Gold Market Radar (April 16, 2012)

Sunday, April 15th, 2012

Gold Market Radar (April 16, 2012)

For the week, spot gold closed at $1,657.35 up $21.12 per ounce, or 1.6 percent from Thursday’s close before Good Friday. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, rose 2.7 percent. The U.S. Trade-Weighted Dollar Index declined 0.3 percent for the week.

Strengths

• On again, off again speculation that the Federal Reserve may need to intervene with more stimulus to shore up the economy led gold to a relatively good week. Both China and the U.S. posted weaker economic data. China’s trade surplus came in at $5.35 billion, substantially greater than the median projection of a $3.15 billion deficit. The weak numbers raised concerns that the world’s second-largest economy faces a deeper slowdown than originally forecasted. In the U.S., nonfarm payrolls rose 120,000 in March, well below market forecasts and a possible sign that momentum in the job market is slowing.
• Randgold Resources jumped 9 percent on Monday on news that a political settlement appears to have been brokered in Mali. Leaders of the recent coup have come to an agreement with the military junta to reinstate the country’s constitution.
• In other positive news, jewelers in India called off their three-week strike over the prior weekend. The Indian government said it would consider scrapping a budget proposal to levy an excise duty on unbranded jewelry. Industry representatives said that if the tax rollback does not materialize the strike would resume on May 11.

Weaknesses

• Technically, silver prices are not following through with the same price strength as gold.  Analysts cite record-high mine supply and demand concerns. In addition, the huge price volatility last year, when the metal crashed 35 percent in a matter of days on two occasions, has dampened silver’s appeal to investors as a cheaper alternative to gold.
• For the second time since February, the CME Group, the largest operator of futures exchanges in the U.S., announced a cut in margin requirements for COMEX silver futures in an attempt to boost liquidity. However, analysts note that margins are still higher than they were last year and it would take some significant interest from investors to drive the price higher.
• The latest Gold Fields Mineral Services (GFMS) report noted that gold prices are expected to be driven by eurozone debt concerns and the prospects of additional monetary stimulus. In their view, gold has the potential to breach the $2,000 per ounce level in 2013. The report also said total cash costs increased 15 percent in 2011 to $643 per ounce, up from $560 per ounce in 2010. Declining mine grades are the largest contributing factor to the increase, contributing $28 of the $83 per ounce net increase. All-in costs (including depreciation as well as general and administrative charges) increased 22 percent.

Opportunities

• Positive economic signs and the rollover of bad European debts through their long-term refinancing operations (LTRO) program pushed the S&P 500 to good returns in the first quarter. However, it is unlikely the recent bright spots are enough for the world’s two great fiat currencies to regain trust from Asia, Russia and the Persian Gulf states. Short-term liquidity issues have been addressed but unsustainable levels of sovereign debt still remain. Western central banks will likely have to keep printing money for some time and those countries with surpluses will have to find a suitable place to park their growing foreign reserves. Currency devaluation has historically been a major policy tool for extinguishing national debt but it also leads to a higher gold price.
• Russia has publicly stated it is raising its gold weighting to 10 percent of its reserves. China, which would like to raise the renminbi to reserve currency status, is eying large gold reserves as well. With official gold reserves sitting at 1,054 tons, China has a long way to go before it can catch up to the 8,000 tons of gold held by the U.S. and the 11,000 tons of gold held by the eurozone. China would likely need to boost the country’s gold holdings in a significant way in order to make its currency competitive in world markets.
• HSBC gold analyst James Steel says that the marginal cost for mining gold, when miners leave low-grade ore in the ground, is about $1,450. Despite a four-fold increase in investment, a lack of great new gold discoveries has made peak gold production a closer reality than peak oil. With world gold output stuck at 2,700 tons for a decade, this creates a natural floor, of sorts, for gold prices.

Threats

• David Rosenberg had some interesting comments on incomes and prospects for a strong recovery in the household sector. The sector has recently been going through the healing process, but is still far from healed. Rosenberg also notes that current real disposable incomes are actually lower than in May 2008 on a per capita basis, $32,600 today versus $34,631 then. Rosenberg says, “You can see why it is that for most people, it is very difficult to talk about economic recovery when real personal incomes have done so poorly and for so long.”
• A recent paper from the African Development Bank (ADB) titled “Gold Mining in Africa: Maximizing Economic Returns for Countries,” points out that gold mining is significant activity in at least 34 of the continent’s 54 countries. The paper notes Africa’s annual gold production is 480 metric tons, 20 percent of annual global output, but concession agreements signed by the governments are unfair. This particularly applies to the royalty rate stated in these agreements. Despite spiraling prices for precious metals, the ADB believes Africa is not cashing in enough from its large gold resources. These agreements severely limit gains from gold mining activity in gold producing countries. However, only a limited number of African countries have actually taken equity stakes in the mines within their borders. It’s worth pointing out that one can only gain access to market returns by risking capital to invest.

Tags: Budget Proposal, Comex Silver, Dollar Index, Excise Duty, Futures Exchanges, Gold Market, gold stocks, Jewelry Industry, Margin Requirements, Market Forecasts, Market Radar, Military Junta, Nonfarm Payrolls, Nyse Arca, Political Settlement, Price Strength, Price Volatility, Randgold Resources, Silver Prices, Spot Gold, Tax Rollback, Two Occasions
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Eric Sprott: Investment Outlook (November 29, 2011)

Tuesday, November 29th, 2011

Silver Producers: A Call to Action

by Eric Sprott and David Baker

November 29, 2011

As we approach the end of 2011, the silver spot price has admittedly endured a tougher road than we would have expected. And let’s be honest – what investment firm on earth has pounded the table on silver harder than we have? After the orchestrated silver sell-off in May 2011 (please see June 2011 MAAG article entitled, “Caveat Venditor“), silver promptly rose back to US$40/oz where it consolidated nicely, only to drop back below US$30 within a two week span in late September.1 The September sell-off was partly due to the market’s disappointment over Bernanke’s Operation Twist, which sounded interesting but didn’t involve any real money printing. Like the May sell-off before it, however, it was also exacerbated by a seemingly needless 21% margin rate hike by the CME on September 23rd, followed by a 20% margin hike by the Shanghai Gold Exchange – the CME’s counterpart in China, three days later.

