The London Bullion Market Association represents 85% of global daily gold trading volume…..

1. Definition: Gresham’s Law

Gresham’s Law is a monetary principle stating simply that “bad money drives out good.” In currency valuation, Gresham’s Law states that if a new coin (“bad money”) is assigned the same face value as an older coin containing a higher amount of precious metal (“good money”), then the new coin will be used in circulation while the old coin will be hoarded and will disappear from circulation because of its greater inherent value. (Investopedia)

By definition, gold and silver are money.

Alan Greenspan in the fall of 2014 said that gold is superior money to all fiat currencies including the USD.

2. The LBMA is trading digital or fiat gold (unallocated gold) that the LBMA states accounts for the vast majority of spot gold trading.

The LBMA represents 85% of global daily gold trading volume and the LBMA’s (and LPPM ) daily pricing is, according to the LBMA, the basis for “virtually all transactions in gold, silver, platinum and palladium”. What happens on the LBMA impacts the global price of silver and gold, so it is our focus.

The open interest in London can be varied to digitally increase and decrease gold and silver positions creating supply of gold and silver to market when account holders hold their ‘positions’ in the LBMA. Due to the leverage of claims vs fractional metal available for satisfaction of the claims, this dictates ulitimate market dislocation.

According to Gresham’s Law, by creating and trading virtual ‘bad money’ (i.e. unallocated or virtual gold and silver positions ), the LBMA is guaranteeing its own demise as the ‘good money’ (i.e. real gold and silver physical bars) will simply disappear from the exchange resulting in market dislocation. Virtual metal created on the LBMA short-circuits the pricing mechanism for precious metals by creating artificial supply.

The markets flow and choose a path to solve problems and the markets will flow around the LBMA and leave it stranded as it is a trading platform that has been used to short-circuit market pricing of gold and silver.

We can see from our discussion last week that the LBMA has an estimated open interest position (claims) of 400M to 600M oz of gold and 3.5 to 5.0 billion oz of silver. These open positions are completely unsustainable as the impossibility of delivery into these positions is clear to the market.

http://www.lbma.org.uk/clearing-statistics
http://www.lbma.org.uk/assets/Loco_London_Liquidity_Surveyrv.pdf
http://www.lppm.com/OTCguide.pdf

3. Dubai intends to open spot gold trading by the end of March 2015

http://gulfnews.com/business/markets/dgcx-aims-to-start-spot-gold-contract-by-the-end-of-first-quarter-1.1453407

Goal of the new Dubai gold exchange is to “set it as a benchmark Loco Dubai price for all stakeholders in China, India, and Africa etc.”

Dubai wishes to develop benchmark gold pricing for Asia and Africa.

Other physical exchanges in Singapore, Hong Kong, Shanghai, Moscow, etc. are going to rapidly bypass the LBMA’s pricing and will ultimately make the LBMA an historic artifact.

4. Some commentators say that the BRICs hold a nuclear bomb on the West which will detonate if they move to a sound money (gold) system

In reality, the LBMA and COMEX are nuclear bombs that are guaranteed to detonate because they are used to distort markets (and have been used to suppress gold and silver markets while fueling decades of financial bubbles with loose monetary policy) and according to Gresham’s Law, these exchanges will, by definition, fail as ‘good money’ leaves these exchanges with only the ‘bad money’ (digital gold and silver claims) remaining behind unsatisfied.

5. We have seen complete market failure before.

Kuwait’s “Souk al-Manakh” also dubbed the Kuwait Camel Market (KCM).

In the early 1980s, the KCM market did a round trip from $5 billion to $100 billion in market cap and back again – at its peak it had the third highest total market capitalization in the world.

Used leverage to explode the value of the Camel Market to astronomical heights (think about the 3.5 billion to 5.0 billion ounce silver open interest (claims on silver) on the LBMA)

“Adding fuel to the fire was the type of informal margin financing through the use of postdated checks, which were accepted as a cash equivalent, as per Kuwaiti custom. This type of personal credit didn’t require a bank balance; the “receiver hopes that there will be one when the due date rolls around.”… …As the Souk al-Manakh market soared to incredible new heights, many speculators became willing to issue postdated checks for double or triple a stock’s purchase price, confident that the share prices would rise by that much by the time they had to pay. (1) An informal futures market arose in postdated checks as investors, upon receiving their shares, used them as collateral to borrow even more money for stock speculation. … By September 1982, the Ministry of Finance ordered all dubious checks to be turned in for clearance, tallying the value of worthless checks at $91 billion.”

http://www.thebubblebubble.com/souk-al-manakh/

In the end, the KCM opened and there was simply silence at the Kuwait Camel Market with stocks going with zero bid. The market had seized and this is what the LBMA is heading for due to the unsatisfiable open interest claims for gold and silver created on that Market.

