By Tom Griffo
Broker/Analyst, Cargill Investor Services, Inc.

Encouraging signs of life

While the price of gold, at $386 as of the end of May, has risen about $15 from its January lows, the market remains well confined within a narrow $30 price range that has persisted for the past 16 months. Indeed, 1994 saw the gold price trade roughly between $369 and $398, making it the second tightest trading range in 20 years. (Only the $28 range recorded in 1992 was narrower.) But gold is flexing its muscles.

Not only have prices improved over the past three months, but in recent weeks gold has also twice flirted with the psychological key $400 level.

And yet, most market watchers, not to mention gold bugs, remain disappointed in the performance of gold. The Midas Metal has clearly under-performed its precious cousins: silver and palladium have recently established fresh six-year highs at $6.05 and $182.00 respectively, while platinum reached a 4-1/2 year peak of over $460.00. And gold remains in a rut.

Under pressure

Gold has been unable to draw much benefit from the trials and tribulations of the US Dollar.

As measured by the US Dollar Index, the Greenback is down nearly 7 percent so far this year against the major currencies. Against the German and Japanese currencies, the dollar's demise has been even more tumultuous, falling more than 9 percent versus the Deutsche Mark and nearly 17 percent against the Yen.

Gold, meanwhile, remains in a rut, just four percent above its January lows and barely changed from year-end 1994.

Moreover, the US Dollar's most recent debacle has been only one of many spasms in the world currency markets. The Mexican Peso devaluation, the Mark's surge against most other European currencies and the Yen's similar jump versus many Asian currencies have all caused distress in financial markets - and gold remains caught in a rut.

The aforementioned strength in silver, platinum and palladium suggests that precious metals markets have not totally ignored the US Dollar's woes and related concerns.

True, all three of these markets have been supported to a degree by their own particular fundamentals - platinum and especially palladium, for example, are in strong demand by the automotive and electronics industries while production of both metals is relatively static; silver, meanwhile, has found support from a large drawdown in visible stocks amid a five-year stretch in which fabrication demand has outpaced new supply.

Room for optimism?

But gold's supply-and-demand fundamentals should certainly not be a drag on the market. Quite the contrary. For while there may be some contention over the degree, most analysts agree that demand for gold has been quite strong while new mine supply has been relatively flat. On the demand side, for example, gold imports by Japan , a country still mired in recession by many measures, totalled 66.8 tonnes through the first quarter of 1995, up a whopping 80 percent from the same year-ago period.

Meanwhile, South Africa, still the world's largest supplier, saw its output fall nine percent in the first quarter, and the head of Gencor's gold division was recently quoted as saying that South African gold output could fall to 515 tonnes this year, a 12 percent fall from 1994 and nearly 100 tonnes below 1993 levels.

And despite these positive supply-and-demand developments, gold remains in a rut.

So, what is holding back gold?

How about inflation, or the lack thereof? True, by most standards, price inflation, at least in the industrialised world, is not a factor. Most government reports on consumer and producer prices suggest price pressures remain well under control. Still, there is reason to believe that inflation is not yet a thing of the past.

Commodity prices, for example, have been on the rise since the first quarter of 1993 (which, interestingly enough, is when the last bear market in precious metals concluded).

The CRB Index has risen more than 15 percent since February 1993. The increase has been slow but steady, raising few alarms in the financial markets, but then again inflation has a nasty habit of sneaking up and biting one on the leg. And with relatively little fanfare, the price of US crude oil has recently flirted with the $20.00-per-barrel level amid strong demand.

Further while while some economists downplay its significance in the modern economy, capacity utilisation levels in the US are at levels that historically portend a pick up in inflation.

So while inflation fears are clearly not present to the degree that would cause a large amount of investment funds to move into precious metals, conversely there is sufficient ancillary evidence to suggest that there is enough potential for inflation to prevent any significant dishoarding by holders of gold.

Many disappointed gold bulls blame the market's inability to sustain a rally above $400 on producer selling. Spurred on by a number of new and old derivative strategies, gold producers, especially in the US and Australia, have continually kept a lid on gold prices every time the market approached - or briefly breaches - the $400 level. There is no doubt that more producers are engaging in active hedging programme than was the case five or 10 years ago and that some employ option-based strategies that may result in heavier selling pressure as the $400 level is approached. Moreover, for those producers who are inclined to hedge, locking in a price of $400 or more certainly makes some sense when one considers that the gold market has not been able to sustain a price above that level since 1989.

Collective action?

Somehow the thought of gold producers banding together, even unintentionally, to keep a lid on the price of gold just doesn't sit right. Miners by nature are bullish, and stockholders of gold-mining companies are certainly not interested in limiting the upside price potential of their principal asset. Moreover, while it is possible to sell forward more gold than is currently available for delivery, it is possible that the impact of producer selling is sometimes exaggerated. After all, producers have always sold gold. That's what they do.

If the perceived lack of current inflation and the impact of producer selling are not enough to prevent gold from mounting a sustainable rally, what then is?

A role for the Bank?