The paper markets still dictate the spot market for physical gold and silver. When we talk about the “paper market”, we’re referring to any paper contract that claims to have an underlying link to the price of gold or silver, and we’re referring to contracts that are almost always levered. It’s highly questionable today whether the paper market has any true link to the physical market for gold and silver, and the futures market is the most obvious and influential “paper market” offender. When the futures exchanges like the CME hike margin rates unexpectedly, it’s usually under the pretense of protecting the “integrity of the exchange” by increasing the collateral (money) required to hold a position, both for the long (future buyer) and the short (future seller). When they unexpectedly raise margin requirements two days after silver has already declined by 22%, however, who do you think that margin increase hurts the most? The long buyer, or the short seller? By raising the margin requirement at the very moment the long contracts have already received an initial margin call (because the price of silver has dropped), they end up doubling the longs’ pain – essentially forcing them to sell their contracts. This in turn creates even more downward price pressure, and ends up exacerbating the very risks the margin hikes were allegedly designed to address.

When reviewing the performance of silver this year, it’s important to acknowledge that nothing fundamentally changed in the physical silver market during the sell-offs in May or mid-September. In both instances, the sell-offs were intensified by unexpected margin rate hikes on the heels of an initial price decline. It should also come as no surprise to readers that the “shorts” took advantage of the September sell-off by significantly reducing their silver short positions.2 Should physical silver be priced off these futures contracts? Absolutely not. That they have any relationship at all is somewhat laughable at this point. But futures contracts continue to heavily influence spot prices all the same, and as long as the “longs” settle futures contracts in cash, which they almost always do, the futures market-induced whipsawing will likely continue. It also serves to note that the class action lawsuits launched against two major banks for silver manipulation remain unresolved today, as does the ongoing CFTC investigation into silver manipulation which has yet to bear any discernible results.3

Meanwhile, despite the needless volatility triggered by the paper market, the physical market for silver has never been stronger. If the September sell-off proved anything, it’s the simple fact that PHYSICAL buyers of silver are not frightened by volatility. They view dips as buying opportunities, and they buy in size. During the month of September, the US Mint reported the second highest sales of physical silver coins in its history, with the majority of sales made in the last two weeks of the month.4 Reports from India in early October indicated that physical silver demand had created short-term supply issues for physical delivery due to problems with airline capacity.5 In China, which reportedly imported 264.69 tons (7.7 million oz) of silver in September alone, the volume of silver forward contracts on the Shanghai Gold Exchange was more than six times higher than the same period in 2010.6,7 It was clear to anyone following the silver market that the physical demand for the metal actually increased during the paper price decline. And why shouldn’t it? Have you been following Europe lately? Do the politicians and bureaucrats there give you confidence? Gold and silver are the most rational financial assets to own in this type of environment because they are no one’s liability. They are perfectly designed to protect us during these periods of extreme financial turmoil. And wouldn’t you know it, despite the volatility, gold and silver have continued to do their job in 2011. As we write this, in Canadian dollars, gold is up 23.4% on the year and silver’s up 6.8%. Meanwhile, the S&P/TSX is down -12.3%, the S&P 500 is down -5.1% and the DJIA is up a mere +0.26%.8

Tags: Caveat Venditor, David Baker, Eric Sprott, Futures Exchanges, Futures Market, Gold And Silver, Gold Exchange, Investment Outlook, Margin Rate, Margin Rates, Margin Requirements, Money Printing, Paper Contract, Paper Markets, physical gold, Price Of Gold, Rate Hike, September 23rd, Silver Spot Price, True Link
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Italy Update – Collateral Effects (Goldman)

Thursday, November 10th, 2011

What apparently has Goldman confused is how its former employee Mario Draghi has let BTP spreads hit the record and unsustainable levels they did yesterday. To wit: “We were actually quite surprised not to see more forceful intervention by the central bank in secondary markets after the LCH announced it would raise initial margin requirements (and wrong in assuming it would have helped keep the Italy vs. AAA spread close to 450bp – it closed yesterday at 500bp over, but is now back at 450bp).” Here Goldman confirms what we suggested on Monday: that the ECB is now nothing but a policy enactment and dictator overhaul tool: “In this context, Italy still has to comply fully with the ECB’s ‘requests’ dated August 8, while Greece’s commitment to more austerity in exchange for financial support has continued to sway (at the time of writing, news that former ECB no. 2 Papademos would take the helm is encouraging).” Even so, the future to Goldman is quite cloudly :Granted, one positive collateral effect of market tensions has been to precipitate a political shakeup in Italy. But the collateral damage created by the price shock in Italian bonds to the stability of the EMU project (aggravated by explicit talk of countries being expelled from the single currency) is high and quite lasting. It will probably take a leap forward into deeper forms of fiscal risk-sharing (Prof Monti is a long-time proponent of Eurobonds) to get the market properly functioning again.” OTOH, Barclays has done the math, and as we pointed out a few days ago, is not surprised.

Full Goldman Sachs Note

An Update on Italy – Collateral Effects

by Franco Garzarelli, Goldman Sachs

An intensification of pressures on the Italian government bond market, especially after the introduction of higher initial margin requirements on repo by LCH yesterday, appears to have unlocked a stalemate in Italian politics. New fiscal measures (technically, an amendment to the Stability Law), which were scheduled to be voted on in Parliament by the end of next week, will now be discussed expeditiously and most likely rubberstamped by this Saturday. This should then prompt the resignation of PM Berlusconi, who has publicly pledged to step aside after their approval. According to the media, there is now a greater chance that a ‘technocrat’ government including high-calibre personalities such as Prof. Mario Monti and former PM Giuliano Amato may be sworn in by the start of next week. It would seem that Mr. Berlusconi himself has endorsed this solution, as the new Cabinet will likely include members of the PdL party. If confirmed in the coming days, this would represent the most market-friendly outcome at this juncture.

To be sure, the road remains uphill for Italy. The new Italian government will have to pass important and politically controversial economic reforms in the coming months under close scrutiny by the ‘troika’ and markets. Debt roll-over needs also run high (around EUR25bn in December and around EUR114bn in 1Q2012), and some help from either the EFSF or IMF backstop credit lines may be needed along the way. But a strong and reputable government leadership should reduce policy implementation risks (thanks to what we have previously called an ‘initial contracting’ with political parties on the policy programme), allow greater discretion on the sequencing of the individual measures (in recent pronouncements, Monti has emphasised growth-enhancing measures, while Amato has declared himself in favour of a wealth tax) and hopefully mitigate social tensions.

In terms of the bond market, we would expect a reduction of spreads following the appointment of a technocrat government, and a more gradual (and volatile) decline in yields after the successful introduction of new measures over the coming months. As we stated in a recent Global Market Views, we continue to see 350bp over 10-yr Bunds as a credible level around which spreads could settle (currently 530bp). But it will likely linger until a more decisive pan-Eurozone response is finally available (the much-heralded Euro area ‘firewall’ to fend off contagion from Greece is still under construction). In this context, whether the ECB is willing to engage in more pro-active purchases remains to be seen.

