Digging deep in search of gold's puppeteers

The inability to pinpoint what drove gold's historical fall this week highlights the way of modern markets. But securities, the yen and hedge fund dynamics were all in play.

One of the intriguing aspects of the implosion in the gold price over the past few days has been the apparent inability of anyone to come up with a coherent explanation for what triggered it and why it was so ferocious.

There are plenty of theories. The Federal Reserve’s open market committee minutes and the discussion about the possibility of an early end to the US quantitative easing program is one factor cited, as are a shift to a 'risk on' investment environment, fears that Cyprus might dump its gold holdings and receding expectations of an inflation breakout in response to the money-printing occurring in much of the developed world.

While any or all of those potential influences might have triggered the break in the gold price (which did stabilise overnight) they don’t explain why the price plummeted so precipitously and produced the biggest two-day fall in three decades.

The problem with modern global financial markets is that they are so opaque and sophisticated that it is difficult for policymakers or participants to track flows of capital and activity. It is obvious that exchange-traded commodity funds were big players in the rout (The young funds adding to commodity swings, April 15) and possible that macro hedge funds, either via the ETFs or directly, also played a role.

To put what happened this week into perspective, Bank of America Merrill Lynch estimated that there were net sales of about 480 tonnes of gold in those two days, or about 20 per cent of the annual mine supply.

That doesn’t mean 480 tonnes of gold, or whatever the number actually was, were physically sold. While there is, obviously, a physical market in gold or securities backed by physical gold holdings, there is also a significant overlay of purely synthetic exposures – purely financial bets on the price that are settled in cash. Some of those are highly leveraged, which might also be a strand in the explanation for the steepness of the fall.

Something curious did happen over the past week. After the Bank of Japan announced on April 4 that it would step up the aggression of its monetary policy easing and planned a $US1.4 trillion quantitative easing program the yen, predictably, tumbled. Over the past week or so, however, it actually strengthened, although it resumed its weakening against the US dollar today.

Ever since Japan announced it would embrace what has been termed 'Abenomics', or very aggressive monetary policies designed to drive the value of the yen down and make Japan more competitive, the yen has been a one-way bet.

Hedge funds have created a massive carry trade, shorting the yen while going long gold. It looked like a perfect trade, given the near-certainty that the yen would remain weak and that in an era of extraordinary loose monetary policies in Japan, the US and Europe, gold’s value would be supported by its status as a hedge against inflation.

When the gold price broke, the yen-gold carry trade would have been undermined, forcing hedge funds to cover their yen short positions and quit their long positions in gold.

The unwinding of those trades would have occurred against the backdrop of a build-up in net short positions in gold by fund managers since the start of this year and an accelerating outflow of funds from gold ETFs (which became a stampede over the past week) as the gold price continued a slide from its peak of around $US1875 an ounce reached in October last year.

Gold itself isn’t a particularly liquid commodity and is costly to store and insure. Gold securities – whether ETFs or derivatives – are, however, highly liquid, as the scale of the selling over the past week or so demonstrates.

Given the probability that there would have been significant leverage associated with the carry trades and ETF exposures (whether within funds themselves or more directly within the investor entities) there would almost inevitably have been cascading margin calls as the price dived, exacerbating the extent of the selling and the price falls.

None of that explains with any precision what actually pricked the gold price bubble, but within the dynamics and structures of modern global markets activity probably lies a large part of the explanation for why the fall was so savage.

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