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Precious Metals' Place in the Liquidity Crisis


You can't eat gold, but you can't eat paper claims, either. As the latter falls further out of favor, something will have to take its place to remedy these constant crises.

The prospect of unlimited quantitative easing (QE) has always been a driving force behind the demand for precious metals. Conventional trading wisdom has always held that gold is one of the best hedges against inflation, with silver acting as both money and a commodity. Since QE is nothing more than money printing disguised through the machine of the Fed's primary dealer network and its US treasury auction system, each additional iteration of QE simply dilutes existing currency in the perceptions of a great deal of investors – especially those residing in overseas jurisdictions that will bear the brunt of any inflationary "default" on official government obligations.

There has at least been some danger that a disruption in the expected steady stream of money printing would take a significant amount of steam out of precious metals demand. So the coincident crash of gold (GLD) and silver (SLV) prices, stock prices (SPY) (QQQ) and the "disappointment" of the FOMC's adoption of only Operation Twist (which does not expand the Fed's balance sheet, meaning no money printing this time) makes some sense.

Applying additional margin increases for futures positions at the same time certainly played a role as well, though the official desire of these exchanges to curb volatility by increasing margins never seems to work out. They only add to volatility, and only in one direction.

However, can we really account for all the selling simply through dashed expectations and margin moves? Further, is "QE to infinity" the only pillar for precious metals demand?

I think those two questions are interrelated in an extremely important manner. I don't believe that the disappointment (for lack of a better term) over Operation Twist can explain such a violent drop, even if the margin increases are again added at the point of maximum weakness in buying appetite.

In my opinion, given the circumstances of the time, the rumors of central bank selling or a serious hedge fund unwind were the final blow that turned what would have been a serious
correction into a rout. The credibility of such rumors is enhanced both by the pervasive lack of liquidity in so many additional markets plus the recent historical record of central banks and governments during a liquidity crisis.

From mid-July through early-September 2008, the price of gold fell by over $250 per ounce, a decline of more than 25%. It happened during a heightening liquidity crisis where banks, including central banks, were desperate to find and hoard any and all possible dollars. The threat of "official" gold sales during liquidity crunches is very real, and rumors of another round offers perhaps a fuller explanation for the gold market that went essentially bidless.

But in that idea of another liquidity crunch and its severity lies what I believe is the longer-term appeal of gold. The banking system suffers from another episode where the terms of exchange between banks are being questioned to the point of inoperability.

The primary source of marginal short-term funding for the largest banks in the world is the eurodollar, Fed funds and repo markets. The first two are unsecured lending arrangements between big banks, carried out largely on a familiarity basis. As we have now seen twice in the past four years, these unsecured markets perform very poorly during crises – they essentially shut down at the all-important margins.

Once that squeeze takes place, the pressure for marginal funding rises in all areas, including the desperate government impulse to sell its gold holdings (a terribly short-sighted maneuver). It also herds banks into more secured arrangements: the repo market.

Terms of secured funding through repo transactions involve some form of collateral. The higher the "quality" the lower the haircut, so the borrower can obtain far more marginal funding with the best-perceived quality of collateral. Such an arrangement favored AAA-rated mortgage bonds during the housing boom.

Of course, the collapse of the perceptions of mortgage bonds in 2008 was the direct cause of that liquidity crisis. Not only were mortgage bond values questioned, where haircuts had to be dramatically altered, but the actual ownership of posted collateral became problematic. Not surprisingly, given the fractional nature of all forms of modern banking, the largest banks in the world had no qualms about using someone else's posted collateral as their own for their own funding needs. This process, called rehypothecation, reached an estimated $4 trillion before the 2008 collapse.

Even today, the IMF estimates that there is still $2 trillion in rehypothecated collateral floating around the repo markets. The IMF does not note what kind of bonds or claims they may be, but a significant amount is surely sovereign European debt (though not necessarily PIIGS).
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