We were actually quite surprised not to see more forceful intervention by the central bank in secondary markets after the LCH announced it would raise initial margin requirements (and wrong in assuming it would have helped keep the Italy vs. AAA spread close to 450bp – it closed yesterday at 500bp over, but is now back at 450bp). To be sure, this fits with Mr. Draghi’s pronouncements at his first press conference: the ECB is picking up the slack, not fixing prices. A broader policy of ‘zero tolerance’ towards states reluctant to undertake fiscal action is also taking hold. In this context, Italy still has to comply fully with the ECB’s ‘requests’ dated August 8, while Greece’s commitment to more austerity in exchange for financial support has continued to sway (at the time of writing, news that former ECB no. 2 Papademos would take the helm is encouraging). Granted, one positive collateral effect of market tensions has been to precipitate a political shakeup in Italy. But the collateral damage created by the price shock in Italian bonds to the stability of the EMU project (aggravated by explicit talk of countries being expelled from the single currency) is high and quite lasting. It will probably take a leap forward into deeper forms of fiscal risk-sharing (Prof Monti is a long-time proponent of Eurobonds) to get the market properly functioning again.

Two observations also deserve to be considered:

Italy undoubtedly has large responsibilities for not being ‘ahead of the curve’ in its fiscal strategy, especially after the central bank stepped into the fray in early August. But the sharp widening in Italian BTPs started in mid-June, after the introduction of ‘substantial’ private sector ‘burden sharing’ (PSI) in the restructuring of Greek debt (which had previously been ruled out by policymakers). The ECB itself had cautioned that PSI would lead to contagion in a deeply integrated financial area, and was proven right. Aggravating problems, policymakers have been unwilling to allow sovereign CDS to be triggered, perhaps out of concern of unintended effects. But, on learning that a severe bond restructuring would not be considered a credit event, many investors apparently judged that they had less risk protection than they thought, and reduced bond exposures.

The recent decision by the European Banking Authority (EBA) to oblige EU commercial banks to strengthen capital positions by building up a ‘temporary’ capital buffer against sovereign debt exposures, including those of Italy, has set in motion a perverse chain of events. Banks sold sovereign securities, preferring to park money with the ECB, and have reluctantly participated in the primary market. The resulting decline in prices following these bond sales perversely led to more sales, and a progressive destruction of demand. As a result, 5-yr BTPs, for example, are now 10 points below where they were at end-September, when price marks were recorded for the recapitalization exercise, illustrating the adverse loopback effects that policy decisions have introduced.

As we argued in previous writing, given the inadequate fiscal governance of the Euro area, the ECB has been saddled with quasi-fiscal responsibilities in this crisis and, understandably, is trading off moral hazard risk (i.e., will the Italian government continue to ‘free ride’ bond purchases, and aggravate economic and political tensions among member states) with financial instability. But the price action since June has been amplified by unexpected changes in regulations and private contracts introduced by governments, creating much uncertainty and thus a self-reinforcing price action. Should a more decisive fiscal response be delivered in Italy, as we expect, and markets not take notice, then a more pro-active approach would be warranted. As Dom Wilson writes in this morning’s Global Markets Daily, ‘doing an SNB’ (unlimited purchases at a set price) may be an effective and ultimately cheap way to halt a dangerous slide.

Tags: Austerity, Bonds, Collateral Damage, Collateral Effect, Collateral Effects, Eurobonds, Fiscal Measures, Garzarelli, Gold, Goldman Sachs, Government Bond Market, Initial Margin, Italian Government, Italian Politics, Margin Requirements, Mario Draghi, Political Shakeup, Price Shock, Secondary Markets, Single Currency, Time Proponent, Writing News
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Roman Empire Under Pressure: Margin Call of 4-5 Billion Euros as Clearing House Raises Deposit Requirements on Italian Bonds

Wednesday, November 9th, 2011

Roman Empire Under Pressure
Margin Call of 4-5 Billion Euros as Clearing House Raises Deposit Requirements on Italian Bonds

Yields on Italian bonds rose once again on Tuesday as margin requirements on those bonds rose sharply. Bloomberg reports LCH Clearnet Boosts Deposit Required for Trading Italian Government Bonds

The so-called deposit factor charged for Italian bonds due in seven-to-10 years will be raised to 11.65 percent, LCH Clearnet SA said in a document on its website dated yesterday. That compares with a charge of 6.65 percent announced in an Oct. 7 document. The additional charges will be applied from close- of-day positions today, LCH said.

Roman Empire Under Pressure

Steen Jakobsen, chief economist at Saxo Bank, pinged me with these comments.

Major investment banks calculate the “margin call” to be around 4-5 billion EUR as of tomorrow.

The Italian situation is very complicated – on one hand Berlusconi has promised to step down, on the other there are no alternatives to him in the opposition, there is no real hope for majority for “someone else”.

Berlusconi has a long history of comebacks, and being 75 years old he has little to lose. The main issue remains whether Italy truly moves forward with austerity and reforms. One without the other has no value for market and for building a fire-wall around Italy.

The facts are simple: No one but Italy itself can save Italy under present conditions.

ECB intervening is merely delaying the inevitable. Italy needs to move forward.

Only two countries has had lower growth than Italy since 2000 – Haiti and Zimbabwe!

This is the present outlook for 2011 and 2012:

Conclusions

A bureaucrat government in Greece and potentially Italy will not solve anything. What’s needed in both countries are:

• A government elected to deal with crisis
• A plan for creating growth and reforms
• An austerity plan underwritten by politicians, labor unions and employers.

That does not seem likely for now, in either country.

At a bare minimum we will have another month of uncertainty. A concerning trivia remains in place: When a country passes 6.5% in 10 year yield – the call for help from the IMF has only been 14 days behind. Italy is different, but the timeline is running out.

Safe travels,

Steen

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Austerity, Berlusconi, Bloomberg Reports, Bonds, Boosts, Building A Fire, Bureaucrat, Chief Economist, Clearing House, Clearnet, Close Of Day, Fire Wall, Government Bonds, Investment Banks, Italian Government, Italian Situation, Margin Call, Margin Requirements, Oct 7, Outlook, Present Conditions, Roman Empire
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Goldman Expects Another 10% Margin Hike For Italian Bonds

Wednesday, November 9th, 2011

Goldman’s Francesco Garzarelli has just released a follow up to the “next steps” piece from yesterday (which so far has been woefully wrong in predicting a ceiling to Italian spread). So perhaps this time Goldman will be a little more accurate, which for those who may be buying Italian bunds on the dead cat bounce, will not be a good thing. Here’s why: ” Should Italian BTPs trade above 450bp relative to AAA-rated EMU sovereigns over a period of time, the initial margin would increase by a further 10%. Currently, the initial margin for repo on Italian securities on LCH ranges between around 4% and 20%, increasing along the maturity structure.” The take away from the above – another 10% margin hike is coming. As for those who bought Italian bonds from Goldman yesterday on hope that the bottom is in, better luck next time – as Goldman says “In the meantime, the higher priced Italian government bonds will continue to be sold, as commercial banks raise liquidity buffers as higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB.” Considering the 5s10s is most inverted since 1994, this is not a very controversial call.

