Nelson Hultberg: Controlling gold over time


By Bud Conrad
December 19, 2005

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
largedelivery 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.

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.


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

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

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 2-1 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.

This incident has come and gone, but it marks an escalation in the
forces driving gold. The tsunami hasn't been cancelled. What we saw
last week was just a blip on the way to much higher gold prices by
the end of next year.


Bud Conrad holds an engineering degree from Yale University and an
MBA from Harvard. He has held positions with IBM, CDC, and Amdahl.
Currently he serves as a local board member of the National
Association of Business Economics and teaches graduate courses in
investing at Golden Gate University. His data and analysis appear in
Doug Casey's International Speculator, which is dedicated to
uncovering gold and silver stocks with 100-percent or better profit
potential and in the pages of the Casey Energy Speculator, which
provides coverage of undervalued emerging energy stocks.He can be
reached at


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