“It did not take a trigger to burst this bubble; it simply crested sometime in the dreadful heat of the Middle East’s summer. Its decline was so discontinuous it cannot be called a crash. There were simply no bids.”

http://www.gold-eagle.com/article/memories-souk-al-manakh

History never repeats itself exactly, but many similarities between the past and the current Russian crisis suggest that the eastern bear could significantly falter in the future:

1. The collapse of the ruble and its scope (Graph 2). The ruble lost over two thirds of its value in 1998. In 2014 it has lost more than half of its value against the dollar. Also the ruble’s unusual one-day falls are similar: Russian currency plunged 22 percent December 15 and 16, 2014 -an echo of the 27 percent fall August 17, 1998. 
2. The currency meltdown is again driven to a large extent by falling oil prices. The Brent crude oil prices dropped from $23 at the beginning of 1997 to $12 in August, 1998 –a plunge of almost 50% (and not very different from the recent dive).
3. In both cases we witnessed a dramatic hike of interest rates. In December, 2014, the Central Bank of Russia lifted the interest rate from 10.5% to 17%, while in May, 1998 the CBR increased it twice: first from 30% to 50% and then from 50% to 150%.
4. The change of investors’ sentiment towards emerging markets. In 1998, investors shifted their money from Russia because of the rise in risk aversion due to 1997 Asian financial crisis. As we pointed out in the last edition of the Market Overview, they also did so because of the strong dollar and the declining profitability of the carry trade. The same is happening right now. The firm greenback, anticipation of a U.S. Federal Reserve rate hike and falling commodity prices are responsible for pressure on emerging-market currencies.

On the other hand, some analysts point out a few significant differences between 1998 and the current crisis in Russia and argue that today’s financial troubles will not be as severe as in the past. Why do they think so and why are they wrong?

1. The ruble is not pegged to the dollar as it was in 1998. External shocks may be absorbed in the exchange rate whereas the Central Bank of Russia is not obliged to defend the ruble. On the other hand, the floating regime in Russia is not pure, it is dirty (managed), which means that the CBR may still be willing to support the domestic currency. And, as Ronald McKinnon from the Stanford University says, the exchange rate flexibility does not provide protection against the carry trade.
2. Russia has much more in foreign exchange reserves. At the end of 2014 they amounted to $418 billion, far exceeding the $16 billion before the 1998 default. Undoubtedly, it puts Russia in a better position. However, the reserves are not infinite and are vanishing at an unsustainable rate. In only two weeks before December 26, Russia used $26 billion to defend the ruble. Having in mind that the 2008 intervention to defend the ruble cost $200 billion, the foreign reserves may protract the collapse, but will not prevent it, especially now that they are lower than the $700 billion of external debt. We should not forget that not all reserves are at immediate disposal. Part are accumulated in special funds and committed to long-term projects. According to some, the usable amount could be only around $200 billion.
3. Russian public debt is much lower. In 1998, before the default, the government ran budget deficit of 8% of GDP and its cumulative public debt was 75% of GDP. Now, the budget deficit and public debt relations to GDP are very small and amount, respectively, to less than 1% and 10%. These facts make a default on public debt more unlikely, indeed, but not impossible. This is because Russian state, private sector companies and banks have accumulated $600 billion in foreign debt (around $100 billion is due this year). Moreover, the external debt to GDP ratio is similar to 1997 levels and higher than before Lehman bankruptcy. Investors should also remember that private companies in Russia are often quasi-sovereign and their ownership structure is rather fluid, so in reality the public debt is larger. This is why credit rating agencies will probably downgrade Russia’s rating to junk status soon.
4. The risk for financial contagion is much lower. The 1998 Russian crisis caused the global flight to quality. Investors were selling various sorts of bonds and buying U.S. Treasuries, which eventually led to the collapse of Long Term Capital Management hedge fund and the stock market crisis in the USA, the S&P 500 index plunging about 20% between July and October of 1998. The level of interconnectedness between Russia, which makes up less than 3% of the global economy, and Western countries is now much lower because of current sanctions (suggesting that Russia cannot presently expect any international help).