Full Goldman Note:

1. Overview

Markets initially took relief from the news of a change of government in Italy, alongside tighter scrutiny by the EC/IMF of the country’s fiscal policy. As we comment below, it may take up to the end of this month to have clarity on what political solution will emerge from the current crisis. In spite of calls for early elections, we continue to assign a low probability to this outcome. Still, pressures on the front-end of the Italian curve will likely persist until political uncertainty clears, with the ECB continuing its secondary market purchases in what we have previously described as ‘passive containment’ mode.

This morning, London Clearing House (LCH) announced a 5% increase in the initial margin applied on Italian collateral. Should Italian BTPs trade above 450bp relative to AAA-rated EMU sovereigns over a period of time, the initial margin would increase by a further 10%. Currently, the initial margin for repo on Italian securities on LCH ranges between around 4% and 20%, increasing along the maturity structure.

A credible commitment to structural reforms in Italy could result in a speedier (and less controversial) financial support from the ECB and the EFSF. IMF backstop credit lines, reportedly turned down by the Italian delegation at the Cannes G-20, could be reconsidered.

Separate from the European sovereign turmoil, and on a more encouraging note for risky assets, Chinese inflation figures for October were market friendly. Specifically, October CPI inflation fell to 5.5%yoy – in line with market expectations – from 6.1%yoy in September. Further high-frequency data reported by the Ministry of Agriculture suggests food prices have continued to moderate, and we continue to expect November CPI inflation to be below 5%. PPI inflation fell to 5%yoy, significantly below market consensus of 5.8%, from 6.5% in September. This moderation in inflationary pressures creates room for a shift to a more accommodative stance by Chinese policymakers. The China Securities Journal reported overnight that credit policy will remain loose in the fourth quarter and suggested that a cut in the reserve requirement ratio could not be ruled out. The prospect of such policy-driven relief for equity markets was a rationale for our long recommendation in Chinese equities, and the HSCEI index is outperforming the region today (+2.2%).

More broadly, the market appears to be increasingly trying to separate developments in Italy, and sovereign Europe more generally, from underlying macro developments, as Kamakshya Trivedi commented in Monday’s Global Markets Daily. In addition to the above mentioned HSCEI vs. SPX position, we are recommending two further macro-informed tactical trades on the back of these dynamics: (i) Long US cyclical sectors vs. defensives through our Wavefront Growth basket; and (ii) short the iTraxx Europe Crossover index. Separate notes by Noah Weisberger, Charlie Himmelberg and their respective teams expand on the rationale behind these views. Our tactical FX recommendation to position long in SGD and MYR, funded out of EUR and USD, also follows this logic.

2. Italy – What Next?

After seeing his parliamentary majority slide further in a routine vote ratifying the 2010 state accounts, last night Italian PM Berlusconi said he would step down as soon as Parliament approves a new set of austerity measures. These should be unveiled in the coming days and passed by the end of next week at the earliest. The measures, which are expected to include the sale of public real estate and the reform of local services, fall short of tackling more politically charged areas such as pensions and labour market reforms.

Meanwhile, the EU Commission has submitted to the Italian Finance Minister a set of questions on fiscal matters, soliciting a reply in writing by 11 November. Although this request may seem intrusive to some, it is completely in the spirit of the greater fiscal coordination and peer review that the EMU countries signed up to earlier this year. In this context, a delegation of the IMF led by David Lipton is expected to arrive in Rome next Tuesday to kick-start a series of quarterly reviews. Such tight oversight by the ‘troika’ on Italy’s economic policy should raise the chances that reforms will eventually go through.

In a note published yesterday, we set out three possible outcomes at this delicate political stage, with different implications for the BTP market and Italian risk premium more broadly. We summarize our views below.

• The most likely scenario is that, in coming weeks, the current centre-right coalition of the Northern League and PdL makes an attempt to rally round another PM candidate who can gain wider acceptance domestically and internationally. In order for this strategy to succeed, the new government will need to win support from smaller centrist parties (and those MPs who have left the PdL in recent weeks). The newly appointed Cabinet would need to prove itself, and reforming the pension system could meet resistance from the Northern League. Still, it would be hard for the ECB and Italy’s EMU peers not to stand by a new Italian government should it genuinely try to pursue reforms. Under this scenario, thanks to the ECB’s interventions, we would expect BTPs to remain capped at around current levels (450bp) over the average of Germany, France and the Netherlands until measures are approved.
• The second most likely scenario is one where the centrist MPs turn down the offer to join a broader coalition. In this case, more MPs from Berlusconi’s PdL party could join forces with formations at the centre of the political spectrum. This could pave the way for a government of national unity of sorts, led by a highly reputable ‘outsider’. From the experience of the early 1990s, the advantage of such ‘technocrat’ solutions lies in the ‘initial contracting’ on the legislative programme (economic reforms agreed with the ‘troika’, better governance through constitutional rules, a smaller public sector, a new electoral law, could all be chapters of such contract), reducing the risks of implementation. We view this as the most market-friendly outcome. The front-end of the sovereign curve would re-price more than intermediate- and long-term maturity bonds, because investors would likely take advantage of the rally to reduce exposure at higher prices. Nevertheless, we would expect 10-yr BTPs to fall to around 350bp over Bunds in fairly short order.
• A third possible scenario involves early elections. These could be held in mid-January at the earliest, although they would most likely be postponed until the Spring amid market turmoil and pressures from EMU peers to strengthen public accounts. This would represent the worst-case scenario for markets, but it is also the least likely in our view. Conscious of the adverse market implications, President Napolitano will probably try to resist dissolving Parliament at this juncture. Also, most centrist parties have openly stated that they want to change the electoral law before a new vote takes place (and a referendum to scrap the existing law is expected to take place next year).

All three scenarios will take some time to play out, a couple of weeks at least. In the meantime, the higher priced Italian government bonds will continue to be sold, as commercial banks raise liquidity buffers as higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB. In conclusion, we are most probably approaching the highs in Italian yields (currently over 500bp over German Bunds in the bellwether 10-yr sector, and 640bp in 2-yr maturities), but a volatile and unsettled market remains our base case until Italy’s sovereign creditors can be reassured that long awaited structural reforms to lift the country’s growth rate will be put in place.

