Follow the (Gold) Money

Wow! Did you notice? The IMF didn’t get any bids for its latest offer to auction 191.3 tonnes of the remaining gold that it wants to sell. Apparently the Central Banks of the world have shown a distinct lack of interest in the proposed bullion sale.

Gold game-over, correct? Not exactly.

Recall that India bought 200 tonnes of gold late in 2009 along with Sri Lanka and Mauritius; each of which also bought small amounts at the same auction. The IMF sale is purportedly based on the IMF’s desire to raise funds to help poor countries. I’ll leave a discussion of that ill-conceived notion for discussion at another time. The fact remains that the gold is for sale and apparently no buyers are willing to step-up and be counted. At least, not publicly counted. Wonder why?

There are probably as many excuses as there are potential buyers. One Philip Klapwijk, executive chairman of GFMS, the London-based precious metals advisor, thinks the IMF’s decision underlines a general lack of buying interest now that gold exceeds $1100 per troy ounce. After noting the publicity that India, in particular, received as a result of their purchase last year, it’s quite possible that other potential buyers simply don’t want to risk any adverse publicity.

China has been reported to be buying gold for quite some time as well as encouraging its citizens to also accumulate gold. It appears that China’s purchases thus far are from local mines within the country. One would think, therefore, that China would be a prime potential buyer for the IMF sale. Could it be that China doesn’t want to rock the US dollar-weakness boat? If China stepped up to the plate, the interpretation could be made that China had lost confidence in their US Treasury holdings. Possibly. It has been widely reported that Russia has also been accumulating gold and, therefore, presents a highly potential IMF-sale buyer. Russia doesn’t have the same US dollar exposure as does China, so their reluctance to step-forward is not immediately obvious.

Still another potential deal-killer is the outright disclosures themselves. Prior IMF sales have included specifics including the name of the buyer, the quantity purchased and the price paid. Gold is extremely volatile. Should the price decrease after such a purchase, the buying entity could then be ridiculed for having over-paid. Recall the ridicule still being heaped, rightly so, on PM Gordon Brown who, while still Chancellor of the Exchequer of Great Britain, managed to sell Britain’s gold stash at the very bottom of the market? You have to admit it takes real talent to be that stupid.

For at least the last two (2) decades, approximately 400 tonnes per year have been sold by central banks. Presuming this year will be no exception, an additional 191.3 tonnes on top of a 400 tonne average is not a small percentage increase. While the IMF has repeatedly stated that they wish to avoid disruption in the gold market and that they plan “phased sales,” what amounts to an almost- 50% increase in volume is certainly a major consideration.

It is also important to acknowledge that European gold sales have recently diminished. If this trend continues, an additional 191.2 tonnes sold could be somewhat insignificant. The jury is still out.

Where does that put us? Do we keep what we’ve accumulated, sell or buy more? To answer that question, you need to go back to basics. Recall why you started accumulating gold in the first place. Has anything changed? Is the dollar now stronger? (Well yes it is, but that is probably a short-lived phenomenon). Have the underlying ground rules changed? Since the world is awash in fiat, has anything really changed to cause you to panic out of your gold? Do I even have to address this question?

Yesterday, February 18, 2010, the Federal Reserve announced that they were increasing the Fed Discount Rate. That was certainly a surprise – at least to most observers. Was it meaningful? I suggest it was not meaningful. Recall that the Discount Rate is completely different from the Fed Funds Rate. The Discount Rate applies to the interest cost of overnight borrowing. If one bank finds itself short on reserves, it borrows from another bank overnight to keep itself within the required percentage reserves. The next day, it covers its needs for reserves and repays the loan. The Fed Funds Rate, on the other hand, refers to the rate banks must pay to borrow from the Federal Reserve. The Fed Funds Rate is much more critical to the actual cost-to-borrow rates businesses and individuals pay. What just happened is unimportant unto itself, but perhaps is more important from a perception viewpoint.

You’ve heard that perception is more important than reality. The immediate reaction to the Fed move was strictly perception because it certainly had no bearing on basic interest rates. Investors want to “know” that the dollar is being protected; that it is being supported; that it is not being sacrificed for the sake of covering the madcap spending spree from Washington DC. On the one hand, we know that the Discount Rate doesn’t affect dollar strength. On the other hand, the fact that the Fed would raise the Discount was apparently interpreted as meaning the Fed would also, some day, any day now (NOT), increase the Fed Funds rate, too, and thus protect the declining dollar. I submit that is why the market reacted positively. It certainly was not a reaction based on fundamentals. Perception works, at least for short time periods.

The argument for owning gold is that it offers an inflation hedge. With world-wide fiat money in circulation that is being increased in volume at the whim of the respective issuing governments, anyone interested in preserving their accumulated wealth must take pro-active measures to protect their positions. One way has been to stash capital in assets that tend to maintain value regardless of debased currencies. Gold has met that need for thousands of years. It’s unlikely that anything will occur to change that protection in the near future. Is this not still the basic protection we seek?

I’m always pleased when what passes for main-stream beliefs pokes fun at my investment portfolio. That tells me I’m still on the correct path to prosperity. I accumulated gold all through the 1970s as protection from the falling dollar. Recall that Nixon killed the dollar on August 15, 1971 when he closed the gold window. Anyone paying attention could then predict the outcome. Gold rose.

As gold rose in price, more and more folks became aware. In early January, 1980, several of us were having lunch at a restaurant when our waitress asked about our line of work. When we mentioned investment advisory, she volunteered as how she’d just taken a 2nd mortgage on her home and bought gold. After she left our table, I said “Guys, it’s time to sell!” I actually sold that afternoon – at $750 per ounce. That was $750 on the way up to the top at $850 before it crashed. Sold too soon, right? Wrong. Never be greedy. It was obvious by that time that the general public had become aware of gold and were now buying. In fact, it was a buying frenzy. As Bernard Baruch was fond of saying, “When the shoe-shine boy starts touting stocks, it’s time to sell.” We’re nowhere near that gold sell-point yet.

Yes, you now see more and more commercials advertising gold investments. At the same time, you see more and more ads from folks who will buy your “junk” gold. There are even Tupper-ware-type parties where neighbors bring their “junk” gold to sell to a visiting buyer. Then the sellers brag how happy they are that they were able to get rid of their “junk” gold and get real cash they can now spend. No mention is ever made that the price they were paid was far below the prevailing spot price of the underlying gold. What a deal!

Is gold in a bubble? Possibly, but if so, it still has a long way to go before the top is reached. The top will make itself known if you simply watch the market actions. In the meantime, what else can you do, if not invest in gold, to help protect your accumulated wealth?

Tex Norton

February 24, 2010

The Daily Reckoning