Nevertheless, the global economy is rather weak and fragile right now. Volatility is up. The gold to oil ratio is above 20, which usually implies a crisis. The Swiss National Bank removed the franc’s peg to the euro, signaling no faith in euro. Thus, the growing problems of Russia may lead to even further elevations in global risk aversion and to portfolio rebalancing or capital outflows from other emerging markets which are more interconnected with developed markets. The fall of the ruble has already affected the currencies in many post-Soviet countries that are still economically tied to Russia. Leveraged investors may also try to cover their losses in Russia by selling debt tied to other emerging markets. Moreover, the deepening of the crisis may attract a landing of another geopolitical black swan released by the Russia. Indeed, fighting in the Ukraine continues to support gold prices.

So, is Russia heading to a new 1998 crisis? Public finances are in relatively good shape, so the government default is not as probable as in the late 1990s (so far). However, Russia is entering into a full-blown financial crisis with banks and companies’ defaults (which may entail a sovereign debt crisis in the future). A crisis caused by the falling ruble and following balance sheet problems, just as in 1998, when private banks as well as the state bank collapsed.

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Thank you.

Arkadiusz Sieron

Sunshine Profits‘ Market Overview Editor

Gold Trading Alerts

Gold Market Overview

This week precious metals continued to consolidate January’s gains in volatile financial markets, with both gold and silver range-bound. Platinum and palladium are up on the week, noticeably stronger than gold and silver. Physical and paper markets appear to have been behaving differently, with prices tending to be firm in London (where physical deliveries take place) and weaker in New York (which is overwhelmingly derivative trading), though at the close of trading in New York prices appeared more often than not to steady ahead of the Asian markets opening.

The US dollar has also been consolidating its recent strength, roughly in phase with the gold price. The logical conclusion from this action is that for the moment, sellers of the other paper currencies are hedging into both gold and the US dollar, which from the point of view of a non-US person faced with a weakening currency makes sense. So long as this relationship persists, it should also give us a clue on the timing of gold’s next move, which will be when the overbought position in the dollar is unwound enough to support its next rise. We may already be there after yesterday’s pronounced dollar weakness, which was technical in nature with the euro strengthening sharply despite a deteriorating Greek situation.

On Comex precious metal traders and bullion banks have been fighting a paper battle, and traders’ positions have now normalised, as shown in the chart below, which is of the short positions of the Managed Money category in gold:

The dotted line is the long-term average short position, which after the extreme volatility of the last two years is where we are today. This return to normality has resulted in the largest four traders (basically the bullion banks) increasing their net short position, which is shown in the next chart.

This is still well above the average since 2006, but with physical liquidity low, the bullion banks are unlikely to be able to tolerate escalating shorts to the extent they have in the past, so they might be forced to capitulate if buying increases much more. Until that moment we should expect them to make every attempt to shake out long positions by triggering stop-loss positions.

It will be important to watch big macro events, such as the possible fragmentation of the Eurozone, a run on Greek banks, particularly if it threatens to destabilise the euro or other Eurozone banks, as well as the developing crisis in Ukraine.

Tensions over Ukraine have rapidly escalated this week, and might become a factor for gold and silver prices next week if America sends military equipment, Russian tanks start rolling, or both. We must hope the Merkel/Hollande peace initiative defuses the situation.

Next week

Monday. Japan: Consumer Confidence, Economy Watcher’s Survey. Eurozone: Sentix Indicator
Tuesday. Japan: M2 Money Supply, METI Tertiary Activity Index. UK: Industrial Production, Manufacturing Production, NIESR GDP Est., US: Wholesale Inventories.
Wednesday. US: Budget Deficit. Japan: Key Machinery Orders.
Thursday. Eurozone: Industrial Production. UK: BoE Quarterly Inflation Report. US: Initial Claims, Retail Sales, Business Inventories.
Friday. UK: Construction Output. Eurozone: GDP, Trade Balance. US: Import Price Index