Tags: Agriculture, Better Luck Next Time, Bonds, Bunds, Central Case, Clearing House, Commercial Banks, Dead Cat Bounce, ECB, Fiscal Policy, Garzarelli, Gold, Government Bonds, Government In Italy, Initial Margin, Italian Government, Margin Requirements, Maturity Structure, Political Solution, Political Uncertainty, Repo, S Francesco, Sovereigns
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Gold Market Cheat Sheet (September 26, 2011)

Saturday, September 24th, 2011

Gold Market Cheat Sheet (September 26, 2011)

For the week, spot gold closed at $1,656.80, down $188.08 per ounce, or 8.56 percent. Gold stocks, as measured by the NYSE Arca Gold BUGS Index, fell 11.74 percent. The U.S. Trade-Weighted Dollar Index surged 2.19 percent for the week.

Strengths

• The week started on a strong note, as the World Precious Minerals Fund benefited from its exposure to the announcement that Agnico-Eagle entered into a definitive agreement to acquire Grayd Resources for C$275M in cash; a 41 percent premium to its prior close. Our fund is the second largest shareholder of Grayd Resources.
• While the senior-tiered mining companies have suggested there is no need to purchase assets from the junior exploration and development companies, our view is that there definitely are some transactions that would make sense.
• While gold fell 8.56 percent this week, and is nearly 13 percent off its recent highs, this type of correction is normal and to be expected. Since the start of the quarter, gold bullion had rallied more than 25 percent in the quarter due to investor concerns over the world wide debt crisis. Technically, if gold falls back to about $1,600 it would just be in line with its upward trend line established over the last five years. A correction to $1,550 would roughly be the next support level.

Weaknesses

• Friday’s five percent plunge in the spot gold price and 13 percent drop in silver apparently reflected the after-market close announcement by the CME that it would raise margin requirements for gold and silver futures by 21 percent and 15 percent, respectively.
• After the Fed noted on Wednesday, “There are significant downside risks to the economic outlook, including strains in global financial markets,” investors were in liquidation mode for all assets classes, including commodities, and sought safety in U.S. dollars and U.S. Treasuries.
• Brought on by more fears of a further economic slowdown, HSBC commented that in normal circumstances this would be positive for gold. Instead, the equity declines have been so steep that investors have raised cash by liquidating bullion as risk managers called for profit-taking on gold, one of few assets classes to deliver significantly positive returns this year.

Opportunities

• One of the main talking points at the Denver Gold Forum, held this week in Colorado Springs, was the perception of how undervalued gold mining equities are relative to the price of gold. Tim Wood, the executive director at the Denver Gold Group, made note that the multiples of equity valuations have not kept pace with bullion. There was much discussion at the conference of whether the valuation levels are an indication that the market is expecting some sort of a pullback or whether there is something else going on. He noted that gold is “acting like a money now and that’s what we need to take into consideration. We are already seeing that in many instances organizations, institutions are starting to accept gold as collateral. Now that hasn’t happened for a very long time. So you can actually put down physical bullion as collateral and we can see gold’s increase in price is really a reflection, not just of the turmoil that we are seeing around the world but it is taking on a very real monetary role because you’ve got this race to the bottom amongst all the currencies.”
• Miningweekly.com highlighted that Nouriel Roubini, a worldwide respected economist, announced to a South African audience that commodity markets were not yet fully pricing in the rising risk that a number of advanced industrial countries, including the U.S., could face a double-dip recession. He was calling for a two-thirds probability to the likelihood that some European economies and the U.S. would report economic contractions in the coming months and quarters. Consequently, commodity prices would experience renewed pressures. Gold, specifically, as a precious metal would likely “buck the trend” as investors seek safety against a possible new financial crisis.
• Ongoing global concerns over the sovereign debt crisis have led influential figures to predict higher prices for gold. Thomson Reuters and Eric Sprott have called for a push toward gold prices of $2,000 per ounce and $2,500 per ounce, respectively, should the debt woes continue. “If governments keep printing more money, the price can go anywhere. It could go to $10,000/oz, it could go to $20,000/oz,” Sprott opined.

Threats

• Short sellers are under threat this week as Silvercorp Metals filed a lawsuit in New York against a stock manipulation scheme. Plaintiffs named in the lawsuit could be hard pressed to make their case when subject to cross examination and the prospect of financial ruin.
• Financial Times published an article saying that regulators worldwide are now focusing on ETFs. The necessity of increased regulation recently came to light over the UBS rogue trader, who managed to accumulate $2.3 billion in losses for the company. Increased international supervision and limits are being considered to eliminate systemic risk connected with ETFs.
• In a highly publicized story, Donald Trump recently accepted bullion as a means of payment for property.

Tags: Agnico Eagle, Commodities, Debt Crisis, Dollar Index, Downside Risks, Economic Slowdown, Global Financial Markets, Gold, Gold And Silver, Gold Bugs, Gold Bullion, Gold Market, gold stocks, Investor Concerns, Junior Exploration, Margin Requirements, Nyse Arca, Outlook, Precious Minerals, Silver Futures, Spot Gold Price, That Would Make Sense, Trend Line
Posted in Commodities, ETFs, Gold, Markets, Outlook | Comments Off

Valuation Gap Makes Gold Miners Attractive But All Miners Aren’t Created Equal

Saturday, August 27th, 2011

Valuation Gap Makes Gold Miners Attractive But All Miners Aren’t Created Equal

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Goldwatchers were reminded gold’s volatility works in both directions this week, with prices falling more than $100 an ounce in just one day. We forecasted the selloff last week, explaining a 10 percent correction would be a non-event. Once again the CME Group hiked the exchange’s margin requirements for gold investment to shake out overleveraged speculation. This is a positive for long-term investors.

One market trend that seems to be attracting more and more attention is the large performance gap between gold bullion and gold stocks. The price of gold bullion has increased roughly 28 percent in 2011, while the S&P/TSX Gold Index was down 1 percent as of Monday. This shouldn’t come as news for subscribers to these weekly alerts; we first discussed this opportunity back on June 17: Will Gold Equity Investors Strike Gold?

A report this week from BMO Capital Markets offered one reason behind the performance gap, “The rate of change in the gold price has been high over the past decade, perhaps too high for investors to gain confidence in that price as sustainable for an equity investment decision.” BMO says it was hard to imagine gold prices could sustain a $1,000 an ounce levels five years ago, but “now it’s hard to see the gold price falling to that level.”

Using the implied value of a defined group of global gold stocks, it calculated the internal rate of return to measure how gold stocks have underperformed compared to the yellow metal. Over a period of nearly 20 years, BMO’s group of global gold stocks has never been this inexpensive. Only twice—during the Tech bubble in 2000 and the financial crisis of 2008—has the internal rate of return compared so closely with the price of gold bullion.

