In the week ending December 16, gold ran up to $540/oz and then thudded back to $500. But that’s not all that happened. Volume jumped in a big way on the COMEX and also on the TOCOM (Tokyo Commodity Exchange). The chart below shows the price of gold in yen, the big volume and the big price drop. What’s going on?

It’s another indication that for gold, times have changed: Japanese investors have become busy players, doing most of their trading at the TOCOM, where last week’s limit-up price movements were followed by limit-downs.

Trading limits (how far settlement prices can move in a day) are imposed by futures exchanges to give traders on the losing side an extra day to settle in cash. When a limit is reached, trading stops. Such events are rare and usually mean that something abnormal is affecting a commodity.

This time the limit moves in Tokyo were accompanied by big trading volumes. In the U.S., the COMEX has also been experiencing unusually large delivery volumes, a red flag that there is new demand for physical gold. Speculators who just want to trade on the price are being joined by others who want to own physical gold. But what has been stirring up the action?

One clue is what happened last week in the foreign exchange market—the biggest rise in the yen in months, from $0.8370 to $0.8733.

The run-up to $540 per ounce looked like a market out of control. One source of the action is believed to be hedge players who were borrowing yen to buy gold. The yen interest rate is still close to zero for short-term credit, so the cost was small. And with the yen on a weakening trend for most of 2005, the net cost of borrowing has often been negative. As the yen depreciated from 105 to 120 to the dollar, the borrower was able to pay off in depreciated yen, which added to the profit for a dollar-based customer.

The other part of the maneuver was gold, which in Tokyo can be traded with enormous leverage. The one-kilo contract on the TOCOM (covering gold worth about 2,000,000 yen) requires a margin of just 25,000 yen. That’s leverage of 80 to 1! As gold was driven higher, this was a big-win opportunity for a hedge play on both ends of the transaction. Now you have the tinder for wild extremes, and the fires were burning, as seen in the limit-up moves at the TOCOM and prices $30 above New York.

As the week progressed, no one knew where gold might run, having come up from just $420 in the summer. On Tuesday, the Fed raised the fed funds rate a quarter of 1 percent, with little reaction until the sun rose in Tokyo on Wednesday. On Monday, the TOCOM had doubled the margin requirement for its gold contract, effective on Wednesday. Changing the rules scares a market. http://www.tocom.or.jp/news/2005/20051212_02.html

Look at the intraday chart comparing gold with the yen. The yen-gold carry trade was socked on both ends.

The picture shows gold crashing and the yen jumping up through the week.

(Courtesy FutureSource)

My reading is that the managers of the world markets, who have an interest in keeping gold contained, took action to slow its rise. The evidence in the cross of the yen against gold suggests that this big carry trade was forced to liquidate, in a self-reinforcing retreat. Seeing that the short-term run was about to abort, the hot money quickly dumped positions. The chart shows the dumping of gold and the yen’s rise in the big movement for the week.

Has this done any real damage to gold? The answer is no. It might even be evidence that bankers and regulators who wanted to see gold stall needed to fire all their guns. But delay is the most they can accomplish. The underlying forces of government deficits in both the U.S. and Japan that are diluting the value of paper currency are still far more powerful than any disturbance from hedge fund unraveling.

A tougher question is whether this hit to gold will affect the still big speculators, such as the so-called “Non-Commercial Speculators” (identified in the Commodity Futures Trade Commission’s Commitment of Traders report as holding large, long positions). This is a group that can move markets, and many of its members tend to be trend followers. If last week’s jog was big enough to force unwinding by the highest-leverage yen-gold carry traders, could the effect roll over to the Big Specs? The jury is out on that, as gold ended the week a few dollars up on Friday. The carry trade has been put out of business, but the direction of the Specs is unknown.

The biggest players, of course, are the biggest holders of gold; the world’s central banks, and they have been negative on gold for years. But there are signs of change, as central bank holdings of dollars grow uncomfortably large and inspire thoughts of diversification.

The theoretical questions are whether bubbles can be detected and, if so, should they be popped? Greenspan’s position is that bubbles can't be recognized when they are occurring and are best dealt with afterward, (as opposed to being managed preemptively). In the stock market boom of the 1990s, Greenspan fretted publicly about “irrational exuberance,” yet refused to raise stock market margin requirements (which the Fed controls), properly fearing a stagnation similar to what Japan was suffering.

The Fed's new head, Bernanke, hasn’t revealed his position on the bubble questions, but his review of the 1929 crash with a Friedmanite criticism of the Fed as the culprit of the depression indicates that he did not focus on the stock market bubble of the late 1920s as a source of trouble. That means he may not understand the bubbles ahead.

Did TOCOM’s management take on the job of bubble bursting? Oddly, there the futures exchanges are their own regulator, and that partly explains the 80-to-1 leverage compared to the 2-to-1 margin requirement the Fed imposes on the U.S. stock market. A fair read on TOCOM’s actions is that their increase in margin merely caught up with appreciation in the underlying contract. But the timing and results indicate that TOCOM management was indeed operating on bubble alert.

© 2005 Bud Conrad
Editorial Archive  Email

www.caseyresearch.com  and www.kitcocasey.com