Crisis of Confidence!

Everyone is perturbed about 15% fall in gold price in 2 trading sessions, but few probably understand how this metal works. People who track my views, lower gold prices may not be a surprise (refer to my earlier article “2013: Tipping point for gold?”). What is worrying though, arguably so, is the pace in which gold drifted down, making it the biggest fall in 30 years, spiking up volatility to 30% from a pre-crash level of 10%.

I don’t dive deep into the reason for such a fall as the financial media has covered extensively over the last few days. What is interesting is that the Precious Metal is the only store in the world where they put up a sign saying “Sale: 20% off” and yet most people are running, screaming into the street. Does that mean gold's stature has changed forever? No, it cannot be.

In order to understand gold, one needs to understand the perception of risk. Sample this toxic cocktail – The unemployment rates in Spain at 26.1% (youth unemployment at 55.6%) and in Greece at 26.8% (youth unemployment at 57.6%). The budget deficits - Spain at -9.4%; Greece at - 9.4%; Ireland at -13.4%; UK at -7.8%; France at - 5.2%. The average budget deficit in 27 nations European Union is at -4.4% against the EU budget deficit limit of -3%. The EU growth in 2012 is at -0.4% and IMF forecast for 2013 is -0.3%. The risk has never been this graver with most of Euro Zone countries in a disastrous state with ever increasing budget deficits, alarming unemployment rates, social unrests and sitting on the verge of a collapse. It is unprecedented today that there are roughly around 40 countries in the world whose economies have either zero or negative real interest rates. Yet, their bond yields travel southwards and the  risk assumed to be contained and everything seems rosy. 

How is this possible?

It is the confidence game (trick!) that central bankers play today. The equation is simple: zero interest rates + quantitative easing = confidence. And, once confidence in the monetary system is restored, growth will be back. In a Fractional Reserve Banking system, number of claims on a single paper (asset/currency) is many and if confidence fails, every investor tend to own their money back at the same time. This is when the Bank Run - Cyprusization of banks? If the confidence is not restored back, there will be a rush to sell bonds, spiking up bond yields creating fear and panic in the market. This vicious money printing cycle cannot continue sine die. 

On August 2011, the fractional reserve lending in gold markets that goes into the gain of central banks and bullion banks for decades came to an end. Very few noticed it when Chavez repatriated 99 tons of Venezuela’s foreign gold reserves kept in the Bank of England back home as gold is the last resort for central bankers to avoid any potential turmoil. Visualizing the danger of a potential fall out of the fractional reserves banking system, countries – viz., Switzerland (Mar 2012), Ecuador (Oct 2012), Austria (Nov 2012), Netherlands and Azerbaijan (Jan 2013) - have initiated the process to bring back their gold kept abroad. But, none of this disturbed us when Bundesbank of Germany joined the party in Jan 2013 by announcing to bring back 11% of their 3391 tons from Banque de France and another 300 tons from New York. What is interesting though is that these 300 tons will take approximately seven years to cross the Atlantic to back home. This is a considerable shift from the start of this millennium when ECBs were selling 500 tons a year under CBGA. Even if majority of the big central banks across the world pull out their gold from BOE and Fed at the same time, there shall be a collapse of the fractional reserve lending system in gold.

With too much money flooding the system from the global central banks, government across the nations are trying to cure the symptoms rather than the disease. Despite this flooding, there is a growing crunch of liquidity in the system that is trying to (re)allocate the capital elsewhere and gold’s fall reflects this reality. The situation is strikingly similar today when compared to 1970s. It seemed that inflation was under control when (US) CPI fell from around 10% to 6% during 1976 and simultaneously gold corrected more than 40% from December 1974 to August 1976. But, Gold swiftly turned up and started to rally and CPI followed later just to double in 1980s. And, if history proves to be a good guide, there is more on the store than most of us could imagine today.

In an era where business cycles are determined every four to five years when new governments get elected, it is prudent to follow tactical asset allocation without losing sight on the strategic allocation. The financial world has evolved far more complex when compared to last few centuries, when precious metals are truly a safe haven. This position was assumed to be taken over by the so called reserve currencies of the world and history has recorded it all for us - from Deutsche Mark to British Pound to US Dollars. And, hence if USD or Euro fails, there shall be a catastrophe, but financial pundits of modern world would soon be able to identify the next safer haven in paper - be it Swiss Francs or Singapore Dollar.

This transition has already begun when big Swiss banks started charging their clients for parking their cash deposit in Swiss Francs. This along with other controlled measures by the central bankers to curb gold demand with a prime objective being to shore up confidence in the monetary and banking system, bullion in all probability cannot be a free market. As bullion derivatives market is far larger than the size of physical metal, a small trigger is sufficient enough to create a big impact. We all know this now, isn’t?

The lists of things that can go wrong are many. Collapse in confidence, surge in inflation, huge social and political unrest, global recession, breakup of the EU, series of sovereign defaults, worldwide currency war, missing central bank bullion were possible outcomes and any of them can trigger a collapse. In each case, the value of gold as a safe haven and a store of value shall enormously increase.

When the asset allocation pattern changes for reason that is more tactical in nature, fund flows back into USD and other developed equity markets, gold fell on its own gravity given the unprecedented rally witnessed all these years. This fall does not mean gold is on the path to a long term bear market. All it gives is a pause on a long marathon that started way back in 2001. The rally will continue for many years and gold is just refilling its reservoir and its energy for the best years that is yet to come. It may take few months or quarters for the lakes to refill back to reach an overflow level.

Gold behaviour has always been associated with the crowd psychology of the market and the current fall reflects that perception of risk being lower. In a fight between real and paper assets, what is real always stays real and in the fight between global central bankers and the real assets, gold shall lose the battle to win the war. In the end, he who owns gold, rules the world!