President Obama has made an attempt to forge an agreement on the heavily charged issue of the extension of Bush tax cuts. This is an important step, heavy in consequences from both the ideological and budgetary perspective. The Republicans, many of whom act as they would not like the Federal Government to have any revenue, seem to be hopelessly wedded to the interests of 3% of the population and to the 1980-era Panglossian “solutions”. The budget hawks (many of them schizophrenically Republican) want to see speedy elimination of deficits. Some argue that a permanent maintenance of Bush era tax cuts would cost the Treasury some $3 to $4 trillion in revenue over 10 years. But polls seem to indicate that the majority of Americans are against these extensions and Obama’s proposal keeps the door open for only two years. Quite how the maintenance of the tax status quo is supposed to solve this economy’s manifold structural problems remains a mystery.

Several researchers have recently argued that the 2001 and 2003 bills were followed by the lowest rate of growth in US non-residential investment and that the benefits of the tax cuts leaked overseas. The combination of a weak dollar and tax cuts may have actually encouraged capital flight from America. Since 2004, coupled with the unprecedented shift by Chinese Communist Party to gear up fixed asset investment, the joint effect was the leakage of funds into emerging market equity and bond funds, commodities and gold – with lackluster performance of the US stock market as a corollary. Note that the emerging markets’ initial reaction to Obama’s proposal has been positive, despite the looming threat of Chinese interest rate rise.

Arguably, US stock markets also first responded positively. The expiration of the Bush taxes hung over the market like a gloomy nimbostratus. There is now a chance it will dispel. On the other hand, the bond market has seen a precipitous sell-off, although opinions are divided how much of the yield increase is attributable to the decision concerning the tax cuts. Higher yields are unequivocally a negative factor for gold. But what does the fiscal move mean for the gold market in the longer term?

Unless the bond market rout scuppers the accumulated gains, the result of the continued tax cuts is the same as for other non-yielding assets: there is no need to rush and realize the gains before the expiration of the decade-old bills. But for gold in particular, the longer-term answer lies in the currency market outcomes linked to the likely combination between US fiscal policy and its monetary activism.

For the most part of the previous decade, gold in US dollar terms benefited from a unique combination of a relatively loose fiscal policy and low interest rates. Such a combination leads to liquidity binge amplified further by low haircuts and high level of collateralization. The rest of the story we know – a boom in housing investment and fall in the nominal value of the currency. This was not the first such experiment in history. UK tried such a concoction in 1988 and the pound lost 20% within a year.

On the other side of the spectrum, we could imagine the policy combining fiscal curbs and a tight monetary policy. Income goes down, deflation ensues and growth is smothered. These days, one would have to seek out arsenic-fed economic systems on another planet to identify a good example. It is therefore more interesting to brood over the asymmetric combinations of fiscal and monetary policies.

A tight monetary policy, coupled with a loose fiscal policy initially triggers appreciation of the currency as higher rates invite capital inflows, promote high demand for money, an external deficit and eventually a fiscal deficit. How quickly the latter evolves will depend on the initial conditions, but the end-result is currency depreciation. Gold investors are wise to accumulate positions in the early stage of this scenario.

Conversely, a loose monetary policy, combined with higher taxes and/or lower government spending initially triggers currency depreciation. Yet even if the nominal interest rates fall, real interest rates go up favoring inflation. Interest-sensitive investment gains and bank reserves fall. This would be the scenario if the Bush tax cut were reversed. Naturally, the initial currency depreciation would be followed by an appreciation (real and then also nominal), pruning gains in speculative investments which would be negatively affected by a rise in real interest rates. Clinton-era US bathed in analogous context. Clinton? Now that was bad for gold!

All this means that in the current monetary context, the continued maintenance of the loose fiscal policy in the United States, however disastrous in the longer term for the sustainability of the country’s public finances, is “good” news for those who hold part of their portfolio in gold. This bond market’s knee-jerk reaction this week and the subsequent dollar strengthening may therefore be short-term phenomena – offering yet another opportunity to late comers.

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As a currency, gold is known to be difficult to adulterate as its supply is fairly price-inelastic. But as a commodity, gold is plentiful – even though many stocks cannot be easily mobilized into flows. This huge, quasi-available inventory means that the price of the metal is as dependent on physical flows as it is on the sentiment surrounding the sustainability of these flows in near future.

The driver of the gold price has for many years been set by Comex futures trading – easily swayed by the perception of changes to the interest rate environment, liquidity conditions and currency swings. The currency myopia of many observers leads to underestimation of the impact that FX market has on the level of gold prices on a given day.

