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Previews of Coming (Fed) Retractions

By Jon Nadler       Printer Friendly Version Bookmark and Share
Jul 21 2009 3:36PM

Although Monday's price gains were not relinquished in overnight Asian bullion trading, fresh gold buyers dwindled in numbers as Tuesday’s trading unfolded in North America. This, in part, because the US dollar also apparently refused to continue on Monday's path and slip much lower than the 78.90s on the trade-weighted index. The greenback, in fact, rose 0.15 during the day and reached back towards 79.05 once again. Call it the Bernanke effect. We did.

Small gains in crude oil (initially rising $0.74 to $64.72) provided a bit of (and about the only) a cushion of warm air under gold prices early this morning. The oil market remains torn between earnings-driven economic recovery optimism plays, and the stark reality of surging gasoline supplies in the face of an anemic summer driving season. By the start of the afternoon, crude found itself trading marginally off on the day, quoted at $83.85 per barrel – and it also pulled gold down somewhat from the morning’s levels.

Gold started the second session of the week with a small gain of $2 per ounce, quoted at $951.10 in New York. Participants were indicating a reluctance to let go of profitable positions, but at the same time not many exhibited the purchase enthusiasm that was seen in previous sessions. Gold remained capped in the mid-to-upper reaches of the $950s, and is starting to once again look like it was just a nice little spec fund play within the broader channel. A quick glance at the latest levels showed bullion off by $2 at just above $947 per ounce. A fairly lackluster session, if you ask us.

A breakout to the upside cannot come to pass absent substantial investment inflows, and we do not see them on the current horizon. At the same time fabrication demand is fast turning from room temperature, to cold. Not the best ingredients for mega-rallies. Like we said a couple of weeks ago, gold needs a fresh chapter in the crisis, and it needs it yesterday.

Indeed, Bernanke's pre-Congressional Wall Street Journal 'testimony' on the steps the Fed will take in order to avoid a Harare-on-the-Hudson inflation scenario in the US, proved dollar-supportive to some extent this morning. As we recall, it has been inflationary expectations -as opposed to actual readings of price and/or wage pressures- that have in large part fueled the recent commodities' rally. That, and visions of vibrantly green shoots - as opposed to the much more muted shade of actual green that is seen in the economic recovery up to this point.

As we said the other day, investors have been return-starved for so long, they are jumping into assets at the drop of any small positive economic news hat. For the moment, the gold equation is still a case of conjoined twins with the US dollar and oil to some extent. Bernanke's WSJ op-ed was evidently factored into this morning's price cake for gold, and it halted significant progress further to the upside for now.

Silver dropped a penny on the open, to start the day at $13.62 an ounce. It later added to those losses, and was off to the tune of 15 cents on the day, at $13.48 an ounce in the afternoon. Platinum initially fell $3 and opened at $1178, but then its losses also mounted, reaching down to the $1169 level following a $12 decline. Palladium first lost, and then gained $1 to finish at $254 per ounce. Truck maker Volvo Group was looking at a difficult period ahead as it reported its worst quarterly loss ever. The wheels of commerce are still not rolling as smoothly or as actively as they should be.

Some of the difficulties still present in the recovery process were reflected in White House NEC Director Larry Summers' frustrated take the current behavior of banks as regards closure on foreclosures, and in his hesitation to characterize next year's pace of economic growth very precisely. Echoing such sentiments, Mr. Summers’ Harvard colleague, Martin Feldstein, envisions the potential for a double-dip contraction in the US economy. Possibly before this year’s end. 

However, when it comes to Fed policy and future inflation scares, Ben Bernanke came out slugging in an overnight piece he wrote for the Wall Street Journal. This came ahead of his actual testimony to Congress later this week. Let's call it pre-emptive jawboning, aimed at a larger than the C-Span-watching audience. The Fed Head did not mince words when asserting his institution has "the necessary tools to withdraw policy accommodations, when it becomes appropriate [emphasis ours] in a smooth and timely manner."

In so many words, the surplus money-vacuuming campaign will be 'not now, but for sure in the future.' Thus, any alarmist hard-money newsletter scribe who alleges that the Fed is behind the curve on this one too, and that it is exhibiting ostrich-like syndromes which spell hyper-inflationary doom, is being disingenuous with his readers. Let's wait for the spelling lesson to come from Mr. B.B. in a little while, and then we can quote the blueprint itself. For now, we hand you the schematic of same, in the form of highlights from the WSJ piece written by the man:

“The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

Chad Crowe

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Speaking of stability or rather, the lack thereof –pricewise- in many a commodity over the past two years, here is another road sign coming up on the regulatory highway. Ignore such signals at great financial risk, is the official motto. Or, alternatively, find yourself shut out from market participation altogether. Marketwatch’s intrepid Moming Zhou brings us up to speed. Sharp curved ahead, and all:

“In their biggest move yet to respond to irregular swings in oil and other commodity prices the past few years, market regulators are considering imposing a range of controls including limits on investments by exchange-traded funds and index investors.

The Commodity Futures Trading Commission said Tuesday it will hold a series of hearings this summer on whether to limit investor positions in energy futures to address the speculation that has roiled prices of oil in the last few years. The regulatory focus comes in the wake of trading patterns that saw oil jump to almost $150 a barrel last year, only to fall back to below $40 this spring before rising again to $70.

