John Dizard: Gold flash crash rouses suspicions of witchcraft


Another patronizing journalist who will never try putting hard, specific questions to central banks, even though, as he implicitly acknowledges in his final paragraph, they plot to run the world in secret. All that is just to be taken for granted ... at least by journalists like himself.

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Gold Flash Crash Rouses Suspicions of Witchcraft

By John Dizard
Financial Times, London
Sunday, March 4, 2012

As they say, a paranoid is someone who suspects nine of the five conspiracies against him. Last week was a feverish one for the more sensitive gold specu ... investors, with a "flash crash" on Wednesday interrupting what had been a stately procession since December to ever-higher highs. Since gold people believe their positions represent not just an investment, but virtue itself, the losers smell witchcraft, and particularly evil Fed witchcraft at that.

What does the gold crash mean, if anything? Was it the result of a conspiracy by short sellers, or, conversely, does it presage another crisis, as gold price declines did in mid-2008 and September of last year?

The $90-plus an ounce sell-off, from a high of $1,790 early in the London trading day came during Federal Reserve chairman Ben Bernanke’s testimony/grovelling to Congress last Wednesday. Taking into account the further declines in after-hours trading, the 6 per cent plus hit cut this year’s gold gains by about half.

... Dispatch continues below ...


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The chairman had just finished saying that the decline in the unemployment rate was "somewhat more rapid than might have been expected," and, shortly after, that "... it will be especially important to evaluate incoming information to assess the underlying pace of economic recovery."

To most, these sound like bland, rather than momentous, statements. However, the day's news cycle, and market tacticians, needed an event to excuse more churning of the customers' accounts, so Mr Bernanke's testimony was taken to mean that the Fed was postponing the start of a new round of quantitative easing of monetary policy. So less cheap money to support risk, and less future inflation.

Apparently, someone, or, rather, two someones with proprietary trading algorithms decided it was time to sell the futures equivalent of 31 tonnes of gold on the Chicago Mercantile Exchange. The crash happened between 10:40 a.m. and 10:54 a.m. eastern US time, with the biggest part of the decline taking place between 10:43 and 10:44, with a further drop in the couple of minutes before 10:54.

Wall Street's religion is chart-reading. But which chart? The one with Japanese candlesticks and outside days? The one with moving average crossovers? Or, for those traders who finished school, applications of cross-asset-class generalised autoregressive conditional heteroskedasticity models?

Nicholas Glinsman, a hedge fund manager in Taubate, Brazil, says: "These large (gold) sell-offs on big volume usually precede market liquidity events." ["Liquidity event" in this context means a widespread lack of ready money to cover immediate obligations.] "In anticipation of those, people have to raise cash somewhere, and that's by selling something in which they've made a lot of money. This happened last September (before the worst part of the European crisis), and, more dramatically, from July of 2008 up to the Lehman crisis of October 2008."

There is something to this. I remember how dollar-short European banks' sales led to a counterintuitive gold price decline in the middle of a panic.

David Goldman, a highly innovative New York fixed-income strategist, has tested a wide range of gold price time series correlations. He makes a strong case that the metal's closest relative (for now) is the yield on US Treasury Tips, the inflation indexed bonds.

"Tips and gold are high-correlated," he says. "They are both deep out of the money options on catastrophic changes in the price level." However, because Tips pay par at maturity (unlike some of their European counterpart inflation linkers), they also protect against deflation. This payoff on either inflation or deflation is so valuable that at the moment the 10-year Tips trades at a negative yield.

As Mr Goldman points out, the two asset classes are so close that they trade very tightly on a minute-by-minute or tick-by-tick basis, as well as over longer time periods. I don't think there are people trading the Tips/gold basis with offsetting long and short positions. However, there are probably long-only portfolio allocators who are rapidly changing their relative positions in Tips and gold.

Geeky enough for you yet?

This persistent pattern of high correlation makes Mr Goldman sceptical that last week's gold flash crash is anything more than a couple of clumsy hedge funds unloading excessively large positions. As he points out, it took an eternity, from 10:54 a.m. Eastern Time all the way to 11.20 a.m., for the Tips market to follow the gold price down. And when Tips did sell off, they did so far more gently. "The Tips market tells us this wasn't all that significant. If it were a general change in perception, then you have seen more happen (faster) in Tips."

My own view is that the Fed, like any bureaucracy, has tons of plans but doesn't really know what it will do next. When QE3 happens, it will be in reaction to immediately preceding outside-the-model events, justified with tortuous rationalisations.

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