But any significant movement on the futures market is ultimately not sustainable without the robust physical flow underneath. It is here – in the markets of India, Europe, Middle East, US and East Asia that the rules of supply and demand reappear – regardless whether gold is purchased and sold for investment or adornment purposes.

What is unique in the current environment is that many of the short-term and mid-term determinants of both the paper and physical market point north. We are seeing as many as eight factors impacting on the gold price over the next 2 months.

First, let us look at the drivers of the gold price. Currently the attention of this fast-paced market is focused on the troubles of European banking system. Yesterday’s successful bond auction in Portugal may have stemmed somewhat the hemorrhage and Euro has stopped sliding. But much depends on the ECB’s next move. The immediate reaction to the delay in the withdrawal of emergency liquidity has been bearish Euro and positive for gold, accentuating further the periodic breakdown of the negative USD/gold correlation.

Secondly, we have the stellar manufacturing data. From Sweden and Switzerland to US and China – the data are nothing short of impressive, coming against the backdrop of positive surprises in economies as different as UK and India. This generates positive momentum in global stock markets and broader commodity markets. Yet for as long as the extraordinary monetary policies remain in place, any such data flow also raises a specter of inflation. And when the economy reflates, no asset rises faster from the starting block than gold. Except that this might have already taken place.

Third, there is the sentiment surrounding the ‘wall of demand’ for gold ETFs coming out of China. Although the first approval for a Chinese fund to invest in gold ETFs overseas is constrained by the tethers of the QDII system, which limits PRC investors’ rights to deploy capital overseas, the news conjure the image of millions of greedy buyers in search of golden security, wherever it is available. As usual, the actual impact will be mitigated, but it is the sentiment that counts.

And finally, we have the WikiLeaks with all the manipulatory, slanderous, self-serving nonsense which delights journalists the world over. Any sophisticated observer of the world’s affairs knows of South Korean disdain for the Chinese “negotiators”, Saudi fears of Iran or mafia’s power in Russia. But because we are touching upon overblown egos, nuclear non-proliferation and major geopolitical faultlines, the barrage of news does contribute to the level of overall market uncertainty.

Then we have the physical market which provides the floor under the gold prices. It currently tells us that any pullbacks in gold against a basket of currencies will be limited. First we have the central bank and IMF sales. The World Gold Council has just announced that the new selling quota since September has been largely used up by the well-documented IMF sales. As of end of October, IMF had 32.7t left to sell and is probably now finalizing the program. This is very constructive for the physical gold market.

Secondly, we have the import tariff jumping phenomenon in India. In the last 3 years, New Delhi’s budget steadily increased the tax imposed on gold imports. Rumors that another increase is in the offing for next February may have contributed to the unusual pace of purchases in the country. In fact, the budgetary round may further exacerbate the seasonal patterns of demand on the Subcontinent – an issue discussed on these pages previously.

The third physical issue is the investment demand inside China. Unlike the expectations of ETF purchase overseas, the current gold flows reflect something of an inflation panic. China’s official banking system has found it difficult to stick to the RMB 7.4 trillion lending quota this year and the tolerated, though largely unregulated minjian jeidai lending system may have increased the money supply by another RMB 4 trillion. As a result, food prices run in double digits and gold imports have increased fivefold.

And finally, we have the miners’ hedging issue. Although the hedges left AngloGold’s balance sheet a while ago, it is interesting to note how well supported the prices were in the subsequent weeks. A similar phenomenon took place after Barrick’s announcement in 2009.

On balance, the comparison of the factors that dominate the macroeconomic newsflow with the gold-specific flow determinants yields a picture in which further price gains may lose some of the recent momentum, but in which pullbacks will be very shallow. Barring a sudden deflationary shock, such as caused by a major default, this scenario is bound to stay with us for several weeks. Anyone hoping for a significant correction any time soon will be disappointed.

