Why Are Precious Metals Prices Falling?

In response to my update yesterday – Demand Shock: The Forces Behind Rising Premiums – many of you sought to know an answer to the question: why are prices falling if demand is so unprecedented? I will seek to explain below. To clarify, yesterday I wrote about premiums; today I am writing about “spot price.”

What is the Spot Price?

The spot price of gold is the price of one ounce of gold as contained within 100 and 400-ounce gold bars traded on the commodities exchange at current market prices. For silver, it is the price of one ounce of silver as contained within a 1,000-ounce silver bar traded on the commodities exchange at current market prices. These prices for “immediate delivery” are distinct from futures prices, which indicate trade value for delivery at a future date. Large institutions, hedge funds, sovereign wealth funds, central banks, governments, mining companies, and many other large traders buy and sell futures contracts (and associated derivatives) for physical delivery, hedging, or simply long/short exposure. According to the World Gold Council“The three most important gold trading centres are the London OTC market, the US futures market (COMEX, ICE, etc) and the Shanghai Gold Exchange (SGE). These markets comprise more than 90% of global trading volumes and are complemented by smaller secondary market centres around the world (both OTC and exchange-traded).”

Liquidity Crisis

As in the financial crisis of 2008, when markets collapsed across the globe, highly-levered institutions hit margin calls on underwater positions. In simple terms, this forces the liquidation of liquid assets. Real estate and large private equity holdings are not liquid. Other assets – especially metals – are highly liquid. The positions are quickly sold off to raise cash to meet margins. As the saying goes, cash becomes king. This is why the value of the dollar is rising despite the unprecedented volume of new dollars that are being injected into the system now and over the coming months. As defaults and bankruptcies accelerate across the globe, dollars will evaporate from the financial system, causing deflationary pressure. It will require ever increasing stimulus to offset the dollars leaving the system.

No matter how much gold you own, when you need to pay your taxes, your rent, or your groceries, you still need to sell gold to buy dollars. The dollar remains the only viable means of exchange. It’s as simple as that. And this is happening in real-time, on a global scale, in multi-billion dollar transactional volume.

Gold as Safe Haven?

This begs the question: why, then, is gold perceived as a safe haven asset? Gold’s strength is popularly based on the notional price of gold in dollar terms. But price is not the same as value. Just as in 2008 following the Lehman Brothers collapse, when gold fell from a peak of $1,000/oz to $740/ounce in a liquidity squeeze, gold’s value relative to the S&P500 now (as it did then) is increasing. In other words, in this sell off, it takes less gold to purchase the same dollar amount in equities. Gold is strengthening on a relative basis. Price is not the same as value.

It is also important to understand what happens after the liquidity crisis. When the dust settles on the global market sell-off, and the demand for the dollar wanes, gold and other precious metals tend to outperform on the way back, as happened in 2009-2011, when gold skyrocketed from $740/oz to $1900/oz, and silver moved from a low of $8.50/oz to $50/oz.

Silver tends to be more volatile than gold, and the sell-off on the front end tends to mirror that of equities because of silver’s industrial demand, but the reversal on the way back tends to be dynamic. This is why you now see the gold:silver ratio at all time highs today.

But What About All of the Retail Demand?

The United States Mint – the largest domestic supplier of retail bullion – produced 120,000 Gold American Eagles in 2019 and 61,500 Gold American Buffaloes. There is an active and robust secondary market, but as far as new production, the total value of newly minted gold output was ~$281M (using an average $1550 gold spot price) in 2019. This equates to a little over $1M in gold production per business day. Meanwhile, the notional value of estimated gold trading per day on the various gold exchanges globally is $100B. Certainly, there are other mints producing gold for the retail market. And certainly the retail gold market worldwide is much larger than $1m/day. But trading previously-minted gold product does not create new demand on the open market – the only retail demand that would affect the spot market is that which is newly minted. So even if the US Mint increases output by 10x overnight, they would be producing only $10M in gold coins per day in a market that trades $100B per day.

Even if all of the mints of the world could collectively output $1B of newly minted retail gold product per day, it would still represent only 1% of daily global trading volume.

The arguments about whether or not the gold price is manipulated, or whether there is enough gold backing all of the derivative contracts, or whether the gold price should really be this or that price, are all red herring arguments. They are no doubt important debates for long term consideration, but they are not directly relevant to why the gold price is not moving today because of retail gold coin demand.

The simple answer is math.