What caused gold’s dramatic crash on Friday, Jan. 30? After several days of researching and analyzing, I think the likeliest explanation is that a perfect storm brought together two normally opposed parties, each of which, for entirely different reasons, wanted gold to fall. And this explanation helps answer an even more important question—what lies ahead for the luminous yellow metal, over both the shorter and longer term.
Some analysts have argued that the extreme selling must have been coordinated among major market players, who either sought to reduce steep losses by covering short positions or wanted to create better prices at which to increase holdings.
But that explanation leaves a litany of unanswered questions. For starters, who made the first call to whom? Since the selling occurred in every market across the globe, are we supposed to believe that major market players, wherever their home base, joined together to make market-controlling decisions? That seems a bridge too big to cross.
A more plausible explanation is that gold’s rapid short-term gains had created a bubble that was susceptible to being punctured—indeed, ruptured—by a pinprick. Bubbles always involve highly leveraged (i.e., margined) positions. These go hand in hand with stop-loss orders, where brokers are instructed by customers to sell if a holding declines to a specified level. Investors who trade with a great deal of leverage are virtually forced to use stop-losses; if they don’t, they risk losing their shirt (or even their entire wardrobe). But once a stop-loss is triggered, its execution is automatic, even if the next available price is much lower than the trigger price. Also relevant is that margin requirements in commodities are typically much lower than for stocks. Speculators in gold and silver often trade on 10% margin or less. At 10%, a 10% drop wipes out your entire investment, and if the decline exceeds 10%, you must provide additional capital—potentially putting you under great financial stress.
The question, then, is what was the needle that punctured the bubble? It always makes sense to look for some event that immediately preceded the puncture. In this case, the event that most analysts seized upon was Trump’s choice of Kevin Warsh as his candidate to replace Jerome Powell as the next Fed chairman. While the decision was announced on the morning of January 30, it already had been widely rumored the previous evening.
But there are two reasons why the selection of Warsh was an unlikely trigger for such a major market-moving event. First, the decision hardly came as a surprise. Two weeks earlier Trump had implicitly ruled out picking the then-presumed front runner, Kevin Hassett, as Powell’s successor. So, for two weeks the odds on Warsh had been rising.
Even more important, Warsh’s hawkish leanings don’t jibe with the plunge in gold. A hawkish Fed would be bearish for gold. But, on the day of the big drop, the yield curve steepened, as short-term rates weakened while long-term rates rose. That kind of action is bullish and indicates market expectations of lower real interest rates or rising inflationary expectations. This is completely inconsistent with the metal’s massive drop.
Collapse of a Chinese jewelry dealer
It seems clear to me that far stronger forces were at play, starting with the fact that gold is an existential threat to the reserve status of the dollar. The U.S. continually has done whatever it can to suppress gold from gaining too much strength. And this time it appears that China was an implicit conspirator, in that it did nothing to stop gold from plunging. It reflected a rare coincidence of interests between the two rivals.
China, by a very wide margin, owns far more gold—including gold held by the government and that held by private citizens—than any other country. I think it’s likely that Chinese authorities had become worried about speculation in the gold market. For example, speculative excesses had led to the headline-making collapse of a major Chinese jewelry dealer that had left some Chinese citizens holding the bag. While total losses were estimated at about $2 billion, hardly major given the size of China’s economy, what was potentially worrisome was social media’s tendency to magnify such events.
Before the crash, Caixin, a China-based online news service, had stated: “A person in the precious metals trading department of a major bank described market sentiment as overheated, advising retail investors to remain cautious despite bullish forecasts from global investment banks.” In the Western world, utterances of unnamed sources from major banks are a dime a dozen. But in China, unnamed sources from major banks are speaking with the full knowledge and approval of the central government.
What’s critical to realize is that this coincidence of interests related to gold between China and the U.S. is a short-term affair only, likely to last two to three months or maybe even less.
Longer term, the outlook is for an historic contest between China and America over whether the world will move to a monetary system backed by gold—a currency with intrinsic value and inherently spiritual grounding—or continue along its current course in which world commerce centers around the dollar—paper that we continue to pretend has real value and that is the apotheosis of materialism.
Fortunately, the odds strongly favor the former. I say “fortunately” not because I’m biased towards Chinese but because I believe a gold-backed system would let the world advance together, essential if we are to avoid a future that becomes unrelentingly grim.