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Stupor, bewilderment, anxiety, shock and anger meet yet another provocation dished out by Pyongyang on its southern neighbor. These are the feelings expressed by those directly and indirectly affected, those still married to the post-war, UN-regulated order, the naïve bunch that has not quite grasped to what extent the rules of the game have shifted. Despite years of international sanctions, North Korea, an entity born out of sweat and blood of Mao Tse Tung’s troops, has now happily turned into a China’s bad boy testing ground. Assessing the patience of neighbors, fraying at the global resolve to cap the mercurial ambitions of the ruling family, helping Pyongyang to run its businesses and obtain more uranium for enrichment… The “global community”, if there was ever one, can’t stop it because Kim’s backers are today full of liquidity-oiled hubris and see no interest in hemming in the wayward behavior. Behavior that may well be channeled through the tensions with the immediate neighbor to the South, but ultimately is aimed at Beijing’s traditional enemies and rivals in the region – Japan and the US. After all, China invited Kim Jong-il when his navy killed 45 South Koreans in Cheonan incident last March. From Burma to North Korea, the neo-imperial Middle Kingdom revels in this sort of archaic clientelism. One just gets tired of the press mantra about Beijing’s concern about “refugees flooding into PRC”. China is managing the ‘refugee’ problem all right, stuffing stacks of banknotes into the pockets of every Manchurian who spots and denounces a non-fluent Chinese speaker in the backyard of the chilly Jilin Province. A police state does not need a private militia to protect its flank. Amnok River is no Rio Grande.

But there is a group of excited investors who, while may not exactly cheer Kim Jong Il’s (and now possibly Kim Jong-eun’s) aggressive antics, are anxious to see instability as a litmus test for further gains in the safe haven asset par excellence: gold, geum, huangjin – or whatever else it the 79th element on Mendeleev’s table could be called in that troubled region.

And the oxymoronically sobering news is – there is actually something to get excited about. In a simplistic, single-variable overview, gold’s usual response to Pyongyang’s ultimately unpredictable actions is positive and not necessarily short-lived.

We looked at 9 incidents caused by the North over the last 5 years, ranging from missile launches, to nuclear tests to warship clashes and bombing campaigns. We added to this any reports concerning dramatic changes at the top of the state’s structure (Kim family issues). We then compared the performance of the gold market in the ensuing period. It appears that gold in dollar terms is lifted by an average 0.09% in the day after an incident. In only two cases (reports on Kim Jong Il’s stroke in September 2008 and the second nuclear test in May 2009) did the gold price actually fall on the news. More surprising yet is the fact that in the week following the events, gold gains an average 2.31%, and a month later it is still higher by 5.36%, in dollar terms.

Of course, this is a single variable extracted from a wealth of other macro- and gold-specific influences. What is stunning is the regularity of the metal’s behavior, possibly coincidental and certainly orthogonal but regular nonetheless. Importantly however, in only one case (May 09) did the subsequent trading reverse the pre-existing trend. In all other instances, gold’s trajectory simply amplified or extended the trend. Remarkably, Korean incidents have a peculiar feature of not occurring during occasional gold market pullbacks.

One hypothesis could be that any posturing or outright aggression induces Asians to actually purchase more gold. This would require further research into historical demand data, but it is an intriguing thought. Just as most Westerners seem resigned to the swell of Asian juggernauts, locals may be a little more aware of the precarious state of liquidity-driven property boom, unresolved territorial disputes, ultra-nationalistic educational systems and the premature demographic peak. Contrary to Norman Angell’s hopeful students, there are reasons to believe a war in a region run by unreformed dictatorships is not becoming any less likely just because many of its inhabitants have now become wealthier.

Nor should the conclusion be any different if you are a South Korean resident and most your wealth is Won-denominated. Not only have you suffered from your central bank’s ongoing intervention to keep the currency competitive against the undervalued Renminbi, but now the Kims up north are doing this job just as efficiently. You may have little choice but to hold gold as an insurance against sudden falls in the value of your currency. On the basis of the 9 peninsular incidents, it turns out that your wallet’s one-day gold price sensitivity is seven (!) times higher than for dollar-denominated gold investors.

For all other gold investors the solution lies elsewhere. For as long as the North Korean forays remain low frequency events (on average every 7 months over the last 5 years, but with significant variance), the option market may not adequately price in the probability of such idiosyncratic shocks. When things quiet down a bit, the lingering uncertainty left by the 60-year long positioning in the region may in fact give the advantage to investors paying for long vol on a regular basis. To all those who retort that this could sound like a bet against traditional Korean concept of kibun (interpersonal harmony), here’s a quick refresher. Although peace and security are the objectives of kibun, flare-ups and hostility occur if it is not observed. The frustrated, exaggerated reactions to the perceived lack of harmony can be observed anywhere in this cultural context – from violent students’ demonstrations to fistfights by upset clients on Korean Air flights. Betting against kibun with option volatility assumptions slightly above the ‘implied’ number on the screen could yet be one way to derive value from the fat boy’s ascendancy into a Beijing-backed loose cannon.

