Monday, 12 November 2012

Sudden swoons are the fate of precious metal prices

The future casino

The futures volume traded exceeds the trade of physical products manyfold. This often is the case for soft commodities, crude and non-ferro metals. Yet precious metals really thrump all. Many on-line trading platforms don’t even allow any physical settlement, reducing a future contract to a bet on the future price. Describing a gold future transaction as "a promise to sell by a party who hasn't got the precious metal to a buyer who hasn't got the cash" is hardly exaggerating.

The sale and purchase of a gold future requires both seller (the ‘short’) and buyer (the ‘long’) to make a deposit, tieing both to the contract. With the gold price slide, the long needs to increase his margin, while the short is credited. With the gold price hiking, the short will need to pony up extra cash. Any short having the metal “good for delivery” (the 100 Oz gold bar) can use it to guarantee delivery. The metal then needs to be stored in one of the vaults certified by the COMEX.
A buyer paying an initial margin of (for example) 5% is as such leveraged up to 20 times the variation of the gold price. This leverage turns the future trade in precious metals into a real casino.
Unfortunately the risk doesn’t stop there. As future investors with MFGlobal have experienced, the cash account they have with some brokers is far from safe, with the potential risk spreading to some of the clearing agencies.

COMEX adds its grain of salt

The initial margin is not fixed. With gold or silver rallying, the initial margin is often raised, not only for new but also for existing future contracts. Future traders not having sufficient reserves to pony up this extra margin are forced to liquidate their future contract. This puts the precious metal prices under pressure. It is generally assumed that the COMEX hikes the margin requirement in order to discourage bullish speculation. This is a misconception. An illustration: The Comex decided on Friday Sept 23, 2011 to raise the margin requirement effective the next Tuesday. During those weeks, gold plummeted after reaching its all time high earlier that month. In doing so, the Comex effectively contributed to acerbate the collaps of the future prices.
It is not entirely illogical that margin requirements can be hiked during a market decline. The increased volatility (daily fluctuations up to $80 for gold and $5 for silver) implies that there are daily ‘margin calls’ for the parties losing (in this case the longs). An increased initial margin gives COMEX the time necessary to check the fulfilment of those margin calls.
Most speculative longs did not take this into account and feel betrayed.
It is evident that the initial margin for futures needs to be adapted when market volatility is spiking. However the communication policy concerning margin hikes seems rather opaque and the timing of those operations feeds the suspicion that COMEX colludes with the (financial) shorts, which are rigging the market.
During a quiet market period (when was that again), initial margins are reduced. Usually small speculators don’t really make a fuzz on those occasions, perhaps because they are fewer in the market.


Since large future sellers (shorts) often are bullion banks and hedge funds run by investment banks, increasing the initial margin in the first place hits the small speculative long. He hasn’t got any access to ‘zero interest rate’ FED reserves. Future trade is a game with unequal opportunities. A future long who correctly positions his trade and should be playing a winning game on the expiry date, may be forced into bailing out of his position due to an unexpectedly severe swoon. Leverage is lethal for the financially weaker party.
A good example is the collaps of the price of silver in May 2011. During previous weeks the COMEX had raised the initial margin several times with only limited success in stopping the silver bull run. An orchestrated sale on Asian markets of silver futures on May 2nd started the collaps of the silver price in thin trading, while European and American markets remained closed. Many speculators saw their unrealised profits evaporate. Margin calls on May 3rd therefore were a difficult hurdle to take, which in itself contributed to the further collaps of the silver market that month. The asymmetry in financial backing between the speculative 'shorts' and 'longs' also contributes to a 'bear-raid' happening within a much shorter time frame than does a 'bull-run'.
The classical proverb is that: "Gold takes the staircase up, but the elevator down".

Doom thinking 

The economic recovery being less vigorous after the 2008 financial crisis is nothing new, as shown by the persistently high unemployment in many states in the US and in several South-European countries. Financial injections and deficit spending could keep the economy engine turning for a while. However as austerity measures are imposed, an economic depression looms.

The deflatory impact of the Greek debt restructuring may have been contained; if more of this is to happen, precious metals are the obvious victim whenever financial institutions are facing major credit losses.

This perspective lead to the lengthy correction of precious metals during the spring and early summer of 2012. 
As speculators are drawing parallels between the strong gold retreat in the midst of the 1970-80 bull market (between Feb 1975 and Oct 1976 the gold price slid 40%), one notices that there is much doubt around. The herd of speculators only returned as the perspective of QE3 was perceived almost a certainty. The much anticipated news was preceded by a gold rally rather than followed by one. After September 21 a rather lengthy and deep 'mid-seasonal' retreat started, possibly ending on Nov 2.
As for now the 'fiscal cliff' hangs as a shadow over the latter part of the end-of-year seasonal gold bull.

I may go on finding reasons for gold demand to weaken, be it a poor Indian monsoon, a weak Rupee or a gold sales tax (even when revoked later on).

Yet there are about as many good reasons to assume a further ascent of gold prices in the months and years to come. The question is: Which arguments get highlighted most. Managing the opinions of potential speculators is much more cost-effective and less risky than rigging the gold market to halt a gold bull-run.

Moreover it procures a window of opportunity to the parties in need of purchasing gold: Central banks of developing nations in the first place.

Knowing who are your allies

To an investor seeking protection against currency debasement and future inflation, what matters is the amount of gold she/he is able to buy. It is obvious that his allies rather are the gold shorts trying to contain the gold price than the speculative longs aiming to profit from a rapid rise of the gold price (and luring the bullion investor into adding to his position on less favorable terms).

The bullion investor may not like to see the dollar value of his gold hoard decline, but it does offer him the opportunity to add more ounces at an affordable price. 

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