JP Morgan & Its Gold Bomb in Precious Metals - Interesting News

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JP Morgan & Its Gold Bomb

November 8, 2002
Roger Arnold
This is also one of the reasons for the constant rumors surrounding JP Morgan and their risk in the gold markets. As gold prices go up JP Morgan loses previous gains their "carry" trades. I will rehash carry trades again this Sunday but I don't feel like writing about here again.

The bottom line is that as the world continues to slow one of the results is an increasing migration into gold to protect assets from probable reduction in the value of all other paper assets.

And this is one of the very real concerns for gold carry traders.

If investors begin en masse to buy gold, not out of expectations of returns, but simply to protect their principal it will become a self fulfilling prophecy.

The best analogy I can think of is "a watched pot never boils".

Now we know this isn't true but it brings up a good point. People watch the pot because they are anxious to get the hot water. Their expectations are very high and it seems like it takes forever to get their desired return; boiling water.

BUT, if they aren't thinking about the water boiling and simply put it on the stove and then go do other things it seems like it boils in no time.

Their expectations are very low and because of this their perception is that they received their desired return much more quickly.

Patience is a virtue and can be rewarding as well.

In other words if investors start buying gold without regard for returns and simply to protect assets it is an indication of lowered investment return expectations by investors as well as lower risk expectations.

Gold becomes the best returning investment primarily as a byproduct of the fact that it is perceived to be the least risky not because investors are buying it with expectations of returns.

Get it?

Perhaps a better analogy although a little less friendly is the rebound date. When you are with someone you love or care for and that person decides to leave you the next person you become involved with is typically referred as the rebound.

The rebound is the person you are left with by default not because you were attracted to them but because they were there.

It is a reactive event rather than a proactive event. The new person becomes the beneficiary of the previous person leaving.

Now, maybe you will fall in love with this new person and maybe not. Maybe once you get to know this new person you will say; huh? why did I not consider this person before?

The reason you didn't was because you were "in love" with someone else or at least thought you were; and that consumed your time disallowed the consideration of others.

There are plenty of people dating each other not because they are attracted to each other but because they believe that person is found to be acceptable to their "friends", attributable typically to men; or they have money, attributable typically to women.

However, no matter what the reason, that relationship in general precludes the "real" consideration of other relationships UNTIL that relationship fails.

Investors relationship with paper assets has failed.

Now, don't get me wrong, it will eventually come back. Investors are not going to flee form paper assets forever. But right now the sheen is off and investors are open to new possibilities and new markets and new relationships.

Some are still trying to "repair" their relationship with paper assets like it's a catholic marriage. To each his own.

Back to the basics:

Lowered investment return expectations across all asset classes by default increases the number of potential investors for those asset classes considered to be risk mitigation plays.

As the number of potential investors for this expands the number of investors actually shifting into risk mitigation investments increases. A portion of those will go into gold.

Gold, contrary to popular belief, is a tiny market in comparison to paper assets, i.e. stocks and bonds.

Even a marginal shift in investment expectations, both risk and reward, resulting in buyers into gold could drive gold prices up dramatically.

Now, here's the catch.

Gold prices increasing causes a push back phenomenon to make it difficult for prices to continue rising.

The two primary things that occur are known as gold carry trades and gold forward selling.

Gold Carry

As gold prices rise investment banks rent gold from holders of gold and then sell the rented gold in the open market to capture the increase in its price. They then take the proceeds from the sale and buy US treasuries. They use the dividend paid on the US treasuries to pay the rent on the gold. And what is left over is gravy. Pretty slick huh?

Forward selling

Forward sellers are typically mines that forward sell their future production as a means of ensuring cash flow stability. This is very common. Farmers do this with agricultural crops as well.
Both gold carry trades and forward selling however increase as gold prices rise which acts as a counter against the gold prices going up too much.
BUT, if the buyers of gold ever come into the market at a faster pace than the gold carry trades can be affected or the forward sellers can promise supply the gold price could continue to rise.

If the gold price can sustain itself above and estimated $350 level for an extended period of time though the momentum begins to build in the opposite direction. In other words as gold carry trading and forward selling makes it very difficult for prices to get above $350; once this occurs theses forces actually reverse themselves and begin to force the price higher instead of lower. I will explain.

The net cost of gold at JP Morgan is estimated at $350 an ounce across all of their gold carry trades. This means that they received an average of $350 an ounce when they sold the gold that they rented into the open market over the past several years.

But, because they sold gold that they rented they also obligated themselves to have to buy back that gold in the future to deliver back to the organization they rented the gold from.

In essence a gold carry trade is also a way of shorting. Shorting is profitable when prices are falling only. If gold prices begin rising the potential for JP Morgan to begin losing money on their trades FORCING them to buy the gold back increases. The buy back is called covering. And as they cover they drive the price further up.

Get it?

It reminds me of the movie "The Right Stuff". The movie is about when Chuck Yeager broke the sound barrier in the X-1. As he approached the sound barrier there was a lot of violent shaking in the aircraft as it was being buffeted by the physical forces of air putting drag on the plane.

So the faster the plane went the greater the forces of drag trying to slow the plane down. But, once the plane got through the sound barrier it actually surged forward. A portion of the physical drag elements actually decreased as the plane went through the sound barrier.

You can think of $350 in gold as the sound barrier for gold. Some actually estimate it as low as $335 and as high as $375. I use $350 as a ball park.

The reason it is important to understand JP Morgan is because it represents over half of all of the gold carry trades in the world. They don't have a counter party to sell their positions to and even the attempt to do so could cause the price of gold to spike.
All right that's enough for today. Have a great weekend and I'll talk to you on Sunday.

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