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Looking for tigers in India is today almost as futile as looking for dragons in China. Other than in the outlying areas of Assam, tourists tend to turn away from their Indian safaris without much success in spotting the archetypal stripes of the world’s largest feline. Still less common is the sighting of a tiger pouncing on its prey – be it a spotted deer or a sambar.

And what about India’s gold market pouncing forward? WGC’s third quarter statistics shed again some useful light on this issue. India’s performance as the world’s largest gold market is critical to the support under the gold prices. Yet with ubiquitous commentary about China’s “rise”, many casual observers may be excused to expect that the dragon is breathing hard on the heels of a tired (and elusive) tiger. Or does s(he)?

The third quarter statistics are important as they span a period preceding the festival-heavy fourth quarter. In this context, retail inventory numbers are less demonstrative than the actual sales. And the numbers are stunning. India’s jewelry demand rocketed 36.5% year on year in the third quarter. Instead, it is the dragon that seems to be tiring, by comparison – with barely 8% growth in jewelry sales over the same period. Throwing in identifiable sales of gold for investment purposes makes the spread somewhat less glaring, but India’s continued growth still outpaces China’s, 28% to 14%. For the twelve months ending September 2010, India’s demand was up 64% yoy, compared to 21% growth in China, yet this discrepancy is probably more illustrative of subcontinent’s demand sensitivity during the depth of the financial crisis 2008-09.

Some of the difference between the performance of the two markets could be explained away by the fact that a strengthening rupee made purchase in India more affordable, at current dollar prices, than in China – where the monetary authorities spend $1bn a day to keep its currency undervalued. Yet longer term time series show that Chinese consumers are momentum buyers and usually purchase more gold in times of stronger prices. Thorsten Veblen’s conspicuous consumption theory goes a long way among Chinese ‘xinfu’ (new rich).

Equally important are the differences in real disposable income, inflation expectations and availability of alternative investments. India has registered a very good monsoon this year, which bodes well for gold volumes in the third and fourth quarter. The country’s equity market has outperformed all other BRIC markets this year (not difficult when compared with the hapless Shanghai Composite, down 12% year to date).

India’s core inflation has been entrenched and earlier this year spread from food and energy to manufacturing goods. This led Reserve Bank of India to intervene several times throughout the year. But a stronger Rupee has somewhat protected the economy from imported inflation. From the domestic perspective there is a downside of a current account deficit as some of India’s investment has to be financed from abroad.

The contrast could not be bigger with China’s model. Disposable incomes are growing more slowly than the GDP, which continues to be overdependent on urban fixed asset investment. Although consumption in value grows, its share of national income is being eroded. In other words, the country grows fast because private consumption continues to be suppressed, with massive transfer of wealth towards the (state-owned) corporate sector. Add to it the manipulated level of currency and you end up with a scenario where relative prices have to adjust through domestic costs and prices. As we know, the inflation numbers have rocketed in China recently, raising expectations of higher interest rates and leading to a bloodbath in commodity markets this week.

In other words, in absence of a major currency reform, China will continue to form a sizable and growing market for gold, provided the growth in disposable incomes catches up with inflation expectations. Yet, in a country with $100bn speed rail budget this will be a rather slow process, lagging the overall increase in wealth. In the meantime, we can still get excited by an odd communist official calling for PBOC to purchase 10kt gold (this is a number that surfaced recently). Since the country produces 324t pa, it may need much higher gold prices to attain this level of reserves from its domestic production. What better way to achieve this than to talk up the gold price and see Xinjiang and Shandong resources convert into reserves? Gold investors, beware.

Thanks to bladder-like swelling on top of their heads, dragons in China could become airborne without wings and imperial houses used to build high thresholds in the doorway to make them fly into their abodes. Today, thresholds for gold market’s explosive growth in China remain high and manifold. And flying is probably done differently.

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The last week has marked several records for the gold market – record highs in US dollar, record volatility, record press coverage in response to the proposals formulated by the World Bank’s president to re-anchor the global monetary system to gold. It is understandable that among this intense newsflow, many investors have lost from sight the details provided by the earnings season and the reporting by the principal actors of the gold market – the mining companies.

The volatile swings in the gold market make an interesting background to differentiate the performance of the main players – both as operating companies and as investment vehicles. After all, the reversal of the correlation between gold’s behavior and the euro/dollar correlation has helped, this time again, to propel the yellow metal with a momentum unseen since last May. But CME’s announcement to increase margin requirements in the silver market subsequently depressed the heady levels experienced by the precious metals for four straight sessions. How did the gold stocks performed through this rollercoaster, and what does it tell us about the relevance of earnings, earnings expectations and the companies’ viability as gold proxies?

