Friday, September 23, 2011

Why Gold Isn't A Safe Haven

In the past couple of days, gold has dropped close to 10%, and is now trading around $1650 per ounce. That's 15% down from its recent peak price of around $1920. Why the belly flop? The answer is that, contrary to pronouncements of bug-eyed gold fanatics who drool from the sides of their mouths, gold is not a safe haven from fiat currencies or the financial system. Instead, it is joined at the hip with the financial system.

Among the most active traders in gold are hedge funds and other financial firms. These market players mainline leverage. And when they can't find a vein, they smoke the stuff. Consider the nature of leverage. It's a loan denominated in fiat currencies like the dollar and the euro. Leverage must be repaid in fiat currencies. Banks extending margin loans don't want to speculate in gold themselves, so they require repayment in dollars, euros or some other fiat currency.

Leverage financed the great gold rush of 2008-2011. This time, prospectors didn't search for yellow metal in stream beds or under the ground. They sought riches in the trading platforms of exchanges. The ones that got into the market two or three years ago hit the motherlode. But as gold bubbled up, smart players began to wonder when the party would run out of punch. The financial crisis of 2008 taught us that bubbles will burst at some point. Stocks and real estate both bubbled up and burst, and gold isn't different. Part of today's selling is to lock in profits while the getting is good. Locking in profits involves converting gold holdings to a fiat currency. That's the only way to take your gold profits and use them to repay margin loans, and buy cars, food, housing, and so on. So when money managers think the gold bubble, as valued by fiat currencies, has peaked, they will sell gold in order to obtain fiat currencies.

Other hedge fund managers may be selling gold because their investors, seeing the world go hinky in recent months, are making redemption requests to cash out. Investors may be worried about stocks, oil, or other assets besides gold that the hedge funds invested in and are now falling in value. But gold is easier to sell than some assets because it has a highly liquid market. So investor redemption requests, in effect, hit the gold market. Investors want payments in fiat currencies, not distributions of gold. That means the gold has to be sold to convert it into fiat currencies.

The players who dove into gold also traded on a leveraged basis in stocks, other commodities and maybe derivatives that no one can easily learn about because the derivatives market, three years after the financial debacle of 2008, remains opaque. Part of the selling of gold is due to speculators having to raise cash to meet margin calls resulting from falling prices for stocks, commodities other than gold (such as oil, which has lost some of its sheen) and, perhaps, derivatives contracts. In this way, leverage used to invest broadly on a diversified basis can have an interlinked downward impact when some markets go wobbly.

The recent woes of the euro add to the problem. A fall by the euro has pushed up the comparative value of the dollar. Since gold tends to trade inversely to the dollar, a good day for the dollar means a bad day for gold. That's another reason for gold investors to bail before they sustain more losses. The inverse correlation between the dollar and gold reveals a vulnerability of gold to a fiat currency.

With the financial markets and world getting hinkier by the trading minute, the selling has accelerated in the past two days. The ship seems to be sinking, and you know who is scrambling to get off first. Leverage dramatically pushed up the price of gold, and now deleveraging and other financial factors are driving it down.

Today's gold market is a creature of the financial system, and is subject to the same pressures and constraints as other assets. Gold isn't a safe haven. What is? That's the question people have been asking since they sharpened long sticks for protection and sought shelter in caves. When you have the answer, please clue in the rest of us.

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