RBC Capital Markets also sees potential in unpopular, undervalued gold equities and urged readers to take “a fresh look” at gold companies in a report this week. RBC says gold companies currently have margins that are at record highs and it believes margins could be approximately $1,200 an ounce for the next 12 to 24 months. This is substantially higher than the 10-year average of $320 an ounce. Comparatively, many current projects were economically sound at $700-$1,000 per ounce gold prices, creating $300-500 an ounce margins.

Right now, BMO calculates the total cost to produce an ounce of gold at roughly $900 an ounce, while the company can turn around and sell that ounce for upwards of $1,400. This puts margins near 40 percent, roughly twice what they were in 2007 and four times higher than in 2000.

Increased profit margins put more money in gold company coffers and this is reflected in the unprecedented amount of free cash flow (FCF), RBC says. The firm says the industry has reached an inflection point with a “substantial wave of free cash flow” coming over the next 1 to 2 years.

You can see this incredible increase in Tier 1 producers, such as Barrick, Goldcorp, Kinross and Newmont Mining. Looking at their trailing 12 months of free cash flow over 10 years, FCF never rose above $2 billion. However, following the trend in gold prices, FCF among these Tier 1 companies stair-stepped up to $4 billion.

Looking forward over the next few years, RBC estimates that if the price of gold remains at $1,850, FCF should stair-step even further, reaching nearly $12,000 by the end of December 2013. BMO estimates the global gold companies will accumulate net cash of $120 billion by 2015 if gold prices remain elevated.

Rising FCF is especially relevant to shareholders, as it allows the gold company to use that money to invest in projects that should enhance shareholder value. This could include pursuing new projects, making acquisitions, reducing debt or paying dividends. Many gold companies are opting for the latter and increasing dividends but these increases haven’t kept up with the pace of rising earnings. The average payout ratio was roughly 20 percent in 2008 but currently sits around 10 percent in 2011.

BMO says, “A dividend policy linked to the financial performance of the company offers investors additional leverage to the gold price. The provision of a meaningful and sustained dividend has the potential to broaden investor appeal and to instill fiscal responsibility for management.” I’ve often echoed similar sentiments.

BMO says gold stocks are currently trading at historically cheap levels, which the company sees as an opportunity investors can take advantage of. RBC attempts to quantify that opportunity by saying “if gold prices remain elevated and/or investors accept a higher long-term gold price, we could see 25-50 percent upside in equities.”

How to Pick Gold Miners
With gold miners, in general, so attractively valued relative to the gold bullion price, the question becomes: Which stocks are the most compelling and have the best leverage to robust precious metals prices?

First, an investor could begin the process through elimination. FINRA highlighted some of the key warning signs when analyzing gold stocks, such as claims of being a “buyout target,” or speculative claims about reserve growth, and grandiose predictions of exponential growth, to name a few. FINRA says investors should be wary of “free lunch” programs that claim profits in gold are “easy,” and we agree.

Research from geologist Robert Sibthorpe shows that only one in 2,000 (0.05 percent) companies would ever find 1 million ounces of gold, and that only a third of those would be able to turn that find into production. In addition, research from Barry Cooper at CIBC shows that these discoveries are becoming even more difficult. There were 51 gold/copper porphyry discoveries of +3 million ounces during the 1990s, but only 24 of such discoveries occurred during the 2000s.

In order to find the diamonds in the rough, I use what I call “The Five M’s” for mining stocks. I discussed this process thoroughly in The Goldwatcher: Demystifying Gold Investing, an investor’s guidebook to gold investing I co-authored with John Katz a couple of years ago.

The Five M’s are: Market cap, Management, Money, Minerals and Mine life cycle.

1) Market Cap
Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: Seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors (<$2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, “Is this company really worth $10 million?” If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (1 million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies—an area of focus for our World Precious Minerals Fund (UNWPX)—we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

2) Management
Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers” – people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

3) Money
Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn’t come up with the results necessary to get an evaluation—find gold for less than $50 an ounce—investors quickly lose confidence. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

4) Minerals
Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples. For example, the current price-to-earnings ratio for Freeport-McMoRan (FCX), is 8x-times forward earnings. This is considerably lower than Yamana (20x), Goldcorp (21x) and Agnico-Eagle (36x). Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

5) Mine Lifecycle
There are many delays and disappointments during the development and operation of a gold mine. Input costs can rise out of control (such as what happened in 2008 when oil hit $140 per barrel), labor workers can strike, and political/environmental policy shifts such as higher taxes or stricter environmental regulations can shrink margins.

During the exploration and development phase, the price of a gold stock often follows a course that ends up looking like a double-humped camel (see graphic). First there’s euphoria over exploration results that are better than expected. The stock price rises as investors race to buy shares. Then reality sets in – this gold discovery is still years away from being an actual producing mine. At this point, there’s a huge correction in the stock price.

Assuming the company continues down the path to development, its share price drifts sideways until around six months before the first ounce of gold is expected to be produced. At this point, the stock begins a strong new leg up when a more sophisticated set of shareholders come into the market. Eventually the price drops off and then levels as the speculative money moves on to the next hot opportunity and the company transitions from explorer to producer.

U.S. Global’s Expertise
Clearly, the task of picking which gold miners to invest in isn’t easy. We actively travel to mining projects in places such as Colombia, Panama and West Africa to “kick the tires” and ask tough questions of management. This is the value that our investment team at U.S. Global Investors provides for our shareholders and how we seek to generate alpha.

Tags: BMO Capital Markets, Chief Investment Officer, Equity Investors, Frank Holmes, Gold, Gold Bullion, Gold Equity, Gold Index, Gold Investment, Gold Miners, Gold Price, Gold Prices, gold stocks, Internal Rate Of Return, Margin Requirements, Performance Gap, Price Of Gold, Rbc Capital Markets, Strike Gold, Term Investors, U S Global Investors
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Gold Market Cheat Sheet (August 15, 2011)

Monday, August 15th, 2011

Gold Market Cheat Sheet (August 15, 2011)

For the week, spot gold closed at $1,746.95, up $83.15 per ounce, or 5.0 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, rose 5.4 percent. The U.S. Trade-Weighted Dollar Index was essentially unchanged for the week.

