In the blog post “Some gold bulls need a dose of realism“, I noted that relative to the Goldman Sachs Spot Commodity Index (GNX) the gold price was at an all-time high and about 30% above its 2011 peak. I then wrote: “Rather than imagining a grand price suppression scheme involving unlimited quantities of “paper gold” to explain why gold isn’t more expensive, how about trying to explain why gold is now more expensive relative to other commodities than it has ever been.”

A rational explanation of gold’s relative expensiveness begins with the premise that major trends in the gold/commodity ratio are invariably associated — in an inverse manner — with major trends in economic confidence. Since credit spreads are one of the best indicators of economic confidence, with generally-widening credit spreads signifying declining confidence and generally-narrowing credit spreads signifying rising confidence, it would be logical if there were a positive correlation between the gold/commodity ratio and credit spreads. As evidenced by the following chart, that’s exactly what there is.

The current widening trend for credit spreads dates back to mid-2014, which is when the oil price began to trend downward and obvious cracks began to appear in the global growth theme. More recently, cracks began to appear in the US growth theme and the pace of credit-spread widening accelerated, leading to an accelerated rise in the gold/commodity ratio.

Could gold become even more expensive relative to commodities in general? The answer is yes, but only if economic confidence continues to decline.

I doubt that the decline in economic confidence has run its course, so I expect the gold/commodity ratio to move further into new-high territory before something more important than a short-term top is put in place. However, there’s a good chance that the gold/commodity ratio will make a multi-year peak this year, due mainly to increasing strength (catch-up moves) in other commodities.

The assertion that the gold price has been successfully manipulated downward over a great many years via the relentless selling of “paper gold” contains more than a few logical and factual holes. In this brief post I’m going to highlight one of these holes.

Before I get to the main point, it’s worth pointing out that in order to sell “paper gold” there must be demand for “paper gold”, since demand for physical gold cannot be satisfied with paper claims. It is also worth pointing out that downward pressure on the price of “paper” gold that was not supported by the “physical” market would inevitably result in the price of “paper” gold making a sustained and substantial move below the price of the physical commodity, which hasn’t happened. Over the past several years the prices of gold futures contracts have generally been very close to the spot price and there have been regular small dips in futures prices to below the spot price, but this situation is a natural and predictable effect of the Fed’s unnatural zero-interest-rate policy. Taking the US$ interest-rate backdrop into account, the price of “paper” gold has generally not been lower relative to the price of physical gold than a knowledgeable observer would expect.

The main point of this post is that while gold is different from other commodities, under the current monetary system the price of gold should never become completely divorced from the prices of other commodities. In particular, the price of gold should always remain within certain bounds relative to the price of platinum.

Now, the platinum market effectively ‘lives from hand to mouth’, in that the bulk of the current year’s consumption will be satisfied by the current year’s production. It should therefore be obvious to anyone with a modicum of objectivity that it isn’t possible to manipulate the platinum price downward, beyond brief fluctuations, by selling paper claims to the commodity. As a result, the multi-decade high in the gold/platinum ratio illustrated by the following chart is evidence that if there has been a concerted attempt to suppress the gold price, it has been ineffective to put it mildly.

I’ve come to understand that adopting the view that the gold market has been subject to a successful and long-term price suppression scheme is like adopting a child — it’s a lifetime commitment through thick and thin. I therefore don’t expect to change anyone’s opinion on this topic, but I’m hoping that some readers still have open minds.

A ridiculous fuss continues to be made in some quarters about the ratio of “registered” COMEX gold to total futures open interest. For example, a 26th January ZeroHedge article includes the following chart and implies that the high (542:1) ratio of open interest to “registered” gold could soon result in a COMEX default. To put it politely, this is unadulterated hogwash.

As explained HERE, the ratio cited in the above-linked article is meaningless, and, in any case, there are now about 15 ounces of physical gold in COMEX warehouses for every ounce that will potentially have to be delivered during the current delivery month. And as explained HERE, converting “eligible” gold to “registered” gold is a quick and easy process.

Don’t be taken in by what are either deliberately misleading presentations of COMEX data or blatant displays of ignorance regarding how the commodity exchange works.

Physical gold ‘flowing’ into GLD and the other gold ETFs does not cause the gold price to rise and physical gold flowing out of gold ETFs does not cause the gold price to fall. The cause and effect actually works the other way around, with the price change being the cause and the flow of gold into or out of the ETFs being the effect. I’ve covered the reasons before (for example, HERE and HERE), but cause and effect are regularly still being mixed up in gold-related articles so I’m revisiting the topic.

The Net Asset Value (NAV) of a gold ETF such as GLD naturally moves up and down by the same percentage amount as the gold price, so a change in the gold price will not necessarily require any change in the size of GLD’s bullion inventory. It’s only when GLD’s market price deviates from its own NAV that a change in bullion inventory occurs. For example, assume that the gold price gains 10%. In this case, GLD’s NAV will gain 10% and there will be no increase or decrease in GLD’s inventory as long as GLD’s market price also rises by 10%. However, if GLD’s market price rises by 11% then gold will be added to the ETF’s inventory to bring its market price and NAV back into line, and if GLD’s market price rises by only 9% then gold will be removed from the ETF’s inventory to bring its market price and NAV back into line.

Note that the manager of the ETF doesn’t have to initiate anything in the above-described process. The ETF’s Authorised Participants (APs) initiate the process in order to generate arbitrage profits. More specifically, a deviation between market price and NAV creates an opportunity for the ETF’s APs to pocket risk-free profits by selling or buying gold bullion and simultaneously buying or selling ETF shares.

All ETFs work the same way. That is, there’s nothing special about the way GLD works. The modus operandi ensures that the market prices of ETFs usually track their NAVs very closely.

Why, then, does the following chart show a long-term positive correlation between the gold price and GLD’s bullion inventory?

Because traders of GLD shares tend to get more optimistic about gold’s prospects and buy more aggressively AFTER the gold price has risen, causing GLD’s market price to rise relative to its NAV and prompting arbitrage that results in the addition of bullion to the ETF’s inventory. And because traders of GLD shares tend to become more pessimistic about gold’s prospects and sell more aggressively AFTER the gold price has fallen, causing GLD’s market price to fall relative to its NAV and prompting arbitrage that results in the removal of bullion from the ETF’s inventory. The correlation is far from perfect, because GLD traders won’t always become increasingly optimistic in reaction to a price rise or increasingly pessimistic in reaction to a price decline.

A final point worth making is that the annual change in GLD’s bullion inventory has always been very small relative to the total size of the gold market. Given the size of the total aboveground gold supply, there is very little chance that a few hundred tonnes per year moving into or out of GLD’s coffers could have a significant effect on the price.

So, the answer to the question “What do changes in GLD’s bullion inventory tell us about the future gold price?” is: nothing.