Disconnect between Gold ETFs and gold futures

By Jon Nadler
Investment demand, which includes gold exchange traded funds, bars and coins were down 46 per cent from high of third quarter of 2008 but slightly up when compared again on a sequential basis, the WGC said in a statement. The retail investment category was also down 31 per cent on year but 11 per cent sequentially. Gold demand in most other regions was lower on the year, except in Greater China, where it recorded a growth of 10 per cent in volume terms." Finally, gold ETF holdings and their recent anemic accumulation patterns continue to show that some kind of disconnect still exists between the buying frenzy in futures and options markets and the market for the physical product.

The amount of metal, that for example, the Zurich Cantonal Bank holds in its silver-, platinum- and palladium-backed exchange-traded funds rose last week, but its gold ETF saw an outflow of nearly 35,000 ounces, the bank said. A tonne of gold leaving the balance sheet when assurances of gold soon doubling are issued every seven minutes? Why, that has to be about as important as the story that Mauritius having bought two tonnes of same was being made out to be, last week. But, who says we need any perspective in these markets? Did we not hear that $200 oil was a carved-in-stone probability on the very day when black gold hit $147 last year?

EW analysis issued late on Friday observed that: [Gold market] Sentiment is extreme, prices remain at the $1151.90-$1167.56 range, there were back-to-back Daily Sentiment Index readings of 97 percent gold bulls, which is the only time in the history of the data series this has occurred, highlighting the extreme to which traders believe in gold’s up trend.

Last week an exchange-traded fund that replicates the performance of junior gold-mining issues began trading on the NYSE. It has taken 10 years since gold made a low in August 1999 in order for the purveyors of the fund to become secure enough in gold’s trend, or the excitement in gold’s rise to become extreme enough, that they feel confident in bringing the ETF to market. Interestingly, the junior gold-mining index that the ETF is based on topped in November 2007, creating a large non-confirm not only relative to gold bullion, but also to the XAU and the HUI (Bugs Index of unhedged gold stocks), which both topped in March 2008.

Finally, today a prominent and well-respected market forecaster said that gold will never go below $1000 an ounce again, “probably ever.” Maybe he’s right and we are wrong, but experience says that when one becomes so confident in a trend that he or she forecasts that it will remain intact for infinity, odds are that extremes are being reached that will result in a trend reversal."

Such reversals may entirely be predicated on a phenomenon that is currently tucked well back on the 'worry' shelf among carry trade-intoxicated exuberant buyers of all kinds of assets classes. The pivotal issue remains the degree of likelihood of an eventual extraction of the stimulus measures that Mr. Trichet was referring to, just this morning (especially, as far as the US Fed is concerned).

As far as the borrowers of near zero-cost dollars are concerned today, there is ample reason to believe that they remain unconvinced as to the timing of such an event. Some, of course, remain convinced that such measures will never be taken. Ever again. Marketwatch's Laura Mandaro dissects the issue in the following piece - from which we bring you highlights:

"Rising fiscal deficits, mushrooming money supply, a return to 1970s-era inflation - that's a recipe for gold to keep notching new record highs, even doubling in value, say the new gold bugs. But there's at least one variable that could upend this investment thesis, and the fortunes of its holders: The Federal Reserve's ability to sop up much of the excess money floating on bank ledgers before it gets into the hands of businesses and consumers, spurring high inflation and a further drop in the dollar.

It's a tricky task but one that a camp of economists and investors think the Fed can achieve. If policymakers under the direction of Fed chief Ben Bernanke succeed, a big reason to buy gold evaporates. "Since we believe Fed will do the right thing, will take remedial action, we're very wary right now," said Milton Ezrati, market strategist for Lord Abbett & Co., about buying gold. "It looks like fears are overblown, and that gold is too high," he said. "We think there's a future in equities."

Countering that view is one that's grabbing more attention as gold futures hit new nominal highs over $1,150 an ounce last week. There's nowhere for gold to go but up, say many of the major investors who have recently bought into gold, because there are too many powerful forces weighing against the value of the dollar, the most popular investment alternative to precious metals. "The reason gold is running now has to do with concerns with deficits and worries about the strength of the currency," said Linda Duessel, equity market strategist at Federated Investors.