Most market-watchers agree that the world's central banks, who together control some 35,000 tonnes of gold (the equivalent of about 17 years of production), over the past few years have taken a much more active role in the gold market.

Apart from the much publicised - and significant - sales by the Canadian, Dutch and Belgian central banks (the latter recently completing a 175 tonne sale just last month), it is thought that these and other central banks are engaged in sophisticated trading strategies designed to create a return on their otherwise sterile bullion assets.

For example, why shouldn't the Central Bank of Freedonia (with apologies to the Marx Brothers) sell some out-of-the-money calls, earning the premium. When you think about it, the risks are not that great, assuming the bank owns a sizeable amount of gold and is writing options on only a small amount of its holdings.

If the bank is "called away" on its options, then any losses would be more than offset by the rise in the value of its overall gold holdings. A glance at gold's implied volatility shows significantly lower volatility for deferred dated calls, suggesting that there is an active amount of call writing going on.

Of course, central banks could have motives other than simply making money on their reserves.

Perhaps no other price level for any commodity has more psychological significance for the financial markets than $400 gold.

If gold sustained a move above $400, it would not take long for those aforementioned back-burner inflationary factors, such as rising commodity prices and high capacity-utilisation levels, to move to the front pages of the financial press (not to mention how much "play" $400 gold would itself receive in the media).

Clearly, with gold below $400, Alan Greenspan (who, if not quite a gold "bug", certainly looks upon the yellow metal as something much more than a barbaric relic) and his central bank
counterparts around the globe have a much easier job.

Extraordinary central bank involvement in gold also helps explain the better performances of late in silver, platinum and palladium, none of which must contend with organised "official sales". True, silver must also contend with large worldwide inventories, widely estimated at between 500 million and over 1 billion ounces. But that amounts to only a year or two of annual new supply. More important, silver stocks are spread out among a number of disparate parties, including investors and dealers, and sales are therefore much more random.

And while platinum and especially palladium are from time to time subject to concerns of Russian stockpile sales, recent price action in both markets suggests that these concerns may be overstated.

If the central banks are in fact responsible for keeping a lid on the gold price, can they - or will they - continue to do so indefinitely? History is replete with examples of financial and commodity markets in which cartels, producers and governments have attempted to fix prices artificially, and in just about every case these efforts have failed, often miserably.

One recent case that comes to mind also involves central banks and their futile efforts to prevent the Yen and Deutsche Mark from rallying against the US Dollar. As is the case with gold, central banks as a group also control more foreign exchange than anyone else, and yet their intervention efforts to hold back the Yen and Mark have been abject failures.

Again the lesson is clear. No one, not even the central banks, is bigger than the market. Of course there's still one little problem for the gold bulls: Until now, the "market" has not attempted to take on the central banks, not en masse anyway. All of which begs the question, what if anything will consolidate and concentrate investor interest in gold? This, after all, is at the heart of the matter.

Investment, speculation or manipulation?

One possible bullish scenario involves another crisis in the foreign exchange markets. While this threat may ring hollow to those who bought gold in response to previous crises, investors are running out of places to stash their money. Having already shown their disenchantment with the US Dollar, won't investors soon become equally wary of investing in Japan and Germany, which both have their own severe structural problems?

A second bullish scenario for gold involves the Middle East, a largely forgotten subject since the defeat of Saddam Hussein in 1990. But stability in the world's major oil-producing region is always tentative at best. At the time of this writing, the US had just implemented a trade ban with Iran in response to Tehran's sponsorship of terrorism. With oil prices already testing $20, any heightening of Middle East tensions could cause reverberations in the financial markets - and finally lift gold decisively above $400.

Positive influences

One final comment concerning the recent sharp rally in the silver. Silver prices have rallied some 30 percent from their March lows and recently breached $6.00 before falling back to their current level of about $ 5.30.

There has been much speculation that the rally has had more to do with "manipulation" by one or more large investors looking to make a quick killing rather than by any improvement in market fundamentals.

According to the conspiracy theorists, the widely talked about 54-million-ounce drawdown in Comex depository stocks since March has simply been a case of crafty investors taking the metal out of visible inventory and warehousing it where it cannot be counted to create the illusion of demand.

When the buyers achieve a desirable profit, they will simply dump the metal back on the market, causing a massive selloff. The idea that the market is being manipulated picked up additional credence after someone(s) exercised more than 4,600 then out-of­-the-money Comex $5.50 calls in early April.

The unexpected, unprecedented and, yes, inspired action caught the shorts completely off guard and generated a rally of nearly 70 cents in the ensuing three days.

It may purely be an issue of semantics, but what some may pejoratively label "manipulation", others may call speculation or even investment.

After all, is Kirk Kerkorian "manipulating" or investing in Chrysler? Was George Soros (who also been rumoured by some in connection with silver's rally) "manipulating" or speculating in the foreign exchange markets when he shorted the British Pound in late 1992? Indeed, did the Hunt Brothers "manipulate" the silver market in 1979-1980? Just asking.

Tom Griffo has been watching and writing about the precious metals markets for nearly 13 years, the last seven from his position as broker/analyst for Cargill Investor Services, Inc.