China’s major leg up
China is the largest market for the trading of physical gold. In recent years, it has become the price setter for bullion, a role previously held by the exchanges in New York and London, where only a minuscule portion of trading is settled with the delivery of the commodity underlying the trade. Until recently, there was little physical trading of gold in any market, but rule changes by the Bank for International Settlements (BIS) elevated gold to an asset on par with the dollar. That change led to sustained and very strong accumulation of gold by central banks throughout the world and sharply elevated trading in physical gold. In a nutshell, any discrepancy between “paper” market pricing and physical market pricing creates arbitrage opportunities where physical pricing must prevail. In the gold market, China, formerly a price taker, is now a price maker, which means it has a major leg up in this monetary war.
It is important to note that China’s gold holdings serve multiple purposes. Over decades, the government has been accumulating massive amounts of gold to back up the yuan and lay the groundwork to secure gold’s role at the center of a new global monetary system. Other gold-backed currencies (along with silver and some industrial commodities) will further serve to fully reinforce a worldwide system completely divorced from fiat currencies.
Gold plays another major role in China, as a source of savings for Chinese citizens. The metal has major cultural and spiritual significance for the Chinese. China’s 15-day New Year’s celebration starts later this month, and many celebrants will dress in red- and gold-colored costumes, with gold celebrating the heavens, or spiritual side of life, while red celebrates the material.
Given this, why would China have wanted a washout in gold prices? Because it views excessive speculation as a threat to persistent gold accumulation—and it’s not wrong. Anything that interferes with individual gold consumption is a major threat to Chinese economic policy, and speculative dropout compounded by social media panic could easily shake the faith of the Chinese consumer in gold. So, allowing this drop could curb the speculation and act as a bit of a warning that will, in the long run, sustain gold’s uptrend.
China has been relying on its global dominance in manufacturing to generate massive trade surpluses to support economic growth. But longer term, and indeed even over the relatively short term, it badly needs a new growth driver. The latest five-year plan targets consumer spending as that growth driver. The biggest impediment to the policy’s success is the major bear market in the property marketplace. According to statistics, the cumulative value of homes, the major source of wealth for Chinese citizens, has declined more than 10% since the peak several years ago. When homes were at peak values, they represented more than 50% of household wealth and were worth 20 to 30 times the value of the gold held by Chinese citizens. Lately, the enormous gains in gold, combined with persistent accumulation, have brought the home-to-gold ratio down to about 7, meaning that gold’s gains were more than enough to offset the loss of value in home equity.
With home prices still vulnerable to further losses, gold must continue to make sizable gains for consumers to become more comfortable in their long-term financial future, a necessary condition for rising consumer spending. In other words, expectations of strong and steady yearly gains in gold are crucial to China’s transition from an economy driven by an underpriced currency and rising trade surpluses to an economy with a higher yuan that is much more dependent on rising consumer spending. An economic model based on an underpriced currency is not sustainable, in contrast to a model based on a fairly priced currency and rising consumer wealth and income.
Gold, by virtue of its unique ability to link the spiritual to the material, is the only asset capable of facilitating the transition from the current unsustainable growth model to one that becomes foundational. Any asset that is purely material will always be subject to severe ups and downs. By contrast, gold, even in the U.S., where financial assets are the driving force, has vastly outperformed the S&P 500 with much less volatility this century. By anchoring their future to gold, the Chinese appear to be following a path similar to the one that led the U.S. economy to greatness in the two to three decades following WWII.
Negative stock indicators
The sharp decline in gold—coincidentally or not—comes at a time when many indicators point to a sharp decline in stocks. That could be negative for gold short term as U.S. investors sell gold to meet margin calls in stocks. However, the longer-term impact is much more significant: Regardless of who sits as Fed chair, lower—and likely dramatically lower—interest rates will be in the offing.
Among recent periods of market turmoil, the current period is likely to resemble 2008 much more than 2020. The latter was a “one-and-done” drop lasting just a few months, while in 2008, the bear market lasted over a year and featured a bone-crushing decline of about 60%. During that time, gold also dropped, but by only half as much as the S&P 500. It recovered, and was setting all-time highs, far sooner than the S&P. If my assessment is correct, the coming period should be even more favorable for gold.
Not only does gold have China on its side, but the S&P 500 is currently more overvalued and—perhaps even more important—is a much larger driving force in the economy than in the past. Today the market’s capitalization is more than twice as big as GDP, an all-time record. This means the pressure on the Fed to inflate will be much greater than in 2008-2009.
With basic commodities much scarcer now than back then, we could easily face a situation where inflation remains sticky despite a likely recession. This terrible environment for stocks will likely be a great environment for gold. My best guess is that downside for gold will likely be a brief retesting of the $4,400-$4,500 area, followed by a massive rally with prices as high as $8,000—or maybe even higher—by yearend.
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