There were several common characteristics in the results published by North American producing companies. Those with significant by-products (base metals and silver) benefited handsomely from lower cash costs. As expected, many companies have boosted their dividends. Those with larger portfolios of operating mines also used the quarter to execute sequencing in a way least damaging to the overall performance of the company. Yet, as usual, there were some surprises and most relate to grade variability in some of the mines.

Using the date of the earnings results, we have compared share price performance of the top 16 North American producers with the earnings surprises presented for the third quarter. By the close of market Nov 10, the correlation has been high – over 64%. The market has been sensitive to past results despite the wave of new interest from the generalist crowd. It punished the laggards (Jaguar, Centerra, Iamgold, Silver Wheaton) and rewarded the winners (Barrick, Freeport, Yamana, Goldcorp). There are, however, some incongruous discrepancies. Despite lower-than-expected EPS at Agnico-Eagle, investors seem to be swayed by negative cash costs at La Ronde. Coeur d’Alene’s miss has also been rewarded, not least due to silver’s epic run but also due to 99% drop in costs at Palmarejo. Kinross’s disappointment has been shrugged away as all eyes are on Tasiast drilling and most operations performed in line.

It would seem that careful, stock-by-stock analysis has rewarded the investor. But what does it mean for a momentum trader? Here the results are much less convincing.

The precious metals market entered a new phase in reaction to QE2 on November 4. By rebasing the share performance of the producing companies back to this date, we find some surprising results, showing little, if any relevance to the recently reported earnings and cash flows. This is less of a case among silver companies, which have enjoyed a stronger run. Hecla – whose outperformace of consensus earnings was nothing short of extraordinary – has squarely beaten the competition, and its share price has risen by 25 % over the week. But here the ‘logical’ correlations end. Overall, the share performance of the main tickers has a weak relationship with the positive earnings surprises – a mere 22% correlation based on 17 stocks which have reported recently. This is still better than the insignificant correlation between cash flow per share surprises and the stock performance. The difference between the two correlations could imply that generalist investor base is now a more important force as it probably focuses on the EPS numbers despite its limited utility in the context of the mining industry.

In other words, the quarterly operating and financial performance of gold (and silver) miners proves to be a poor guide for the stock’s response to rapid price swings of the underlying asset. The recent spell of momentum trading (with some big liquidations last Tuesday) bears even less relation to longer term beta between the North American gold producers and gold prices in US dollars. It shows that short term gyrations in the market have to be taken in the context of much more long-term relationship between the gold prices and the way they affect both the revenue line of the operating companies and their cost of capital.

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This is clearly a week that calls for a historical perspective. In the United States, presidential historians are scrambling to find historical parallels to the tsunami of discontent that swept through the House of Representatives, undermining the policies of the current Chief Executive. Monetarist historians are trying to find any precedent similar to the Fed’s decision to expand its balance sheet in the order of $75bn per month (plus reinvested maturing mortgages). And dollar historians are now eyeing the greenbacks slide, seeking anchors beyond what looks on charts like a one-year long contour of a perfectly symmetric Swiss mountain. Henceforth, Mariana Trench anyone?

The combination of the feared legislative gridlock, monetary hyper-activism and the relentless dollar slide is making gold bugs licking their lips. This is the case in particular in countries whose currencies are pegged to the lameduck dollar and possibly among investors in countries whose authorities have decided to step up intervention into their capital account. Brazilians, Koreans, Indians, Canadians and Chinese are certainly a lot more excited about gold’s renewed attempt to break nominal records. And you may excuse Australians, Europeans, the Swiss, the Japanese, Scandinavians and South Africans for not sharing much of this effervescence.

We are touching here, in fact, a two-fold issue. First is the way in which gold’s local gains depend largely on the relative value expectations formulated by the fx market. Secondly, it raises the perennial question of the universality of the product.

For as long as the developed economies represented 75% of the global GDP, this did not quite matter. But as the first decade of the new century has seen their contribution shrunk by a third (in PPP terms), what ‘others’ can gain from a particularly fungible form of investment is a highly relevant question. Cultural and regulatory differences abound – from the ultra-sensitivity of Vietnamese savers, who use gold shops as a proxy for black market hard currency hedges to countries where private ownership of gold is still not permitted.

