recognize is that gold sales are significant primarily for their impact on "market participants" (keeping us peasants in line!) These sales have very little impact on the relative values of currencies vis-a-vis one another.

In fact, public gold sales allow governments to maintain confidence while parting with much less gold than would have been required under the old gold standard (involving transfers between governments). The longer governments depress the price of gold, the more the imbalances will accumulate. Sooner or later, gold buyers will attack the currencies.

But in the meantime, gold is a very unattractive long term investment unless you are writing options on it.

The producers of gold do not believe in it and don't know how to defend its price. In this environment, the threat of central bank sales has allowed the commodity funds to push the price down at will with no resistance from investors. They are in the process of pushing it down to levels that trigger mine closures, curtail exploration and bankrupt weaker mines.

Bank selling creates volatility and opportunity for the futures traders.

And in the meantime, we wait.

Ygg-


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