Front-Running the Central Banks

How the intentions of the world’s largest gold players have probably switched to the buy-side
John Maynard Keynes once described speculation as a beauty contest in which contestants were asked to choose faces from hundreds of photographs, the eventual winner being the person whose choices most nearly corresponded to the average opinion of all competitors. “It is not,” Keynes wrote, “a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” Keynes’s example, a paradox, was designed to make markets seem silly – after all, Keynes believed that markets were destabilizing. In the real world, predicting average opinion (and average opinion of average opinion) is common practice. Take the beauty contest that is today’s gold market. Like the contestants who try to estimate what the average opinion of beauty will be, gold speculators try to get into the head of other market participants to determine if these players will be future gold buyers or sellers. If the speculator determines these participants will become buyers, a position is built up ahead of time in order to sell to these soon-to-be purchasers, preferably at a higher price. Vice versa if they are to be sellers. This sort of speculation is something like educated front-running. [Ed. note: By front-running, the PollittBuro means the practice of buying something while taking advantage of advance knowledge of pending buy orders.] If every participant was playing this head game, and all were equally good at it, the result would be Keynes’s paradox. Luckily for gold speculators, not every participant in the gold market speculates, nor are they all driven by concerns for the bottom line. Enter central banks. The largest players in the gold market are those huge lumbering beasts of the financial world, central banks. Unlike a small investor, who can turn on a dime, your average central bank is weighed down by a large bureaucracy tied down to musty theories and practices. Once they pick a path, they follow it relentlessly. Observe Figure 1, for instance, which shows total central bank holdings of gold since 1950. For the last forty years or so, the world’s central bankers have been constant net sellers of the metal. And all the way down everyone knew they were sellers. Whereas a hedge fund manager can hide his tracks, central banks (especially the western ones) must conform to some basic level of transparency, although the use of gold derivatives certainly clouds matters. Quarter by quarter, it has been possible to track their selling in the official data. Central banks have sometimes made their intentions even more obvious by announcing ahead of time their intention to sell. The Bank of England, for instance, preannounced a 415 tonne gold sale in 1999. Speculators drove the gold price down some 10% before the transaction went through. All of these “frictions” make it that much easier for speculators to front-run central bank gold trades. There seems to have been a switch in the intentions of central banks. According to World Gold Council (WGC) data, 2009 was the first year since 1988 that the world’s central banks (including the IMF and World Bank) added to their gold reserves. If 2009 was a fluke, 2010’s jump in gold reserves seems to imply that a fundamental shift has occurred in central bank gold intentions. After all, the last time central banks added to their gold reserves two years in a row was back in the 1960s. Given this switch, the side from which to front-run central bank gold trades seems to have inverted to the buy-side. Two types of central banks are responsible for the change. According to WGC data, the European ones, huge sellers since 1965, have sold insignificant amounts in the latter half of 2009 and 2010. Non-western central banks, neither buyers nor sellers through most of the 2000s, began to add to their positions in earnest in 2008 and 2009, and continued to do so in 2010. Why the turn in tide? Central banks often hold significant stocks of foreign assets, mostly in the form of foreign government debt (the most typical investment being US Treasury Bonds). For political reasons these central banks want to diversify away from such assets as they provide an implicit subsidy to the debtor nation (mostly the U.S. Treasury). And for economic reasons, holding too much of one asset-type, government bonds, is a dangerous proposition – especially when so many nations are 1. trying their darndest to weaken their currencies, never a good scenario for fixed income investments and 2. showing incredibly large deficits, bringing worries about