Gold bugs would like you to believe that there is something uniquely ‘universal’ about gold’s attractiveness. As any absolutist claim, this betrays poor knowledge of history. There is nothing deterministic about the appearance of gold coinage in the first place. The country which popularized gold coinage was Lydia in western Asia Minor. The reason was the relative availability of electrum (a natural alloy of gold and silver) found in local river Pactolus. Lydia happened to be located near the juncture of important trade routes and the combination of scarcity with low annual fluctuation of output made (gold) coinage a more attractive form of value exchange than grain or barter. But at the same time that Lydians were putting their ‘staters’ into circulation, Mesopotamia used copper ingots and China used proto-coinage made of bronze. These developments occurred between 9th c and 6th c B.C. and go some way to deny the validity of universalist claims of gold’s “eternal” value.

The myth of gold’s universal value is widespread. Every Latin American populist, from Guatemala to the Andes, runs on a platform of historical victimhood, branding the educated (white) elite as the direct descendants of Spaniards who “took our gold and gave us pieces of glass”. The fact that such trade did take place at the beginning of the 16th c proves the point that the attractiveness of gold pales in comparison to products or assets whose availability, at a given time, is even less constrained. Just ask any rare earth trader.

When Placer Pacific’s explorers penetrated Papua in the 1930s, they were stunned to see how little interest the Highlanders had in alluvial gold. Prospectors’ camps did not even have to guard the inventory of naturally occurring gold. This and other stories should remind us that there is nothing deterministic about the gold’s value.

This is a tough statement to make on a day when the yellow metal is, again, hitting a (US dollar) nominal high. But the travails of the global monetary system and the attempts of the Federal Reserve to reflate the world’s economy will bring solace to gold investors only in some parts of the world. The relative size of the winners’ capital and its propensity to leak into alternative assets will determine how high gold can go against the basket of currencies, not just in the dollar and the Renminbi.

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The nature of investment in commodities has been transformed in the last 5-6 years. Until around 2004, commodity futures, benefiting from predictable backwardation used to enable investors to buy the futures one or two months before expiration and then sell them at a price difference called the roll yield. At which point, one could (and usually did) buy futures with later expiration. From natural gas to copper, it was an easy ride. Gold, incarcerated in its contango, did not quite participate in four decades of the futures spree. But just around that time, the gold ETFs made their appearance. Having accumulated over $100bn in assets under management over the last seven years, precious metals ETFs now represent a very considerable portion of commodity investment universe. Broader commodity indices, despite spot price rises, remain in doldrums.

Surely, important structural changes are affecting the base metals. First, there is China with its mercantilist attitude to stockpiling. Just like the US has strategic oil reserve, China’s Strategic Reserve Bureau has been sitting on 1.5% of the global copper, zinc and aluminum market since 2009. Local governments in China mimic this behavior, accumulating inventory for… the rainy day? For an inflation day? For a 2008-style collapse in trade financing? For a war in the Pacific?

The second structural shift is occurring in the contango investment. Unlike in gold, contango in, say, aluminum, is unusual as the commodity is by definition scarce – utilized, embedded in the infrastructure, vehicles, power lines and scrapped for secondary supply with a considerable lag. And yet, contango did develop in several scarce commodities in 2009. In aluminum traders found a means to turn profit by holding physical metal and selling forward into the contango, benefiting from low storage costs and low borrowing costs. This “inventory financing” ensured that prices have remained high and the margin could be offset to the cost of carrying excess inventory. This metal will be liberated one day, either when the curve reverses or when the prices go up to offset the cost of breaking the warehousing contracts.

But this is not the game available to the Joneses and whatever is left of their baby-bummer wealth. And so, banks, traders and producers are now rushing to offer a whole array of base metals ETFs – first in aluminum and copper, later also in zinc, nickel and other LME metals. The excited buzz is understandable, given gold ETFs past and current success, but is this reasonable?

Other than onerous regulatory filings, gold benefited from several advantages at the time of the launch of the first products. First, storage costs are around 1/50 of what one has to pay for much lighter (less dense and therefore more expansive in terms of floor space) aluminum. Secondly, gold has a unique characteristic of being quite plentiful for investment purposes. When the word came out that a Swiss bank was planning a platinum ETF, opponents raised precisely this argument: the relative scarcity of platinum would defeat the purpose of the investment vehicle, leading to higher volatility in the prices of the white metal. There is little evidence so far that this has been the case.

What the PGM ETFs did show earlier this year, however, is that the initial enthusiasm for the new product is no guarantee for the sustained success of the tracker. Indeed, skeptics point out that after the initial phase, base metal ETFs will simply constitute an additional inventory, unavailable for consumption – in some ways just another version of those Chinese stockpiles, except more visible to market participants.

