EDITOR’S NOTE: The following report has been circulating heavily on “Gold Bug” web sites in recent days. The Royal Bank of Canada has recently denied that it is the official bank view of the market, and that it was prepared purely for internal use. However clients of the Bank have told “Gold Bug” activists that it was disseminated to key bank customers.
TRANSCRIPT OF REPORT FOLLOWS…
RBC GLOBAL INVESTMENT MANAGEMENT INC.
Report on Gold
Clearly, with gold stocks on a tear as the gold price moves laboriously forward battling the fervent attempts to suppress it, one must be comfortable with the notion that the gold price is going to overcome the forces that are aligned against it. What is happening today is no different than what was happening in the late '60s and the very early '70s, when the Gold Pool was in existence and the gold price was contained at $35 per oz. by a consortium of central banks that dumped a considerable amount of gold to keep prices down. Today, instead of the overt action of yesteryear, it is covert because the market is allegedly free, and it has entailed a different mechanism, which has resulted in a humongous physical short position. In addition, there has been an enormous amount of derivatives piled on top, which could make the ultimate upside explosion all the more spectacular.
So the question obviously is: "Will the gold rally ever begin?" The following arguments emphatically suggest that it will more than rally; it will explode to the upside.
1.Unsustainable Supply/Demand Imbalance
Mine production has flattened out at 2,600 tonnes and is beginning to fall due to a lack of exploration, falling grade at many mines due to previous high-grading, and the closing of older mines as they run out of ore. It has been estimated by Beacon & Associates in an exhaustive study that if gold prices were to remain under $300/oz., production will fall in the neighborhood of 25% over the next 5 to 7 years. Scrap supply tends to average about 600 tonnes annually. Demand is currently estimated to be roughly 4800 tons (primarily jewelry) without any investment demand from the Western world. The present deficit has been met by direct central bank sales (roughly 400 tonnes per year) and central bank leasing for mining hedges and financial speculation.
2) Unsustainable Short Position
Central banks have ostensibly lent increasing amounts of gold to earn interest on their reserves. However, when one lends at an rate (less than 1% generally), the question arises as to whether there may be another motivation. As a rising gold price stands as a direct repudiation of their alleged responsible monetary policy, perhaps this is the real reason they have been so aggressive in this area. Bullion banks have borrowed gold from the central banks for their own accounts and those of various speculators, such as hedge funds and financial institutions (the carry trade) and for producers (mine hedging) and have used derivatives to limit their risks and generate additional income. The loaned gold has been sold into the physical market and is now in jewelry, primarily in the Middle East, India, and other parts of the Far East. The size of the short position, officially acknowledged to be more than 5,000 tonness by the bullion bank apologists, is thought to be well over 10,000 tonnes and may exceed 15,000 tonnes. To put this in context, this constitutes between one-third and one-half of all central bank gold, and the vast majority of it is no longer accessible.
3) Unsustainable Low Inflation
The gold price has a tendency to rise at the first whiff of accelerating inflation. CPI inflation has been unrealistically low due to the very strong dollar, which has underwritten vicious foreign competition and removed pricing power in many sectors. However, in the final analysis, inflation is a monetary phenomenon and the aggressive interest rate cuts and monetary expansion to avoid recession/deflation is expected to result in re-inflation. Year-to-date, the liquidity injection is more than $1 trillion and MZM has grown by 16.5% in the past year. To avoid debt default, the Fed must err on the side of ease, virtually ensuring upside pressure on the CPI. In addition, the "war on terror" superimposed on Bush's mammoth tax cuts and a four-year government real rate of spending increases that is the greatest since the '60s portends large U.S. government deficits, yet another recipe for inflation.
4) Unsustainable U.S. Dollar
The U.S. dollar has been levitating for a long time, but the underlying fundamentals continue to erode. The U.S. current account deficit exceeds $400 billion annually, and the continuation of this chronic deficit turned the U.S. into the world's largest debtor as most of these deficits are being recycled into U.S. debt instruments. However, foreign appetite for U.S. securities appears to be ebbing and the chart on the U.S. dollar looks very toppy . Gold is already in a bull market in U.S. dollars, and an established bull market in every other currency. If the reserve currency, the U.S. dollar, falters, gold could well be launched on the upside as people recognize its status as the only "true currency."