None of these [new] fund investors fit the typical description of a "gold bug" or the investor who eschews most other investments, even during long down cycles, out of the near-religious belief that gold will keep rising. These gold bugs suffered a long slump during the 1980s. After gold hit a high of $850 in 1980, on the heels of double-digit consumer inflation and as the Soviet invasion of Afghanistan spooked global financial markets, gold fell for much of the next two decades. Will this new generation of gold bugs find out they're right - or follow the path of prior generations, which rode long, drawn-out declines after tremendous spikes?

Much of the answer depends on how two main prongs of the argument for higher gold turn out. Here's a quick rundown:

Once the more than $1 trillion the Fed has pumped into the financial system starts getting lent out by risk-averse banks, the supply of money held by individuals and businesses will mushroom, some economists, investors and policymakers contend. More dollars in circulation will make every one dollar worth less -- and every ounce of gold, denominated in those dollars, worth more.

The basics of this argument: By creating a slew of new lending and asset-purchase programs designed to make it easier for banks and institutional investors to lend, the Fed has added more than $1 trillion to the banking system. Those additional funds are in addition to near-zero interest rates in place since December. Much of this extra money is sitting on banks' balance sheets. That's evidenced by a contraction in bank credit over the past several months and a swelling in what's known as "excess reserves," or cash held by banks beyond requirements set by the Fed. These reserves have risen to more than $1 trillion from an average $1.9 billion in the 12 months before Sept. 2008.

But not everyone's convinced this new money introduced into the system will lead to a weaker dollar, higher inflation, and pricier gold. The Fed says it's going to prevent inflation from happening by raising interest rates and unwinding its special loan programs, and some people believe it can do it. "The Fed has the tools to prevent the massive amount of excess reserves it's created from being activated," said Paul Kasriel, chief economist of Northern Trust. Fed officials have said they're preparing strategies, such as raising rates on reserves banks hold at the Fed and employing reverse repos, for when they want to start taking money out of the system. They will use these tools when the economy shows real signs of recovery but before it leads to debilitating inflation.

Some, like Kasriel, think it can avoid a rerun of the 1970s, when inflation jumped over 10%, unchecked because the Fed was worry that clipping inflation carried too high a cost for the rest of the economy. "The Fed in the 1970s made a huge policy mistake, and part of that was political," Kasriel said. "Bernanke is not political." And the Fed should have plenty of warning once the steep pile of excess reserves move from banks to businesses and individuals, says Goldman Sachs economist Ed McKelvey.

"Excess reserves are not some secret sauce that creates inflation out of thin air," he wrote earlier this month. These reserves have the potential to create inflation if left in the system too long, he acknowledged. "This is where the Fed's exit strategy comes in."

The U.S government in hock -- that's the second main reason gold is likely to keep rising, some gold advocates say. They point to a long list of countries where high deficits led to inflation and currency depreciation. Germany between the two world wars, and a slew of emerging markets, from Argentina to Zimbabwe, are the most extreme examples. One problem with the deficit spending argument is a weaker currency doesn't always follow.

Japan in the 1990s ran high deficits, with government debt as a percentage of GDP topping 90% in later part of the decade. But inflation was nearly nonexistent and the yen was surprisingly strong. "The reason a deficit is dangerous it that it puts pressure on a central bank to print money. The Bank of Japan refused, so they didn't have any inflation," said Ezrati. The U.S. may succeed in reining in its budgets -- as President Barack Obama promised while traveling in Asia earlier this month.

And factors that can weigh on a currency over the longer term can get sidelined in the short-term. These could produce painful jolts for gold investors banking on a weak dollar. Many economists predicted that the trade deficits experienced by the U.S. in the early part of the decade, a result of the country's heavy foreign borrowing and spending, would batter the U.S. dollar when this relationship started to unravel. Some of their calls became stronger when the subprime crisis exploded two years ago, putting a freeze on consumer spending. In fact, the dollar strengthened last year, at the heart of the financial crisis."

Options expiry and the dollar's ability to tread water above key pivot points remain the focus of the day. Otherwise, the financial and mainstream media continues to have a never-ending source of material for fresh, large-font gold-related headlines.

Jon Nadler is Senior Analyst, Kitco Metals Inc.