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already at 12%. or 3% of world supply.6% 3. for several years to come.08 0. this buying would account for roughly 3.63 25.000 tonnes. The listing of a stock on the Buy List should be considered as advice to carry a position in that stock.9% 5. and the proverbial man on the street. This leaves 9 banks in our sample.5% 2. We assume that South Africa. Browsing through our 10 possible gold buyers. They will probably be active bidders supporting the market on declines. Canada. With equity markets effectively shut off.000 0. Which is why we think it very possible that central banks’ attitude to gold has turned and. On the other hand. Australia.800 tonnes of gold to reach the 6% level.S. Starting with quantity. We estimate today’s value of official U. and Softchoice. Switzerland. Given world gold stocks of 150.21 1.60 1.808 average non-Western 23. For information on our policies on research dissemination.005 0.S. trillion. and the Euro Area as a whole still holds some 20% of central bank assets in gold (see table. Pollitt & Co.3% 8.3% 15. that leaves central banks with few options other than gold in which to diversify. South Africa India Russia Sweden Turkey Australia U.049 0. The only stocks currently on the Buy List are TMX Group.168 0. Pollitt & Co.5% and 1.pollitt. and what sort of pressures might this put on the gold market for the next few years? The answer depends on the quantity of gold as a proportion of total assets that the typical central bank wants to hold.0% at around $350 billion.4% 1.343 0.43 0. 8% and 7% respectively.S.3% 0.5% 0. and the U. this doesn’t solve the larger puzzle.3% 5. A simple model we have built shows what would happen if the Euro Area. Inc.059 32. Ontario January 31. www. There are two ways for gold to grow to 6% of total assets: through increases in quantity or increases in price.66 915.003 0. India and Russia. our rough estimates show that the 9 remaining central banks must purchase about 5. or about 16% of total Fed assets.3% 6. and Saudi Arabia would all be significant buyers.34 15. Franco-Nevada. The removal of a stock from the list should be considered as advice to reduce a position in that stock.(Continued from page 1) credit quality to the fore. effectively front-running their trades.3% 3.08 0. around 36% of the Bank of England’s assets were held in gold. In conclusion. are open to debate. By the end of the Bretton Woods days.1% 4.168 3.06 312.K. All opinions.041 1.402 0. gold ETF purchasers.040 10.004 0.0% 7. 2011 Source: Central Bank Annual Reports World Gold Council John Paul Koning jpkoning@pollitt.37 0. our 9 remaining banks still need to buy about 4.793 8. Pollitt provides continuous coverage of all stock ideas on its Buy List. Of those.4% of their assets in gold. opposite). But even if we remove the Japanese. Even when they are so The information contained in this report is believed to be reliable. Turkey. The question is: how much gold might central bankers conceivably buy. including the 6% level. If the 6% level were to be attained entirely by gold price increases. does not issue ratings or price targets on any securities mentioned within this letter. Saudi Arabia Indonesia Japan China Brazil Mexico Canada South Korea Total CB As. For the largest non-Western central banks hold only 3% of their assets in gold. it’s probably a fair speculation to assume that one can step in line ahead of the world’s central banks as they purchase gold.53 16.30 1. of CB 2010 year end (tonnes) currency.009 0. and helping it along on rises. Inc. Toronto. to reach the 6%. a gold price of $1680 would do the trick. but its accuracy and/or completeness is not guaranteed. not bonds.3% 0. The assumptions of our model. gold Gold Holdings of the World's Largest Central Banks Central Bank Switzerland Euro Area U. But central banking law usually prevents central bankers from purchasing equity.010 0.6% of their assets tend to be held in gold. the nations in which said central banker looks for equity will rarely look kindly on the practice.55 0. One way to protect a portfolio from currency devaluation and sovereign credit risk is to buy equities. Along with China. that leaves a significant chunk of motivations unanalyzed: those of hedge funds.9% 3. it is unlikely to veer back the way it came anytime soon.9% of the world’s supply. while the remaining 11 central banks in our sample grow their gold holdings up to an even 6% of total assets.71 0. Inc. in the old gold standard days.500 tonnes.9% 12.134 125 558 775 125 116 80 310 323 73 765 1. UK. jewellery buyers. Pollitt intends to maintain a Buy List of 10-15 stocks. the central banks of Brazil and China hold a meagre 0. neither buying nor selling.235 1. The Swiss National Bank (SNB) keeps around 23% of its assets in the metal. but we think that number is conservative.17 0.6% 20. the central banks of South Korea. the Japanese and Chinese account for very large chunks. Sweden. please see our website. the Federal Reserve held some 25% of its assets in gold certificates.130 0. were to keep their gold holdings steady for the next few years.34 0. . Brazil.387 0. trilAssets lion) price) 1. like a herd of elephants trumpeting down a new trail.004 0. For while we’ve peered into the minds of the world’s central bankers as best we can. Stock Recommendation System and Terminology: Pollitt does not issue price targets for companies.4% 0. nor does Pollitt & Co.5% 3.Gold Value (local Gold as % Gold held sets (local currency. estimates and other information included in this report constitute our judgement as of the date thereof and are subject to change without notice. Of course.98 2.054 34 8 3 14 0. maintain and publish current financial estimates and recommendations on securities mentioned in this publication. discontinues coverage of the stocks highlighted in this letter. do not reduce their holdings to 6%. Averaging the world’s 18 largest central banks together (these account for 80% of official gold reserve holdings) about 6.88 129.