5) Unsustainable Prices for Financial Assets
Western world investment demand will be the true fundamental that drives gold much higher. Gold tends to be counter-cyclical and investors buy it when financial assets begin to lose credibility. Ownership and pricing (P/E) of financial assets are at historic highs and if inflation accelerates, the U.S. stock market is extremely vulnerable. The ratio of the S & P 500 Index to the price of gold reached an all-time high, by a considerable margin, in 2000, but this parabola have been broken and a downward trend is in effect. At the margin, if a small amount of money is moved from financial assets into gold, the price effect on gold will be dramatic and the ratio will continue to move in gold's favor.
6) Increasing Evidence of Unsustainable Gold Price Manipulation
a. Aggressive gold lending, which from an economic perspective is indefensible, has filled the supply/demand gap.
b. NY Fed gold has been mobilized when the gold price is rising.
c. Timing of Exchange Stabilization Fund gains/losses corresponds to gold price movements.
d. Audited reports of U.S. gold reserves show unexplained variances.
e. Minutes of Fed meetings confirm officially denied gold swaps.
f. Rules on gold swaps revised but subsequently denied. However, individual central banks have repudiated the denial.
g. U.S. gold reserves have recently been re-designated twice, initially to "custodial gold" and latterly to "deep storage gold."
h. Statistical analysis of unusual gold price movements since 1994 indicate high probability of price suppression. The invalidation since 1995 of Gibson's Paradox -- that gold prices rise when real interest rates fall -- suggests that the real manipulation began then.
i. NY gold price movements versus London trading defy odds.
j. Timing of huge increases in bullion bank gold derivatives is consistent with gold price declines.
k. Rapid decline in U.S. Treasury holdings of gold-backed SDR certificates is not explained.
One or two of these factors could be viewed as random, but the full body of evidence is overwhelming.
It would appear that gold is beginning to be viewed as money again. Gold is the only monetary asset that doesn't represent somebody else's liability, and with U.S. real short-term interest rates now in negative territory, there is no disadvantage in holding gold. Those with a vested interest in containing the price of gold -- central banks, bullion banks, heavily hedged gold companies -- will not die easily, but the tide is moving strongly against them and the embedded short positions could catapult the gold price higher while imperiling the future of those holding the short positions.
The great rallying cry of the bears is the mobilization of even more central bank gold to the tide. Recently, Ernst Welteke of the Bundesbank has spoken publicly of the Germans selling gold after the initial Washington Agreement limiting European central bank gold sales to 400 tonnes per year expires in late 2004 with the intention of redeploying into stocks and bonds. Formerly, commentary and action of this sort by central banks (the announcement of Swiss sales, the initiation of English gold auctions, etc.) devastated the gold market but this elicited little more than a yawn. An astute gold analyst in South Africa postulated the reason why, perhaps. There are strong rumors that Deutschebank has borrowed an enormous amount of gold (more than $10 billion worth) from the Bundesbank over the years to facilitate the carry trade, producer hedging, etc. and it is becoming apparent that there is no way they will be able to pay it back. Perhaps, to make good on their gold loans, they will reimburse the Bundesbank with stocks and bonds and Mr. Welteke is readying the German public for with his statements.
In addition, there are enormous dollar reserves building up in the Far East, particularly in China, and the Far East has acknowledged being significant buyers of gold. So the flow of central bank gold is not only one-way. Even the Russian Central Bank is on the buy side. The shibboleth of central bank sales will undoubtedly be trotted out again, but it is losing its sting, particularly if the possibility that as much as half of all the central bank gold may already be in the market starts to become more widely recognized.
In addition, in the '70s, when gold was rising sharply in price, central banks, after having been heavy sellers at $35/oz., sold little or none at higher prices. Central bankers are no different than the momentum players; if the price is rising, they are more likely to be buyers than sellers.
One last observation concerns the gold share price action prior to the explosion of gold prices in the '70s. Then, as now, gold stocks rose to prices that made no sense to observers who had a static view on gold prices, but the stock buyers knew that sharply higher gold prices were inevitable. I suspect that is the case today, particularly when one examines the foregoing evidence.
7) Gold Stocks
Gold stocks are perceived by many to expensive, but, in fact, they are considerably cheaper than they were in the late '90s. The central banks' overt attempts to bring the gold price down (Swiss sales, British auctions, etc.) at that time removed the premium in gold shares and it is now gradually being restored as confidence returns to the sector. In fact, if the gold prices were to rise sharply, I would not be surprised if the price to NAV continued to rise due to a shortage of viable gold stocks.