We are all used to reading that gold rose because the dollar fell or that gold fell, because the dollar rose. The picture conjured up is one of traders racing in to actually buy or sell gold as they watch the exchange rate move. When U.S. Treasury yields rose this week, the dollar strengthened slightly and the gold price dropped. When we watched this happen it seem to happen immediately and precisely and we were led to believe that much more was happening than met the eye. After all if gold moves in the opposite direction to the U.S. dollar, this implies that it is moving not just with but almost riveted to the euro. What's the story behind this?
What is an Arbitrageur?
In the early seventies before IT reached the level of mere mortals, just as the calculator arrived, there were many men in the city of London armed with their mechanical Abacus' made their money from buying an item in one market and selling it in another. Take, for instance, gold shares which, at the time, were primarily South African when that country produced around 750 tonnes [today it is close to 150 tonnes]. London Stockbrokers saw that the prices in the two centers were often slightly different. So there was money to be made in smoothing out these differences by buying in the cheaper center and selling in the more expensive one. It was not quite as simple as that though, because these men, called "Arbitrageurs" had to buy Rands [foreign currency] to pay for their gold shares at the same time. To do this they sold the very liquid De Beers diamond mining shares in South Africa to acquire them [they closed the position by buying De Beers shares in London]. Ticker tape machines were used for communications alongside the phone. These Arbitrageurs did not leave any open positions overnight, after all their prime purpose was to eliminate price differences between markets, not to take a position in shares or currencies. And this is the difference between an Arbitrageur and a trader. An arbitrageur wants to eliminate risk and simply take the difference between the two market prices and put it in his pocket. The trader is taking a risk on the price moving the way he has positioned himself to profit from. If you can deal enough times as an arbitrageur, you will have a very profitable business!
Today the same operation takes place in all markets and items and is computerized. So when we saw the U.S. dollar rise, this made gold in New York more expensive than in London, even if for only a few minutes. The arbitrageurs then step in and buy gold in London and sell it in New York, as fast as they can. This week saw that happen. With the speed of computers these trades are constantly smoothing out prices in global gold markets making the prices move quickly in line with one another. However, there still remain main and minor markets. The main market is where one deals the largest volumes with the largest number of market participants and the minor ones are where the small deals are done with a few players. Arbitrage opportunities exist where the markets are liquid so liquidity levels are paramount. An arbitrageur can only deal in volumes that the smaller of the two markets can accommodate. The speed with which the narrowing of the different market prices happens, relates to this liquidity factor. Understanding this leads us to the key question, just where is the market for gold made?
Where is the market in gold made?
A 24- hour market means that one can buy and sell all the time in any business day somewhere in the world. But not all markets are open at the same time. Asia opens as the U.S. winds down, while London opens as Asia winds down and the U.S. opens in London's afternoon.
And this does not mean that each market is trading the same volumes as each other. Each market relates to the supply and demand it can attract. This is a key point to understanding the shape of the gold market. The international gold market was developed in London while Britain was in its heyday. One of Britain's colonies, South Africa, supplied at its peak 1,000 tonnes of gold a year to the market, so it was natural that London, at the time also the hub of world business would develop the systems and institutions that developed the world gold market in London. At the time of the gold standard the gold market in London made the system possible. New gold supplies allowed for the expansion of money [gold] as the world grew [today rising gold prices could fill that role too]. Over time the gold market realized the inefficiency of having each dealer or market make its own price and have arbitrageurs smooth out the differences, so they came up with the system of bringing the main bullion dealers under one roof, putting them in contact with their clients by phone, putting forward the net amounts of gold to be bought or sold at different prices, until a balance between the two was found at a particular price. This price was then Fixed and all the buying and selling was then done at that price. Over time this became attractive to all in the gold market. The 'Fix' [price] then reflected around 90% of the world's gold deals at that moment. After the Fix new deals come along changing prices and markets with each of the world's gold markets reflecting their own features and disparities until it all came together at one price agaoin at the next Fixing.
London is also ideally placed to 'touch' all other gold markets by its place in the world's time zones. When the afternoon Fix occurs, it attracts demand and supply from the entire developed world, making that price the most reflective of demand and supply at that moment. The morning Fix attracts Asia as well as Europe. London therefore remains ideally placed to stay the 'hub' of the gold world.
While the last quarter century has seen the gold market fade from view as a monetary factor, the gold market did not cease to function. In this 21st century we have seen a resurgence of interest in gold and the resuscitation of the gold market. This has brought to life the gold markets of the world and attracted the institutions that manage them. Yes, there has been a change in the bullion banks that do this. European banks are involved [but these are global banks such as Deutsche and Societe Generale] and there is one that came out of Hong Kong - H.S.B.C. [short for the Hong Kong and Shanghai Bank], which is now an entirely global bank. Given the presence of global banks and their clients and the system of Gold Fixing, London will continue to remain the center of the gold world. A useful link for you to follow the Fixes on is www.GoldFixing.com where you can see the last gold price Fix, and the overall buyers and sellers [how many of the five bullion banks were buyers and how many sellers, at the last Fix.
When the Fix is made it is made in three currencies, the Pound Sterling, the U.S. Dollar and the Euro. The exchange rates between the currencies are, as it were, 'Fixed' too for the moment the price is made. This bears some thought.
If the dollar immediately falls 1% right after the Fix, what should happen to the price of gold in the dollar? It should rise by 1%. The same applies to the other two currencies. So, essentially, this is why the gold price rises as the dollar falls. But you may then say that that implies that the gold price moves with the euro? It appears that way until you see the gold price rise in the euro. To understand this you have to move out of the gold market per se and look at the currencies. By looking at the top five world's currencies, you will be able to see if it was the dollar falling, the euro falling or both gliding down together. What has happened over the last decade is that the thought that the gold price was a decided by its U.S. dollar value has changed as the dollar has dropped in value and reputation. The euro did take its place in value and reputation terms until this year when it too lost its name, to some extent. As to the Pound Sterling, it is now a junior, senior currency. What we must recognize is that gold has stopped being an item priced in the U.S. dollar and has again become an item that reflects the price of currencies as they do against each other. This shift in emphasis has described its move back into the monetary arena.
The Changes we expect as the Chinese market matures
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