While traditional speculators such as hedge funds and investment banks go in and out of the markets, big pension and endowment funds in recent years have also diversified their investments into commodities to hedge against inflation and a weaker dollar. Some positions grew so large that legislators and analysts said the trend was pushing oil prices to levels that couldn't be justified by fundamentals.

A MarketWatch analysis last week showed that passive investors increased their crude-oil holdings to the equivalent of more than 600 million barrels in June, up more than 30% from the end of last year, likely supporting the climb in oil prices. In Tuesday's trading, oil futures fell more than 2% to as low as $62.35 barrel on the New York Mercantile Exchange, following a 4% slump on Monday. Oil fell Tuesday because people realized "there was no fundamental justification for oil rising over $70 a barrel, " said Adam White, director of research at White Knight Research & Trading.

Also on the CFTC's radar was commodity ETFs such as the United States Oil Funds and the United States Natural Gas Fund. Those ETFs have become so big that at one point USO held more than 20% of Nymex's front-month oil futures contracts. The CFTC said Tuesday it is reviewing position exemptions it has given to derivatives dealers that help institutional investors conduct index, or passive, trading. Index investors gain exposure to a range of commodities by tracking a major commodity index, such as the 24-component S&P GSCI commodity index.

California Public Employees' Retirement System, the biggest U.S. public pension fund, now has about $600 million in commodities that track the S&P GSCI. Bob Burton, a spokesman for the fund, decline to comment on the CFTC's actions to hold hearings. "Markets dynamic, supply and demand, is more important than the so-called speculation [in commodities prices], " said Clark McKinley, another spokesman for the fund, in an earlier interview.

Institutional investors typically buy commodities by engaging in trades with swap dealers such as J.P Morgan Chase & Co.and Goldman Sachs Group. These dealers, in turn, hedge their risk by taking a similar position in futures exchanges. The CFTC currently allows swap dealers to take unlimited positions on energy commodities. It also classifies swap dealers in a category that's usually reserved for oil producers and refiners.
The CFTC's efforts were supported Tuesday by Sen. Byron Dorgan, D-N.D. and Sen. Carl Levin, D-Mich., who have been calling for a crackdown in commodity speculation.

"Excessive speculation is distorting prices, undermining our commodity markets and hurting our economic recovery," Levin said in a statement. CFTC Chairman Gary Gensler indicated the agency will seek views on applying position limits across all markets and participants, including index traders and managers of ETFs. "This different regulatory approach to position limits for agriculture and other physically delivered commodities deserves thoughtful review," he said in a statement.?

Now consider the following CPM Group NY gold ETF chart, which, BTW, only takes us out to the beginning of this year (recent balances have exceeded 35 million ounces for all such ETFs combined). Consider what has taken place over the course of the past two years in these holdings of bullion. Then consider the price of gold over the past two years.

Finally, consider the underlying fundamentals that have since developed in the gold market. Like record supplies of scrap flowing into the market in Q1. A full year’s worth, actually. Like the virtual death of fabrication demand. Then, start thinking. Hard. About issues such as “distorted? prices, speculative funds at play, and fair value. Say no more.

And, finally, something that is even more distorted, albeit hardly real (must be the summer heat and staying out far longer than the SPF factor in that lotion allows before damage takes place). The latest in desperate tinfoil club attempts at spinning gold market fairytales, concerns an actual non-issue. Read it and weep (with laughter):

Theory: Comex has asserted their right under their rules to deliver the equivalent paper interest in Exchange Traded Funds such as GLD in lieu of the delivery of physical bullion for those standing for delivery under the rules of the commodity exchange. Aluminium hat-wearers ask: Is GLD really the same as physical bullion? Then conclude that:

" appears that a lot of investors believe and trust that investing in GLD is the same thing as buying physical gold bullion ( we have news for you: aside from on-going management fees which eat into your balances, it is). A close reading and analysis of the GLD Prospectus, however, reveals that investing in GLD is drastically different from owning gold.?

Reality: This "bombshell" is a plain old bomb, nothing more. The contract specifications at the COMEX will not change. It will not be changing to accept ETFs. Traders we know have spoken with CME and the allegation is nothing but a bunch of mortadella at this stage.

It (the change) is not in consideration, and nothing has changed in the way business is being done. One can call the CME, one can call real-world trading desks (we have) and one can consult the people in the know. At that point, the propagation of bullstuff can stop. Someone is still smoking something very stale out there in Al land. 

Further: The CME clearinghouse has $8 billion in capital behind it and it has had no significant delivery notices, nor has anyone noticed anything that looks like it is out of kilter, however we had these nonsense "news alerts" and "urgent notices" since last year, from some of the same "groups" and they too, were also false. Remember, COMEX was supposed to default last December.

"They" do not understand the basic fact that the exchanges don't hold the ETF's gold, but that it is designated depositories, (such as HSBC for example) that do. This, among other things they try to mischaracterize, and it only shows that this type of commercial agenda-driven yellow journalism still exists, and that it is –at the end of the day -highly damaging to uninitiated readers.

Until tomorrow,

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.