Collateral Consequences – Tuesday Kitcommentary


Bullion Bars

The PBOC made good on its previous promises to combat inflation by hiking its key interest rate overnight to 6.06% effective as of tomorrow. The central bank also raised the 12-month yuan deposit rate by a similar quarter percent, to 3%. The lifting of rates came on the heels of similar anti-inflationary moves that the PBOC undertook in October and December of 2010.

The US dollar declined to 77.87 on the trade-weighted index in the aftermath of the Chinese rate adjustment, and gold speculators saw this as an opportunity to lift the precious metal by nearly one percent shortly after the New York market had opened with a minor, $1.80 per ounce loss at the $1,350.00 level. As well, the (logical) initial reaction in gold overnight was to experience some more profit-taking type of selling. Rising interest rates (headline, or real) might not be as conducive to further gains in commodities as some hard money propagandists would have us believe.

Curiously ‘lost’ in the news on Monday were remarks made by ECB Governing Council member Yves Mersch. The comments were related to the sharp rise in commodities’ prices. Mr. Mersch noted that:

"if the commodity price push should lead to second-round effects that leave inflation at an excessive "plateau" and risk destabilizing inflation expectations, there will be a "rigorous reaction" from monetary policy, he assured."

"The ECB has always said that price stability has "absolute priority" and it has always taken the necessary steps to fulfill its mandate." Mr. Mersch then added a new ‘wrinkle’ to the interest rate hike equation, by cautioning that "the ECB’s ongoing liquidity-support measures [would not] prevent it from tightening monetary policy, if necessary. We can hike interest rates without having exited" from non-standard measures."

Digest that, for a moment.

By contrast, it appears for now that Mr. Bernanke and his central bank (along with investors, apparently) are counting on inflation not getting out of hand due to spiking food, energy, and metals prices. This, even if the current year may witness a short-term rise in prices due to such pressures. While ‘headline’ inflation is starting to have a (rather subtle) effect on the Fed’s monetary policy, its focus on core inflation and the apparent desire to record US economic growth rates at above 3.5% is leading to some bets that it will not raise rates very soon, even if it might soon alter the language it used last month when it alluded to "downward-trending inflation."

Trading-room "shop talk" from New York this morning indicated that gold specs were hoping that tomorrow’s return of Chinese traders would offer additional reasons for the metal to gain in value. Stay tuned. The yellow metal is in "recovery mode" following several weeks of declines and market technicians envision a possibility of it revisiting the $1,370-$1,400 range if the current rebound exhibits ‘legs’ (read: if it is able to maintain closings above $1,360.00 for a few sessions).

After the first hour of trading in New York the snapshot price check indicated gold ahead by $10.00 an ounce, at $1,362.1o on the bid-side. CFTC data continued to reveal that speculative interest in gold bullion is still waning — to the benefit of other, apparently more ‘attractive’ metals. The shrinkage in long gold positions (10,500+ contracts lost in the latest reporting week) continued for a fifth week last week, despite the apparent recovery in bullion values.

Where did some of the interest flow? Well, some of it went into silver, (though the increase in long positions could be chalked up to short-covering as opposed to new buying), and — no surprise — to platinum and palladium (not to mention copper). Better fundamentals yield better positioning.

Silver was up by 27 cents this morning, quoted at $29.71 per ounce, and platinum was higher by $8.00 at $1,847.00 the ounce. The Austrian Mint announced that it will not produce five and ten ounce silver coins this year "because of the high price" (read: we weren’t going to sell too many of those, at these lofty levels). Palladium climbed $6 to reach $822.00 and rhodium remained static at $2,450.00 per troy ounce. On the losing side this morning, crude oil fell $1.28 to the $86.20 per barrel mark, and copper declined 0.5% to near $4.50 at last glance.

At least one fund manager was heard issuing a note of caution on certain bonds and gold at this juncture. Charles de Vaulx, whose International Value Advisers’ mutual funds are showing a quite sizeable cash position at this time (ranging from 16 to 21 percent), is not very fond of holding T-bonds, corporate bonds, emerging market equities, and…commodities (oil and natgas excepted).

Mr. Valux — while still holding 4.5% of his funds’ monies in the yellow metal (down from 6.1% recently) — cautions that gold is not behaving like…well, gold, anymore, as "it is rising along with everything else." The fund manger notes that "the classic reason to own gold is because it isn’t correlated to your other investments. Gold may face headwinds if real interest rates — in other words, interest rates minus inflation — rise." Correct, on both counts.

Much ado was on display following JP Morgan‘s announcement that it will accept gold as collateral for transactions involving securities lending and repo obligations. The ink had not yet dried on the news item’s printed pages, when a string of affirmation about gold’s "currency" status inundated the blogosphere. Someone "forgot" to mention that the CME had already been accepting gold as collateral since last October…

Frankly, considering the types of assets had been taken as collateral in previous years, the news should not come as a "shocker." In fact, it should probably raise certain questions about the timing of the development and underlying conditions it may reflect. That, aside from structural questions, such as what loan-to-value JPM will factor in when making such lending decisions and what happens when a borrower possibly defaults on its obligations.

If anything, the JPM move underscores two realities: a) that more investors have gold in their portfolios and wish to use it to free up some value with which to play in other markets, and, b) that JPM is quite adept at trading the stuff and feels confident enough in its expertise at same to handle most potential future situations related to such collateral’s swings in value (unlike other financial firms). A succinct observation on the matter was made last night by the market technicians over at Elliott Wave.

The EW passage reads as follows: "We read the news for what it means. Was there pressure by investors to have gold accepted as collateral five years ago when [gold] prices were under $500, or ten year ago when gold was under $300? It is only after prices have risen for the prior 11 years that investors are secure enough in gold’s trend to push for its acceptance as trade collateral. The news says that investors push for gold to be used in counter-party risk transactions; [but] it means that gold is either at, or close to a significant trend reversal."

Do not worry about that just this morning, however. The counterintuitive and counter-trend (given the Chinese rate move) technical rally will have many concluding (once again) that only way to go here is skyward. Also (probably) lost in today’s news shuffle will be the remarks made by Richmond Fed President Lacker. Mr. Lacker noted that:

"the Fed should "quite seriously" evaluate the pace and size of the [QE2] program."

This, given the fact that:

"there has been a distinct improvement in the economic outlook since the Federal Reserve launched its $600 billion bond buying program last November."

Such remarks will likely be dismissed as anything but "serious" in certain camps.

We will return tomorrow. Quite seriously.

Jon Nadler
Senior Analyst

Kitco Metals Inc.
North America and

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