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A Secret Time Bomb Made of Gold
September 12, 2007

THE VOLATILITY SEEN THIS QUARTER IN the stock and credit markets may be new to younger investors. But there is something lurking out there that can make things really dicey.

A little-known fountain of free money called the "gold carry trade" is in danger of drying up. And if it does, then markets from gold to bonds and even stocks can be in for a wild ride.

Before even explaining what the gold carry trade entails, let me first say that its demise has been forecast for nearly a decade. In researching this topic, I found articles as far back as 1998 looking for an explosion in gold prices and commensurate damage to other markets, if not the economy. In other words, this is a story that is as old as Methuselah.

But with a sinking dollar, soaring commodities, and several diverse technical conditions on the charts, the dynamics are coming together to make the end of the gold carry trade a lot closer to reality than ever before.

The gold carry trade is similar to the yen carry trade, which has been a hot topic in the markets this year. Basically, money is borrowed from one source at a low interest rate and invested elsewhere at a higher rate. As long as relevant exchange rates and asset prices remain stable, a profit is made with little effort.

Central banks are sitting on huge supplies of gold that earn them no interest and cost them money just to store securely. To earn a little revenue on these static assets, they loan their gold to banks, called buillon banks, at a ridiculously low interest rate on the order of 1%.

The banks turn around and sell the gold in the market, typically in the London bullion market, and invest the proceeds in a higher-paying asset, such as long-term Treasury bonds. If bonds pay 4.6% then the banks earn an easy 3.6%.

The problem is that if the gold price starts to rise, profits can be wiped out or turned to losses. And in today's market, a falling dollar not only boosts gold prices but it also makes Treasury bonds less attractive to foreign investors. That reduces demand and weakens prices to create a potential double-edged sword for carry traders.

The banks, of course, realize this and hedge their gold sales by buying gold futures. According to Kevin Schweitzer, senior vice president with Hudson Securities, a firm that makes markets in gold stocks, the hedge is not perfect. If central banks call in their gold loans, the banks cannot wait for contract expiration to take delivery on the gold they purchased via their futures contracts. They have to pay back their loans right away and if gold prices are stable, there is no problem for the banks going into the physical market to buy back their gold.

However, if gold starts to rise quickly, the added demand from the banks to buy gold can exacerbate the rally causing what amounts to a mad dash for the metal. The market will respond with steeply higher prices, and Schweitzer sees this pushing gold to $850 by the end of the year.

All of this is fundamental in nature so let's examine the technicals a bit more. As the chart shows, gold peaked in May 2006 in what some labeled a speculative bubble. However, rather than falling quickly as burst bubbles portend, the market moved sideways for the next 15 months (see Chart 1).

Paul Mylchreest: Gold War: "Gold is money and nothing else" – Gold is sending a warning

Conflict between governments and gold

Its role as the ultimate form of money puts gold into a situation of permanent competition with unbacked (by precious metals) fiat currencies created by governments and, consequently, with the governments themselves.

This conflict is still unappreciated by many, although not those from the 'Austrian School' of economics, like Ludwig von Mises:

"The struggle against gold, which is one of the main concerns of all contemporary governments, must not be looked upon as an isolated phenomenon. It is but one item in the gigantic process of destruction which is the mark of our time."

The lesson of history is that paper currencies that are not backed by precious metals ultimately tend towards their intrinsic value, i.e. zero.

It cannot be refuted that at times of maximum economic or financial crisis for the US economy during the last century, or when the dollar's status as the reserve currency has come under severe stress, the US Government (aided by other governments in some cases) has tried to manipulate the gold price. The three most obvious examples are:

> The Great Depression of the early 1930s: President Roosevelt confiscated gold from US citizens who were hoarding it ahead of an anticipated devaluation of the US dollar (US citizens could not legally own gold again until the beginning of 1975).

> The collapse of the London Gold Pool and the Bretton Woods system in the late 1960s/early 1970s. The Federal Reserve and eight European central banks pooled their gold resources in an unsuccessful attempt to suppress the price of gold
and preserve the dollar's value at US$35/oz versus gold.

> The runaway inflation of the late-1970s. The US Treasury and the IMF sold approximately 1,200 tonnes of gold during 1976-80; nevertheless the gold price reached its all-time high of US$850/oz in January 1980. In April 1978, the IMF took
further action to demonetize gold. In the Second Amendment of the Articles of Agreement of the IMF, gold was removed as a means of inter-nation settlement.

In a 1981 American Institute for Economic Research essay, the economist, Ernest P Welker stated:

"Beginning in 1975, the United States, aided by the principal members of the International Monetary Fund (IMF), began a 'bear raid' on the gold markets of the world. It was a raid of unprecedented proportions and duration. The underlying purpose of this raid was to convince the citizens of the major nations that paper currencies are better than gold. Success of the operation would ensure that inflating by excessive issues of paper currencies could continue indefinitely."