Strengths

• As reported on Mineweb, precious metals analyst David Morgan anticipates that silver could reach $65 to $75 an ounce. He attributes the main demand for silver coming from the East, where silver demand is growing for both industry and as an investment.
• Year-to-date, demand for silver in China and India is up 30 percent. Silver demand in China and India has increased sharply in recent years as more investors use silver as a store of value. About 70 percent of China’s silver demand comes from the industrial sectors. Albanian Minerals President and CEO Sahit Muja said, “Silver demand in China and India is set to rise 40 percent in 2012.”
• Reuters reported that gold available in exchange for cash has been drying up as prices are rising even higher. In Mexico City, it has been noted that fewer customers have been coming into the shops that buy bullion from local residents. The success of the cash-for-gold industry over the past three years has left fewer and fewer people with any “old gold.” For those who did cash out in 2008, they missed a three-year bullion boom in which prices doubled.

Weaknesses

• On Thursday, exchange operator CME Group raised margin requirements on gold futures by 22 percent, to $5,500 per contract from $4,500 per contract, which is the first time gold margins have been raised since November 15, 2010. Following this announcement, we saw gold settle to $1,764 per ounce.
• Rising margin requirements put a damper on gold prices on Friday, too, with prices slipping another $17.
• Overall, the gold stocks held up pretty well with the pullback in bullion prices.

Opportunities

• Eric Sprott believes gold has been the metal of the past decade, while silver is the metal of the decade to come. He says there is a large imbalance between demand and supply and that the metal is set for a major re-rating which will, in turn, bring the gold-to-silver ratio down to much lower levels.
• BlackRock’s investment strategist, James Holt, has said that the group will use profits from gold and bond investments to shop for bargains among the falling global equity markets. He stated that the firm will be seeking to put its resources into asset classes that are getting cheaper and cheaper, namely equities. BlackRock, one of the world’s largest money managers, holds 5 percent of its $83 billion global allocation fund in gold equities and gold exchange traded funds (ETFs). This could have a substantial positive effect on the gold equity market.
• Goldman Sachs and JP Morgan raised their gold price forecasts for the year, expecting the commodity to continue its surge as the sovereign debt issues in the U.S. and Europe intensify. JP Morgan now expects spot gold to soar to $2,500 an ounce by year end.
• Investors have been flocking to seek refuge in bullion amid economic concerns triggered by a downgrade of the U.S. debt.

Threats

• The last time we saw increased margin requirements for silver, just over three months ago, we saw silver fall from close to $50 an ounce back to below $34. Depending on market response, this scenario could be a possibility for gold as well, although there was much more leverage in the silver space compared to gold.
• The Ecuadorian President Rafael Correa has said that his government is demanding that mineral companies pay an 8 percent in mining royalties before “starting to extract the mineral.” His main driver behind this new policy is to assure that mining operations are “environmentally friendly and socially responsible,” with residents of the cities, parishes and communities near mining projects being the primary beneficiaries. Royalties to the extent of 8 percent have never been seen before and can make a project potentially uneconomic.
• Resource nationalism is one of Ernst & Young’s main concerns in its list of top ten risks facing the mining sector. As many governments struggle with budget deficits, the continuing boom in commodity prices has made the mining and metals sector an easy target as a source for increased revenue.

Tags: Bullion Prices, David Morgan, Dollar Index, Eric Sprott, Exchange Operator, Gold Equities, Gold Futures, Gold Industry, Gold Market, Gold Prices, gold stocks, India, Industrial Sectors, Margin Requirements, Muja, Old Gold, Philadelphia Gold, precious metals, Silver Index, Spot Gold, Time Gold
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Commodities 2011 Halftime Report

Sunday, July 17th, 2011

Commodities 2011 Halftime Report

By Frank Holmes, CEO and Chief Investment Officer
U.S. Global Investors

Commodities don’t all perform in the same way. In any given year, a particular commodity will go gangbusters and outperform the group. However, that commodity will typically come back to Earth and underperform the following year or the year after that. This is why active management is important when investing in commodities. Active managers can benefit from rotating from winners to laggards or by investing in the companies which produce, farm or mine commodities most effectively.

After two straight years of tremendous gains for many commodities, the first six months of 2011 haven’t been as kind. As of the end of June, only two commodities (silver and coal) saw double-digit increases, and only six of the 14 commodities we track—less than half—were in positive territory.

Silver was the leader, rising more than 12 percent, followed closely by coal (up 11.95 percent). Other commodities increasing in value included gold (5.6 percent), crude oil (3.83 percent), lead (2.16 percent) and aluminum (1.73 percent).

Returns are based on historical spot prices or futures prices. Past performance is no guarantee of future results.

Silver
Silver prices got ahead of themselves earlier this year, climbing 58 percent to nearly $50 an ounce. This registered a four standard deviation move, representing extreme territory on our models. Thinking silver, which has historically been a narrowly-traded market, had become a potential haven for speculators, officials stepped in and raised margin requirements on the Comex. This quickly deflated the bubble and prices naturally reverted back toward the mean but remain well above where they began the year.

Coal
Strong demand from reconstruction projects in Japan along with reduced supply because of flooding in Australia, Indonesia, South Africa and Colombia led coal to be the second-best performer.

No country was more affected by the lower supply than China as coal powers the Chinese economy. The country is the world’s largest consumer, gobbling half of the world’s coal. Coal accounted for 71 percent of China’s energy in 2008—more than three times the United States’ share. The Electricity Council estimates that China’s coal demand will reach 1.92 billion tons in 2011, up nearly 10 percent from 2010. Chinese electricity use was up 13.4 percent on a year-over-year basis in May and is now expected to rise 12 percent this year. (Read: Coal Use in China Shines Light on Growth)

Gold
Gold prices passed $1,500 for the first time ever in mid-April of this year and ended the quarter just slightly below that mark as a mixture of the Fear Trade and Love Trade proved to be an enticing concoction for investors here and abroad. The World Gold Council reported that demand for gold as an investment was up 26 percent on a year-over-year basis during the first quarter. In China, demand for gold was so strong it outpaced the combined gold demand of the U.S., France, Germany, Italy, Switzerland, the U.K. and other European countries. (Read: Asian Tiger Sinks Teeth Into Gold)

Although gold prices held steady during the first half of the year, the share prices of gold companies have lagged. Ralph Aldis and I discussed this hot topic in depth a few weeks ago. (Read: Will Gold Equity Investors Strike Gold?) Many gold companies’ corporate cash flows and earnings per share have been rising, and more companies are paying dividends. Gold stocks also appear cheap compared to the price of gold. We believe investors will be drawn to these qualities, lifting gold stocks along with the strong bullion price.

