The primary feature of the financial markets this week – and, indeed, for many weeks past – has been the very high level of volatility. Price swings far in excess of anything considered normal in a given market have now become common place, to the point that if they continue, the accepted notions of ‘normal’ will have to be adjusted – or thrown out entirely.
Perhaps the best – meaning the most dramatic – recent example of this phenomenon has been provided by the precious metals markets. As discussed in this column over the years (see for example, “What’s good about gold”, in February 2012), precious metals are an especially difficult market to analyse, because for many people they have symbolic, totally irrational status. Hence the phenomenon of ‘gold bugs’, people who believe in gold – although what exactly they ‘believe’ in varies. In many cases, it is the quasi-monetary/ quasi-religious concept that gold has functioned as a store of value for thousands of years – which makes it far superior to ‘fiat’ money issued by governments, because the latter are subject to dilution (via inflation) and even destruction or confiscation, at the whim of the ruling person or junta.
A variant, or supplementary aspect, of this belief syndrome which is more utilitarian and perhaps more rational, is that gold is a useful, or even essential, component of a diversified investment portfolio. In inflationary times, or even facing the threat of inflation, most financial assets will lose value but real assets, such as commodities and real-estate but especially precious metals, will retain their value.
In the face of the unprecedented monetary expansion in recent years, most analysts have predicted that inflation would surge and not a few have warned of ‘inevitable’ hyper-inflation. This view has led to a huge rise in the number of people coming to accept and acting upon the beliefs noted above. The result: after making a 20-year low in 1999 at around $250 an ounce, gold’s price rose for ten successive years from 2002. This uptrend climaxed in early 2011, when gold prices climbed over $1900 – more than double their previous historical peak in nominal prices – and silver soared briefly to $50 an ounce, equaling the level touched in the previous silver mania in 1980.
Since then, central banks have continued to inject staggering sums of money into their flagging economies, but inflation is still nowhere to be seen – and precious metals prices have been in retreat. Until recently, this retreat was a gradual and orderly affair, but two bouts of massive selling – the second this month – have turned it into a rout. On Tuesday, gold prices again shed over one hundred dollars in the course of a single trading day, falling close to $1200 an ounce, or nearly 40% below the 2011 record level. Silver, which traded down to near $18 an ounce, is almost-thirds below its peak.
The gold bugs are in total disarray. After crowing about how gold must rise to stratospheric levels, first because the Chinese central bank would switch a chunk of its currency reserves from dollars to gold, and then because ordinary Chinese – not to mention innumerable Indians – were queueing up to buy physical gold, to the point that the Indian government had to clamp down on gold imports, they are at a loss intellectually, although not financially, since most of them bought at much lower prices. The more rational among them understand that the rise in medium- and long-term interest rates is the kryptonite that is killing gold. But the speed of the collapse is a technical phenomenon, rather than a fundamental one: because so much of the gold buying in recent years has been made on borrowed money, the margin calls demanding more collateral on their loans issued to the speculators as the price falls have triggered forced liquidation, sending the price plunging and creating a negative loop of further forced sales, further drops, and so on.
Thus endeth all prolonged booms, in spectacular busts made more dramatic by the widespread use of leverage and of sophisticated speculative instruments (such as ETFs based on gold or gold shares). It is more than likely that the price slump will soon reverse and a sharp rise ensue. But that won’t help — the magic has gone out of precious metals for at least another generation. The true believers will mutter about how TPTB (The Powers That Be — in normal parlance, the government and its agencies) have brought gold low by deliberate and dastardly manipulation – conveniently ignoring how the dastardly manipulation of interest rates allowed gold to soar in the first place.
But the muttering won’t repair the precious metals market, which is rapidly losing its liquidity. The vicious circle now at work there – and soon to be at work in many other markets – is that volatility leads to loss of liquidity, because most people are scared to enter volatile markets, and loss of liquidity causes increased volatility. To sit through that and think only about the long-term requires not just strong belief but also strong nerves.