August 4, 2015

In a blog post a couple of weeks ago I noted that it’s normal for large and fast price declines in the major financial markets to be accompanied by unusually-high trading volumes, meaning that it’s normal for large and fast price declines in the major financial markets to be accompanied by increased BUYING. I then wondered aloud as to why it is held up as evidence that something nefarious or strange is happening whenever an increase in gold buying accompanies a sharp decline in the gold price. Right on cue, ZeroHedge.com (ZH) has just published an article marveling — as if it were an inexplicable development — at how the recent sharp decline in the gold price was accompanied by an increase in buying.

As is often the case in the realm of gold-market analysis, the ZH article incorrectly conflates volume and demand. The demand for physical gold must always equal the supply of physical gold, with the price rising or falling by the amount needed to maintain the balance. If sellers are more motivated than buyers, then price will have to fall to restore the balance. The key point to understand here is that for every buyer there must be seller, and vice versa, so the purchase/sale of gold does not indicate a change in overall demand — it only indicates a fall in demand on the part of the seller and an exactly offsetting increase in demand on the part of the buyer. It is also worth noting — even though it should be obvious — that demand for physical gold cannot be satisfied by paper gold.

Trading in paper gold (gold futures, to be specific) clearly does have an effect on the price at which physical gold changes hands. The paper and physical markets are inextricably linked, but this link does not make it possible for the demand for physical gold to rise relative to the supply of physical gold in parallel with a falling price for physical gold.

What happens in the real world is that when the futures market leads the physical market higher or lower it changes the spread between the spot price and the price for future delivery. For example, when the gold price is being driven downward by speculative selling in the futures market, the price of gold for future delivery will fall relative to the spot price. In a period when risk-free short-term interest rates are being pegged at or near zero by central banks, this can result in the spot price becoming higher than┬áthe price of gold for delivery in a few months’ time. This creates a financial incentive for other operators in the gold market to buy gold futures and sell physical gold. For another example, when the gold price is being driven upward by speculative buying in the futures market, the price of gold for future delivery will rise relative to the spot price. This creates a financial incentive for other operators in the gold market to sell gold futures and buy physical gold.

The bullion banks are the “other operators”. They tend to focus on trading the spreads between the physical and futures markets. In doing so they position themselves to make a small percentage profit regardless of the price trend and therefore tend to be agnostic with regard to the price trend.

After harping on about the dislocation between the physical and paper gold markets, a dislocation that doesn’t actually exist but makes for good copy in some quarters, the above-mentioned ZH article moves on to the level of the CME (often still referred to as the COMEX) gold inventory. To the sound of an imaginary drumroll, the author of the article breathlessly points out that the amount of “registered” gold at the COMEX has dropped to a 10-year low and that the amount of “open interest” in gold futures is now at a 10-year high relative to the amount of “registered” gold.

The information is correct, but isn’t relevant other than as a sentiment indicator. It’s a reflection of what has happened to the price over the past few weeks and the increase in negativity that occurred in reaction to this price move. It is not evidence of physical-gold scarcity.

I currently don’t have the time to get into any more detail on the COMEX inventory situation. However, if you are interested in delving a little deeper you could start by reading the July-2013 article posted HERE. I get the impression that this article was written in response to the scare-mongering that ZH was doing on the same issue two years ago.

Thanks largely to the unprecedented measures taken by the senior central banks over the past few years, there have been many strange happenings in the financial world. However, the increased buying of physical gold in parallel with a sharply declining gold price and the reduction in COMEX “registered” gold cannot be counted among them.

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