WHAT´S BEHIND THE SOARING GOLD PRICE? MACLEOD FINANCE

What’s behind the soaring gold price?

We’ve all been trying to work out why the gold price is rising so suddenly, because that will play a large part in how it goes from here.

MACLEODFINANCE

 

I’m in Zurich speaking at a conference, and the hot topic is what’s behind the rise in the gold price. 

No one seems to have a clue and I have not been much help, but there does appear to be an answer to the question.

The most plausible explanation is from someone far closer to bullion markets than me, and that’s Ross Norman of Metals Daily (he’s not at the conference).

Understandably, he has addressed this question as well. 

He has concluded that the answer lies in the options market. 

I quote:

‘There have been some large-ish trades reported by CME for call options with strikes at 2300, 2350 and 2500. 

But again not really sufficient to drive the market much higher.

‘By a process of elimination, that just leaves the OTC options market ... and that seems to have been corroborated today by the LBMA data. 

Someone has evidently made a monumental bet on the gold market via the OTC options market. 

The broad rationale for using the OTC options market is clear ... it is sufficiently liquid yet not entirely opaque. 

This really has been a stealth rally and the economic equivalent to muddy footprints across the floor have been hard to discern.

‘It appears a counterparty has taken a particulalry large bet on gold and squeezing the market ... arguably sufficiently large that it could even generate a self-fulfilling outcome. 

As the bullion banks grant calls at strikes above the market, they will purchase gold to delta hedge themselves as they are short gamma. 

As the price rises, they buy more ... creating a feedback loop. 

Nice.’

But the devil is in the detail which, because it is the OTC market, is scant. 

We don't know the precise volumes, strike prices and expiry dates ... all we know is it appears to be extremely significant in size.

The full article is here.

Norman concludes that once the options expire, the position and related hedging will unwind, and normality (likely lower prices) should return.

The background could suggest a different outcome.

We know that Chinese demand has been promoted by a high savings rate and a disillusionment with other savings media, particularly property and stocks, and that it is the easiest way to hedge yuan credit value due to exchange controls. 

But whatever the reason, the run up in prices has produced mark-to-market losses for the bullion banks, and they will be considering cover for unallocated gold account balances in favour of their customers. 

These are always fractionally reserved, and worse still, not necessarily by bullion but by gold derivatives.

Managers overseeing the position are acutely aware of the consequences of a sharp and unexpected rise in the gold price. 

The only thing they can do is cap the potential losses and pray that the price stops rising and falls. 

This is where Norman’s analysis could hit the nail on the head because you would do this with an out-of-the-money call option. 

As he points out, it spreads the problem to other banks who go into the market to cover themselves, and when the panic subsides, your losses are restricted to option money.

To me, this is a typical evolution of a market crisis. 

Norman could be right, and that when the option expires, underlying hedges would be unwound potentially reversing the effect. 

But before that happens, it leads to two possible alternative outcomes:

a.     The rise in the gold price puts one or more other bullion banks in trouble, perhaps leading to a covert rescue by the authorities, and/or

b.     The option giver stands for delivery.

The first needs little elaboration, but the second does. 

We have been seeing a trend for participants standing for delivery on Comex: why not in the OTC options market?

In silver, over 1200 tonnes have been stood for delivery this year, mainly from Indian industrial sources to do with ramping up photovoltaic cell production. 

This point will have not been lost on big buyers of precious metals. 

If you want big bullion deliveries not immediately available from the refiners (join the queue!), why not go through the paper markets?

Out of the money options seems to be an odd way to go down this route, but we don’t know what the forward delivery LBMA prices are in size. 

In the current atmosphere, it could be more limited than an out of the money option. 

And for anyone covering their intentions it could make sense.

One to watch closely!