Brexit Drives Gold Frenzy

Prices of gold and silver

So let’s look at the only true picture of the supply and demand fundamentals. First, here’s the graph of the metals’ prices.

Gold-silver ratio

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. The ratio was down a hair this week.

For each metal, we will look at a graph of the basis and co-basis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and co-basis in red.

Gold basis and co-basis and the dollar price

Here is the gold graph.

If you wanted to make a case that the price of gold was going to go higher, a picture of gold abundance (i.e. the basis, the blue line) spiking up would be discouraging. The scarcity (i.e. the co-basis, the red line), already deep into negative territory, fell further in a sharp drop from -1.2% to -1.6%.

One can now make an annualized carry of +1.5% to buy gold metal and sell an August future, which will deliver in two months. Where else can you make that kind of return? For comparison, the LIBOR rate for two-month maturity is 0.52%.

There can be no question that the marginal buyer of gold is the warehouseman. With such an outsized profit to carry it, surely these folks are keeping busy and off the streets.

Why is there such a profit to be made carrying gold? Because current speculators are leveraging up even further, and/or new speculators are entering the game, adding their fresh leveraged bets to the table. After all, gold should go up in an event like Britain leaving the euro zone.

As we hinted above, there is a case to be made that gold is a better asset to hold than UK gilts, German Bunds, or US treasuries. It’s the same case that could have been made in 2001 when the price of gold was low, in 2011, when the price was high, last fall when the price was lower or Thursday when the price spiked to $1359. However, you can’t trade based on the background story.

Maybe some people will change their preferences. Meanwhile, the debtors are under a rising burden for each dollar of debt due to falling interest rates, not to mention a rising number of dollars of debt as well.

About 18 months ago, the Swiss National Bank had been struggling to maintain a peg to the euro, set at 1.2 francs. While the SNB had been blustering that it had unlimited resources to squander, it finally had to let go when it hit its stop-loss. When that happened, the interest rate in Switzerland plunged. Keith wrote a paper arguing that the Swiss franc will collapse.

Negative interest is not just a disincentive to hold paper currency (though it is, of course). It is not merely that gold becomes more attractive than negative-yielding paper (though it does, of course).

More importantly, negative interest is a powerful incentive to destroy capital. If you could borrow at -1% per annum, then you have a license to lose capital at a rate of 0.5%. Would you want to extend credit like this?

We note that the Swiss yield curve has sunk further beneath the surface of zero, since that article in January 2015. The 20-year bond is now drowning, and the 30-year is practically zero. 18 months ago, the 10-year was about -0.25%. Now it is below -0.53%.

At some point, this will begin driving people to gold. Not to make a bet on its price, using leverage, and ultimately to make more dollars. But to own, as a way of avoiding falling rates and rising counterparty risk.

However, it doesn’t look like we’re at that point just yet.

Indeed, despite the rise in the market price, we see a drop in our calculated fundamental price. It’s now a bit under $1,100, or about $230 below the market. As we often say, we do NOT recommend naked shorting a monetary metal.

It is always possible that some central bank will do something even more crazy and the price could go +$250 in an instant. Additionally, chartists may be drawn to bet on the gold price because they see momentum. We can tell you that the metal is overpriced, or conversely the dollar is underpriced. By a sizable amount.

Silver basis and co-basis and the dollar price

Now let’s turn to silver.

It’s a similar picture in silver.

The fundamental price didn’t move much, while the market price is up about 27 cents. The price of the metal is about $2.60 over what we calculate is its fundamental.

Interestingly, this puts the fundamental ratio below the market, under 72. We shall see if this state persists.