Gold Volatility Whips Market

By Patrick A. Heller February 23, 2010

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The gold market suffered but overcame two major onslaughts last week.

After U.S. markets closed last Wednesday, the International Monetary Fund announced that it would offer the remaining 191.3 metric tons of gold from its planned gold sales onto “the market” rather than central banks. By making it appear that more than six million ounces of gold might be dumped onto retail channels over time, some investors panicked into selling, which pushed down the gold price.

Gold eventually fell more than two percent but then recovered all lost ground within 24 hours of the announcement.

The nature of the IMF announcement indicated that it was done to drive down the price of gold. Revealing such plans is a tactic that guarantees that the IMF sells the gold for the lowest possible price. If the IMF was really trying to raise the maximum funds for its own operations, it would not sell its gold by this process.

The quick recovery in gold prices meant that another tactic was needed. Late on Thursday afternoon, the Federal Reserve announced that it had increased the interest rate banks would have to pay the Fed for overnight borrowings. This was meant to be a signal that interest rates might rise in the near future, which again knocked down precious metals prices.

Still, gold came right back the next day. Over the weekend, Asian markets climbed as high at $1,130. When the U.S. markets opened Monday, the price was immediately taken down to the $1,110-$1,115 range.

There is a huge incentive to hold down gold prices this week. Gold options expire Tuesday, with more than 5,000 call contracts (over 500,000 ounces) that could be exercised at a price of $1,100. Should the COMEX close Tuesday above $1,100, these contracts for immediate delivery would be called. That would put a supply squeeze on the dwindling COMEX gold dealer inventories, which are down 25 percent in the past three months to only 1.65 million ounces.

Also this week, Fed chair Ben Bernanke will be testifying before the House Financial Services Committee and Senate Banking Committee. There is an effort under way to encourage a member of one of these committees to ask Bernanke the very same questions about admitted Federal Reserve gold swap arrangements that the Fed has refused to disclose in response to the Gold Anti Trust Action Committee’s Freedom of Information Act Request. If ever there was a week that Bernanke needed to appear competent, this is the week.

The U.S. government, the member nation with the largest voting power in the IMF, leaned on the IMF to make it appear that some of its gold might be sold to the public (which, if it occurs, I think will at most be only a token percentage of the total), then risked crashing stock and bond markets by raising one of the key interest rates. To me, these actions were obviously taken solely to try to suppress the price of gold.

Such extreme measures worry me that there are some horrendous financial developments about to break. There are so many potential crises waiting to collapse that I cannot discern just which ones they might be.

In the short term, I expect extremely volatile gold and silver markets. I expect to see more extreme efforts made to hold down prices at the same time that demand for physical metals soars. Daily swings of 5-10% are possible. I expect that the result of all this volatility will be significantly higher prices than we see today.

The safest way to participate in the continuing long-term bull markets for gold and silver is to buy physical metals, not paper contracts, and avoid trading on margin. As prices are whipsawed, those with margin accounts could actually lose money despite prices eventually reaching new highs.

In the 1979-1980 bullion boom, I worked as a certified public accountant. One client was a commodity broker who personally bought several thousands of ounces of silver on margin. The day before the price of silver rose almost consecutively until it reached the January 1980 peak, it dipped about five percent. This client was unable to cover the margin call and saw his silver position closed out. If you don’t buy on margin, you won’t have this risk. At that time, I owned significant positions in gold and silver coins, almost all of which I sold in early 1980 for sizable profits.

The idea of purchasing precious metals on margin is to multiply the hoped-for profits. However, in volatile markets, the strategy could backfire. Buy physical gold and silver with your own funds, then relax and sit back to watch the coming fireworks.

Patrick A. Heller owns Liberty Coin Service in Lansing, Mich., and writes “Liberty’s Outlook,” the company’s monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at http://www.libertycoinservice.com. Other commentaries are available at Coin Update (www.coinupdate.com) and Financial Sense University (www.financialsense.com). His periodic radio interviews can be heard on the Korelin Economic Report at http://www.kereport.com.