Gold and Derivatives

November 27, 2008 Inflation, Physical Gold, Politics No Comments

Happy Thanksgiving to all and an apology for not writing yesterday but prior commitments left me unavailable.

The Dow closed up 247 at 8,726, the NAS up 67 at 1,532 and gold, at the time of this writing, is up $7.30 at $813.40. Broad swings are made easier with little volume, so I do not put a lot of stock in the results of the trading till the majority of the real players return from holiday on Monday. As a result of this, yesterday’s market was very thin, as will be Friday’s, so just maybe a look at the big picture today will be of more value.

It is widely expected that the Fed will lower interest rates to .75% at their meeting Dec 16th to try to slow the ever deepening recession. This will help bolster gold’s appeal as a hedge against inflation and a store of value in tough economic times. This move will put downward pressure on the dollar and may take away some of the current “flight to quality” buying that has been occurring during this global financial meltdown. With the way that the government has ratcheted up the supply of dollars in the world, this bubble should not last too long. At some point the numbers, if not already, will become too large for the markets to ignore and then the dollar will begin its decline into “third world” status.

The Pillars Of Stability Are Beginning To Crumble

In this “financial crisis of historic proportions” one word continually bubbles to the surface and that is “derivatives”. No, on second thought, that is not the word. I think they want to call it “bad debt”, or is it “toxic paper” this week. What ever the press wants to call it, it was spawned in the derivatives market. Derivatives are unregulated and therefore almost a complete mystery. No one knows how many there are or how to value them in this environment. What is known is that they cover the spectrum of all the markets and are the major reason for the financial mess we now find ourselves in.

In keeping with the spirit of the law of unintended consequences we must acknowledge the effects that derivatives may have on the price of gold. It appears that as the derivatives are called due, the holders, funds, or whatever entities have to unload all the securities that they can in order to meet their cash requirements. That explains why gold stocks has been rolled over just like the regular equities, although not quite as severely. The question that remains is how many more of these dominoes are going to fall, triggering more liquidations. That, my friends, is the $64 question, that no one can answer at this time. World events may play into this like yesterday’s terrorist attack on Mumbai, which may very well bolster gold sales in India and around the world.

There are just too many factors that enter into the derivatives question. Anyone who pro ports to know the facts is simply blowing smoke in my opinion. Suffice it to say that the derivatives market could push gold to test the $632.00 level or they could be the trigger that sends gold through the $1000 mark and beyond. It is best to be prepared for either event. I, for one, will take advantage of lower gold prices if they come and will be taking profits if the market goes the other way.

Under normal market conditions, the physical price is not necessarily tied to the futures price. Shortage of future supply might effect the relationship, world events etc. As an example, physical gold might shoot up over night due to some major world event while the futures price may be only effected slightly. Currently the futures price and the spot price are connected. If hedge funds sell large amounts of gold on the futures market the spot price goes down with it. This will also work in the other direction, but I feel that by the time funds are buying gold en mass the two will not be so tightly connected and the physical will lead the futures up.

Have a Happy Thanksgiving!