Wednesday, August 20, 2008

The Disconnect Between The Physical Gold and 'Paper Contract' Markets

By Patrick A. Heller, Market Update
August 19, 2008

Gold and silver prices declined again in the past week, though they have showed signs of recovery early this week.

When prices fall sharply, that normally indicates that there is a lot of liquidation taking place. You will also tend to see new information which explains why investors are suddenly reversing course.

That is not what is happening in the gold and silver markets. Gold is down over 18 percent and silver more than 30 percent in the past five weeks because of widespread government interventions in the markets.

Two major forms of government intervention are:

-- Foreign central banks are buying massive amounts of US dollars to prop up the value of the currency. In the three weeks to Aug.8, the Bank for International Settlements reported over $52 billion of such activity, which does not include any unreported behind-the-scenes transactions.

-- Despite massive demand for physical gold and silver, the central banks stand ready to "lease" precious metals to prevent any more major spikes in the lease rates for these metals. Nonetheless, there were some spikes over the past few weeks where lease rates soared for a day. The central banks are practically begging their trading partners to borrow gold and silver and sell it on the spot market.

Their success in driving down prices significantly has resulted in margin calls for leveraged investors. Those that could not meet the requirement to put up more funds had their positions sold out. Closing out their leveraged positions dumped even more precious metals on the markets.

In effect, the prices of gold and silver have fallen because of a large number of sales of "paper" metal. Central banks and their trading partners are selling short huge amounts of gold on paper contracts that will have to be replaced "someday." They are not selling gold or silver because of any fundamental change in those markets. Instead, they are simply selling as part of their strategy to support the U.S. dollar and stock markets and to knock down gold and silver prices. Prices are certainly not falling because all of the world's political and economic turmoil supporting higher gold and silver prices have been resolved.

So what has been happening in the markets for physical gold and silver?

Almost the exact opposite of the paper contract markets. Virtually no physical gold or silver is being liquidated by long-term investors. Instead, they are trying to purchase gold and silver like crazy.

Activity at our store mirrors what is happening at coin shops and bullion dealers across the country and around the world. Physical supplies have almost totally vanished, with customers now having to wait weeks or months to obtain delivery for almost any gold coins or ingots. Late last week, the U.S. Mint indefinitely suspended sales of 1 ounce gold American Eagles because it simply could not meet demand.

In Mumbai (formerly Bombay), India, banks and bullion dealers late last week reported that sales had jumped eight times above recent levels, to more than 125,000 ounces per day! That means that demand from just this one city is now absorbing more than 50 percent of worldwide gold mining production! As in the U.S., would-be gold buyers in India, traditionally the world's largest gold-consuming nation, now have to wait for delivery of gold.

As a result of such strong demand, premiums have jumped significantly. Both the American Eagle and South Africa Krugerrand premiums have jumped about 2 percent relative to gold in just the past week. Canada 1 ounce gold Maple Leafs are up about 1percent relative to gold. Purchasers of such coins may have to wait three to five weeks before the coins are available to fill their orders. Gold coins such as the Mexico 50 peso and the Austria 100 corona are still relatively available, with their premiums up only slightly.

If no one has any physical gold to sell, and premiums are rising on what is being sold, that is not a sign of a market that is flooded with physical metal. While the paper contract gold market trades a far higher dollar volume than the physical market, it is the supply and demand of physical gold that will ultimately determine an equilibrium price for gold. Right now, the physical market is saying that the prices of gold (and silver) are far too low. This could be the last great buying opportunity, even if it means you have to wait a while for delivery.

Patrick A. Heller is coin dealer and author of the newsletter Liberty's Outlook. See

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