Oil
After two straight years of solid gains, oil prices finally surpassed the $100 per barrel mark once again early in 2011. This time, it was a dose of geopolitical risk and a natural disaster that sent oil prices shooting upward. Oil prices have since bounced around the $90-$100 range for West Texas Intermediate (WTI). That range has held up despite U.S. consumers cringing at gasoline prices, the International Energy Agency (IEA) releasing an additional 60 million barrels of oil to the market and China’s ardent attempts to cool its economic growth. (Read: Playing Cat and Mouse with Global Oil)

Despite tightening measures, China’s per capita oil consumption has retained its upward trajectory and is headed toward levels similar to Taiwan and South Korea. There’s still quite a gap to close before that happens, but China’s oil consumption per capita has increased over 350 percent since the early 1980s to an estimated 2.7 billion barrels per year in 2011. Nearly 100 percent of that has taken place in the past decade. In addition, oil consumption per capita has risen sharply in recent decades in other Asian countries such as Malaysia (nearly quadrupled) and Thailand (doubled).

Looking Forward to the Second Half of 2011
We think commodity price movements will fare better during the second half of the year. Goldman Sachs wrote in a report last week that it expects global economic growth to be “generally supportive of rising commodity demand” and “this demand growth will be sufficient to tighten key commodity markets over the next six to 12 months.” We believe gold, oil and copper are some of the commodities which could see the biggest gains. For the sake of brevity, we’ll highlight gold here today.

Gold
As BCA Research puts it, “[gold] prices have benefited from a ‘perfect storm’ in recent months: falling real interest rates, a weak dollar, fears of a U.S. recession and/or debt default, and European stress.” Those factors, which I affectionately refer to as the Fear Trade, are what sent gold prices flirting with the $1,600 an ounce level this week. There was also the release of Federal Reserve meeting minutes that showed QE3 is possible, though not yet probable given Chairman Bernanke’s testimony this week. By the way, if you haven’t already seen Bernanke’s exchange with Congressman Ron Paul on gold, go to YouTube and check it out for a good chuckle. Washington’s reluctance to present a solution to the debt ceiling issue also contributed heavily to gold’s performance.

Paul was bringing attention to the threat of currency debasement, a major reason investors all over the world are turning to gold. According to U.K. research firm Capital Daily, the U.S. monetary base has increased more than 200 percent since September 2008. Meanwhile, gold prices have risen only about 70 percent over the same time period. Capital Daily says “if the two had been directly related, gold should already have risen to around $2,800 [an ounce].” That’s obviously a lofty expectation but illustrates that gold prices haven’t appreciated nearly as much as currencies, such as the U.S. dollar, have been debased.

In fact, don’t believe what you read about record high gold prices. Yes, gold hit a high in nominal terms, but the price is more than 30 percent below the 1980 peak of $2,400 an ounce if you adjust for inflation.

This was a banner week for the Fear Trade but don’t count out the Love Trade. Gold is about to get even more attractive because we are heading into the fall and winter gift-giving season. This is the time of year when gold jewelers typically do their biggest business. The kickoff is the Muslim holy month of Ramadan, which starts next month and ends with generous gift-giving in early September.

The key to this seasonal strength over the past few years has been demand from China and India. You can see from the chart that the rise in gold prices has been closely tied to the rise in gold demand from China and India. Back when the average per capita income in China and India was well below $1,000 a year, gold prices hovered just above $200 an ounce. As average incomes have approached $3,000 a year over the past decade, gold prices have followed. With the long-term outlook for wages in both these economies rather rosy, gold demand should continue to feel the trickle-down effect.

Those investors looking for more of a technical indicator can take a look at the ratio of gold and oil. Capital Daily says that the ratio of the price for one ounce of gold to one barrel of oil (Brent crude) is currently 13.5. Since 1970, the average has been around 16. Gold prices would need to rise to $1,870 an ounce in order to reach historical ratio levels with $117 per barrel Brent crude oil, according to Capital Daily.

Based on seasonal demand strength and sovereign debt fears of the U.S. and several European countries, we think gold prices could be headed higher.

Tags: Active Management, Chief Investment Officer, Coal, Comex, Commodities, Crude Oil, Digit Increases, Extreme Territory, Flooding In Australia, Frank Holmes, Futures Prices, Gangbusters, Halftime Report, India, Investing In Commodities, Laggards, Margin Requirements, Reconstruction Projects, Silver Prices, Speculators, Standard Deviation, U S Global Investors
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A Not-So-Marginal Risk in Silver

Wednesday, June 8th, 2011

By EconMatters

Our research analyst John Gray was interviewed by Carolyn Cui from Wall Street Journal regarding why we believe CME should have raised margins on silver earlier and had missed the best opportunity to do so.

Below are excerpted from Carolyn’s article–Tripped Up by the Margin–dated June 8, 2011 along with some more of our thoughts:

Commodity investors have long been used to wild market swings driven by wars and hurricanes. But recently a new risk has been added to their list: margin requirements.

Investors are still crying foul over CME Group Inc.’s decision to raise margins five times over just eight trading days. Between April 25 and May 5, the exchange operator increased silver margins to as much as 12%, or $21,600 per contract, from 6%. Silver tumbled 25%.?

Chart Source: WSJ.com

The lack of disclosure riles John Gray, a researcher at EconMatters.com, a website dedicated to economic and market analysis.

“They need to be more transparent,” Mr. Gray said, adding that margins should be a consistent percentage of the contract price, and that exchanges should give more warning of any moves.

Mr. Gray is among market participants who say the CME should have raised silver margins earlier. CME increased once in March, but didn’t make any changes until a month later. Silver prices gained about 30% to $47.151 an ounce between those moves.

“It should have been a red flag to CME when silver crossed the $40 threshold that they needed to raise margins significantly,” Mr. Gray said.

EconMatters additional comment:

Compounding the problem is that brokers also raised their in-house margins on top of the ones CME implemented. Carolyn’s article noted Interactive Brokers “overstepped the exchange twice” in hiking silver margins, while MF Global is another broker, had also charged more margins on silver than what was required by exchanges at the time.  That set off a mass liquidation spilled over even to the other asset classes as well with investors scrambling to cover the newly raised margin requirements.

Ideally, margin requirement should be set by the criteria the Exchange deems proper based on experience and historical pattern, and preferably at a fixed percentage at all time, instead of jumping all over the place as illustrated in the chart above.  So as the price of the underlying commodity goes up or down, a consistent percentage of margin requirements is maintained–i.e. more real-time mark-to-market.

This will help reduce market volatility as traders won’t get caught off guard and be forced to liquidate large positions in order to meet the sudden raised margin requirements.  A fixed percentage also will increase the transparency while keeping the risk of over-leverage in check.

Note – Carolyn’s full article is available here at WSJ.com.

Tags: Asset Classes, Chart Source, Commodity, Contract Price, Exchange Operator, Hurricanes, Interactive Brokers, John Gray, Margin Requirements, Margins, Market Participants, Market Swings, Mf Global, Mr Gray, Ounce, Red Flag, Research Analyst, Silver Prices, Wall Street Journal, Wsj
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