September 12, 2006


Like thrill-seeking amusement park patrons, precious metal investors have been on a wild ride in recent days courtesy of some new steep track laid by European central banks.

Unlike their counterparts across the English Channel who, under the guidance of Chancellor of the Exchequer Gordon Brown, unloaded more than half of their stash of the yellow metal a few years back at rock bottom prices below $300, central bankers on the continent seem to have a far better sense of timing.

Since late last week, rumors of renewed European central bank gold sales have preoccupied commodity traders and armored truck drivers the world over, the September 26th deadline for Washington Agreement sales looming just a couple weeks ahead.

Spot gold touched $584 an ounce on Monday before climbing back up to $596 in overnight trading in Hong Kong. This marked lows not seen since late June after the steep correction from multi-decade highs of over $720.

Stephen Roach of Morgan Stanley last week commented, "The mega-run for commodities has run its course", this following warnings in May that the half-decade long commodities bull market was a bubble waiting to pop.

Those familiar with Mr. Roach's "world on the mend" comments just prior to the May pummeling of global financial markets may want to consider the possibility of his most recent pronouncement, like the one in May, also being an excellent contrary indicator.

Other analysts view current price levels as buying opportunities. After breaking through the $500 mark last December, prices have averaged well over $600 so far this year giving little indication that when they go down, they will stay down for long.

Looking back a year ago, when purchases were made for jewelry fabrication in anticipation of the 2005 Indian wedding season, prices were in the $480 range - quite cheap when compared to 2006. Jewelry manufacturers may consider prices below $600 an ounce to be a bargain and choose to load up while they can, upward pressure in the form of physical demand causing prices to rise as quickly as they fell.

But, the rumored gold sales by central banks are of the greatest interest in recent days, coming as they did shortly after the Labor Day holiday as traders returned to their desks, investors once again began looking for places to deploy funds, and Indian jewelers began preparing for the upcoming wedding season.

There is little else in the world that can knock down another bout of nascent gold fever than word of central banks once again tiring of the drudgery of dusting off pile after pile of gold bars that have no practical use in contemporary monetary systems.

But there's a reason why central banks sell gold as they do.

In his memoirs, Paul Volcker, Federal Reserve Chairman back in the 1980s, lamented the inaction on the part of central banks to sell enough of their supply to contain the gold price. He said that soaring gold prices in the late 1970s and early 1980s "knocked the psychological props out from under the dollar".

Considering recent dollar strength and the slope of the line in the chart below, it is clear just how important psychological factors can be.

But, one has to wonder how long this can continue.

Selling gold to depress its price when measured in a paper currency that has been and will continue to be created in astonishing quantities in support of profligate spending by Western countries - this seems to be a long-term plan that will eventually cease to work.

At some point, there will be no gold left to sell, a goodly portion of it having found its way into the vaults of emerging economy central banks elsewhere in the world, as gold moved from Europe to the U.S. early in the last century.

Many wonder how much of the stuff still sits in central bank vaults, various lease plans and a gap of more than three decades in regular auditing of Fort Knox inventories only adding to the uncertainty.

At some point, individuals judging that a moderate gold price proves ongoing able stewardship of paper money, upon learning that the central banks have little gold left in their vaults, may abruptly change their views on paper money.

And gold.

At that point, the chart of gold prices may stop resembling a roller-coaster and appear more like a rocket.