But what the ETFs phenomenon does is confirm the observation that investors purchase commodities in times of inventory surplus, a phenomenon first observed in early 2006, when copper hit an all-time high. These market conditions have returned in late 2009, likening base metals to gold and, especially, silver, whose prices tend to rise with the onset of physical surplus. This investment demand – an old leg in gold, but a brand new feature of base metals market – will durably affect the price expectations of these commodities, adding to structural (production cost) and cyclical (inventories and demand fundamentals) factors.

It is unlikely that the base metal stocks will suffer from the introduction of ETFs and the resulting equity crowding out to the extent that the gold companies did between 2005-2008. Neither Lundin nor Century Aluminum nor countless others benefit from the market premium offered by the nature of the variable cost of capital – an important differential of the gold stocks. The market ripples of these new products may be less perceptible than many observers fear.

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The effervescence in commodity markets has been barely checked by China’s 25bp interest rate hike this week. Gold bugs, silver bugs, LME complex bugs – have all espoused a worldview buttressed by the stories of a ‘supercycle’, ‘the collapse of the global monetary system’, ‘currency wars’, and now even rare earth wars. This year’s price charts – in gold as in other metals – seem to bear out this enthusiasm, although one wonders how positive for the rest of the developed nations such trends are.

What these commodity punters and casual observers seem to share is pervasive currency myopia. Until mid-October, most metals, including gold, notched multi-year nominal highs. Silver, gold, copper and tin were particularly hot and seemed hotter by the day in an incessant drive redolent of the heady days of Spring 2008. But peek under the cover of the US dollar’s weakness, and the story is much less compelling.

The Fed first alluded to what has now commonly been dubbed “QE2” in late August. In a classic ‘triple waterfall’ effect, further confirmation of impending purchase was delivered on September 21, and then again sealed with FOMC’s minutes, released last week. At every turn, the dollar responded by abseiling ever deeper against traded emerging market currencies, against the Yen, and most importantly against the Euro. FX markets simply assume that increased liquidity will impact long term interest rates in the US, eventually driving the greenback further down.

When the trend reverses, as it did briefly last Tuesday, comments abound about “commodity selling”. But how relevant are Chinese interest rates for the global liquidity binge, other than potentially sucking even more illegal capital flows into the country? China remains the marginal buyer of the last pound of copper and the last ton of iron ore, but it is not (yet?) a similarly dominant source of physical demand for gold. And yet, gold responded to this short-term reversal with southbound conviction.

There is no mystery to it. Most of gold’s “gains” since last June are a matter of nominal adjustment to the denominator’s value. The denominator (i.e. the dollar) has fallen nearly 13% on a trade-weighted basis, a measure still flattered by the untradeable nature of the renminbi. During the same period, gold has gained only slightly over 8%. Looking at gold in other currencies, we may have a hunch that the stories of “buying” (most of time) and “selling” (as on Tuesday) are, most of time, suspect. On any given day, one has to look for gold to rise in a cyclically weak (currently the dollar) and a cyclically strong (right now the euro) currency to draw a solid conclusion about gold’s popularity or lack thereof. And to understand the underlying trend, it is advisable to adjust gold prices for the trade-weighted dollar, however imperfect even this measure is.

Viewed from this perspective, we notice that gold has not made any gains since the heyday of European panic buying in May-June. Most of the nominal gains that the metal has registered since then simply reflect the dollar’s losses.

gold adjusted for trade-weighted dollar

Interestingly, similar story appears when we analyze copper prices, adjusted for the dollar weakness/strength. The red metal has not made any significant gains since as far back as March. The copper bullishness, which marked the LME week in London, should, in short term, translate into dollar bearishness and little else. While no one denies the well-documented problems of the slow replacement of the current mining production and supply challenges going forward, the spot premiums on Asia’s physical markets are falling and near-term copper demand appears to be slackening.

copper adjusted for trade-weighted dollar

In theory, low value of the dollar should be good for commodity purchase, as it makes them more affordable for Yen, Pound, Euro and other currency holders. China, the marginal consumer, has a structurally driven demand. The bill it foots for, say, iron ore, is bound to generate much hand-wringing among steelmakers, but the client must eventually relent, despite the artificially low value of its currency. Likewise, large trade imbalances driven by oil imports lead to increase in the supply of dollars against other currencies whenever oil prices rise. Yet none of these commodity/currency mechanisms are present in gold, which is economically inert. Weak dollar is not, per se, “good” for gold because the metal is predominantly an investment good today and its demand relies on the perception of its future value. A much stronger Rupee, or a much stronger Renminbi, against the dollar, could yet drive copper, molybdenum and metallurgical coal into a bubble territory, but in the local markets they might trigger negative price expectations and actually depress future demand for gold.

