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Gold Looks for Traction
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(June 4, 2006) Commenting on gold’s trip beyond $700 last month, analyst Peter Bernstein said, “All the necessary conditions for a mess were there.” Now, with the US intending to ‘talk’ with Iran, gold’s recent war premium may be lessened, but “necessary conditions” prevail that will pick up and carry gold prices for some time forward…
U.S. trade and budget deficits have not gone away. Oil prices seem stuck around the $70/barrel level. China’s off-take of copper and other base metals has not abated. The U.S. dollar seemingly earns even less international respect every month, and its status as the world’s default reserve currency is increasingly being challenged. Inflation, always with us, bodes likely to increase over the next few months as higher energy and basic materials prices make their effects known to the economy.

In short, the fundamental reasons for owning gold haven’t changed. However, due to the fact that trees don’t grow to the sky, gold today can be bought 10% cheaper than at the height of last month’s run-up into the $730s.

Even Barron’s this week (6/5/06) headlined: “If Gold Slips to $600, Buy It!”

In that article, Michael Kahn makes the following point about where we likely are in the current gold rally:

“At the time of gold’s recent peak above $700 an ounce, several “experts” predicted that it was head to $1,000, $2,000, or $3,000 an ounce…Such forecasts are reminiscent of the Dow 30,000 type predictions made in 1999 and 2000 before the stock bubble burst. Is this a danger sign? Not really. The stock market was on everyone’s mind in 2000, and the wildly bullish calls drew massive media coverage. Current gold calls aren’t getting the same coverage on Main Street. Don’t be fooled into being a contrarian. Contrarianism depends on doing the opposite of the masses, not the opposite of a handful of people. It’s one reason to view the current decline as a correction and not the end of the bull market.”

Elsewhere in Barron’s, Christopher Whalen’s article about banking derivatives (“A New Form for Risk – are these derivative over-the-counter, or under it?”) highlights a threat to banks and financial markets in general – the trading of unregulated credit-default swaps (CDS) to the tune of possibly some $40 trillion among banks.

You might ask, what’s the worry in banks trading these esoteric derivatives among themselves? After all, they’re financial adults, accustomed to handling risks of all sorts. But Mr. Whalen’s most chilling point is the counter-party risk that banks rather casually take on in a quite un-transparent trading environment:

“Since highly leveraged hedge funds are the predominant seller of CDS contracts to banks, a growing portion of the aggregate credit risk of the U.S. banking system is held by unregulated, under-capitalized players who have little incentive to limit risk.”

“Say a bank has $10 million in exposure to GM. The bank can lay off all or part of the credit-default risk to another bank or, more likely, a hedge fund, and then think itself risk-free. But the bank’s overall risk has increased, because it added a new leg to the original bilateral credit agreement. Where once the bank had only to worry about GM, now it must worry about GM and the hedge fund.”

The massive market in derivatives of all kind has been a point of concern since it first came to light during the collapse of Long Term Capital Management some eight years ago. At that time, in a market much smaller than today’s, the collapse of hedge fund LTCM caused a domino of counter-party positions to fall and set off alarms in central banks the world over. It took the intervention of the New York Fed to prevent a general world-wide financial crisis at the time.

Today, essentially nothing has changed, except we are now aware that when so many financial institutions are interconnected through swaps and derivative positions, often with parties unknown or of limited capital resources, stuff can happen.

Whalen cites an estimate of the total size of the market in derivatives traded by US banks to be $96 trillion as of November 2005.

To say that $96 trillion ($96,000,000,000,000) is a lot of money is a meaningless statement, because there literally isn’t that much currency on this planet. Ninety-six trillion is such a tremendous number that there’s nothing monetary to compare it to. For comparison, all the gold ever mined in the world (most of which is still around) at today’s price of $630/ounce totals some $3 trillion worth, or about 1/32nd the value of all these derivatives.

Any measurement of derivatives is almost beyond the limits of human understanding. You might as well try to imagine the number of grains of sand on quite a few beaches.

And the 96 plus twelve zeroes figure is six months old. At the current rate of growth, today the market in financial derivatives traded by US banks is no doubt over $100 trillion. Or, to put it another way, one tenth of a quadrillion dollars. Does stating it that way make it any more comprehensible?

The miracle of monetary creation by government fiat is a marvelous thing to behold, but leave it to the private sector to go it a few orders of magnitude better.

For instance, the financial inventions known as derivatives that are emerging today from laboratories staffed by young, creative MBAs and stochastic calculators seem in every aspect to resemble viable creations, useful new tools in allocating risk among consenting parties. But, like Dr. Frankenstein’s creature, they are patched together from parts gathered here and there. Start with fractional reserve banking, use fiat currencies as your medium, and buy, sell, and swap contracts ‘derived’ from various markets and risks, creating a market in derivatives on financial instruments among banks, corporate debtors, and hedge funds, all perched atop each other like acrobats at a circus. What a show!

Which is not to say that all complicated transactions are inherently unstable. But who vets all the counter-parties involved? Every bank and hedge fund is of the opinion that they have each ameliorated all risk, or at least quantified and limited such risk. The image that comes to mind is that of a house of cards waiting for a strong wind to blow it all down.

Is it any wonder that people are pulling a portion of their assets out of this impenetrable swamp where, they are told, their ‘money’ resides, and putting it into something as easy to see and understand as gold? In today’s environment, the case for owning precious metals is stronger than ever.

 

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