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Only gold market veterans still remember the jovial hectoring socked onto gold mining executives by the late Julian Baring of Mercury Asset Management. Baring – in his days the most successful gold investor – spent the late 1990s castigating gold mining companies for selling gold forward. Baring’s tirades fell mostly on deaf ears but the miners soon rued their studious indifference. Famously, Ashanti – the chief victim of Baring’s verbal prowess – soon caved in under the weight of the margin calls when the sudden spike in the gold prices squeezed their positions.

AngloGold Ashanti’s closure of the hedgebook last week ends the nearly 20 years’ legacy of mining companies’ activity in the gold lending market. Skeptics believe that this could be a contrarian signal for the gold market and that the lack of accelerated buying from the miners closing their hedgebooks will remove one of the key supports under the physical flows. Arguably, net de-hedging did help to provide additional demand for gold since the last quarter of 2001, or roughly since the 10-year long bull market began. Yet the hedging and de-hedging decisions are about producers’ expectations of the future demand for their product – and the environment today could not be more different from the 1990s.

The mechanics of gold hedging was simple. Producers would borrow gold today against future production expectations. This borrowed metal was sold and the proceeds were reinvested into risk free rate instruments. To close the contract, the miner had to deliver the borrowed bullion back to the lender and the risk free instruments (e.g. Treasuries) were sold. The receipts from these instruments were effectively the revenue for the mined ounces. Naturally, this only made sense when the sovereign interest rates were way above the expectations of future gold prices. Today, this feels like stone age. But it was the market reality of the roaring 1990s.

Historically, there were three reasons why gold producers’ output was partly hedged – in reverse order of importance: acquisitions, project financing and strategic revenue security. First, during the ongoing consolidation, many smaller producers were acquired by larger rivals. Although the larger players could more easily diversify their risks, small and mid-size companies often could not secure the financing without the commitment to sell the product at a predictable price. These legacies soured revenues of companies which eventually acquired Ashanti or Bema. The other type of hedges was, precisely, related to project financing. Banks could de-risk support for capital-intensive projects in frontier markets if at least part of the future cash flow was guaranteed. Yet the timing and structure of these hedges oftentimes clashed with the strategic planning of the mining companies and their treasury departments. This is because the latter engaged in the third – and much larger – form of program hedging. Since the gold price was fixed, the value of these products depended on the combination of the interest rates and gold lease rates. The former were usually fixed, the latter most often floating – at least since the new accounting standards were introduced in 2001, pruning interest in hitherto successful spot deferred contracts.

Options were also used extensively. Less abstruse than the negotiated forwards, options focused investors’ attention on the so-called “committed” and “protected” ounces. There was, supposedly, more comfort with the latter than the former. Yet the complexity of the hedgebook’s overall architecture flummoxed even sophisticated analysts. I often found that a combination of short puts and forwards was not adequately appreciated as a cost-efficient alternative to close out parts of the book. In response, miners endeavored to concentrate the market’s attention on the delta of the hedgebook, rather than committed/protected ounces. Unfortunately, this measure of the book’s near term sensitivity to gold price’s movements was dependent on too many variables (spot prices, interest rates, volatilities) for most investors to be able to project the marked-to-market value of the book.

At the antipodes of Julian Baring’s principled harangues, there was the fragmented Australian mining industry. Aussie executives did not engage in the debate about hedging. They simply did it, without much pressure from the local, somewhat isolated investor base. On the other hand, Barrick’s wiz-kids embarked on roadshows trying to educate investors about the more arcane aspects of the book, which peaked at 20m ounces in 2001. Newmont famously dipped a toe into the hedge world at all-time low gold prices. And AngloGold – whose hands were tied by the commitment to pay dividends to Anglo American Plc – had to insist on the maintenance of revenue security, and endure investors’ wrath or indifference as a result.

All of this is now a closed chapter. Barrick bit the bullet in 3Q2009, charging $5.7bn to its earnings in the process. AngloGold Ashanti has now accelerated the demise of its one hedge, at a cost of $2.7bn. Both transactions were, arguably, accretive on NAV basis. Among the majors, only Kinross still has to battle with the legacy positions inherited from Bema’s takeover.

The end to net growth of gold hedging ushered us unheralded into a new gold market in 2001. It will be worth considering whether the end of de-hedging also marks the beginning of a new era.

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