Gold – John Paulson is safe. For Now…

The supposedly safe Gold market shocked many (and not just the gold bugs) on the 12th April by dropping 5.2 percent in a single session, erasing $79 from its value. It seems that not even the weekend break saved investors as the yellow metal then opened on the Monday with the same excessive bear tendency with another blood bath that saw it drop 8.7%, closing the day at $1,351 – off another $129/oz.

In just two sessions, Gold lost a tub thumping 13.5%, shrinking $208 in value per troy ounce and incorporating the largest fall in over 30 years. Many investors were caught off guard, with the legendary hedge fund manager John Paulson being one of them. During this two-day period alone, Paulson lost almost half a biillion on his SPDR Gold holding and another $10 million in Anglogold – a very unuseful day at the office! 

With Central Banks the world over expanding liquidity through unconventional monetary policy measures, Paulson’s bet on Gold is in fact a sound and rational one. However, the other fundamental pillar of the Gold “story” is the inflation one, as in a resurgence of it at some point. Problem with this is that with the debt overcoat swaddling Western economies that it remains dormant, even in Japan which has embarked upon a major monetary easing experiment with the primary intent of creating inflation. With the US economy still registering growth and falling unemployment, the fiscal cliff fears all but forgotten, and muted inflation readings, Gold has some decent headwinds against it and the downtrend now remains in place from Summer of last year. Many are now asking – are we at the end of the extensive twelve-year bull run?

According to data from the US Commodity Futures Trading Commission, hedge funds and other large speculators held around 70,000 short contracts on April 23 – within 0.6% of the all-time high reached just a few weeks prior to this. For once the speculators seemed to be correct. On April 23, a few days after the major drop observed in precious metals, the number of outstanding short contracts remained largely unchanged and yet demand for ‘physical’ gold has been setting records. This is an odd disconnect as one would logically expect them to move in tandem. In fact, the US Mint ran out of its smallest gold coin last week as sales surged the most since December 2009. Central banks around the world have been said to be buying gold again, especially Russia and Kazakhstan. Demand for jewelry coming from India has also picked up, to such an extent that the premium paid on the gold price for immediate delivery rose from $2 to $10. Even the “vampire squid” Goldman Sucks closed its sell recommendation last week reasoning that the banks are expected to see more demand for gold than last year in conjunction with the physical dynamics detailed above.

So, our friend Mr Paulson must now be sleeping a little easier… During the period between April 15 and yesterday, he managed to recover almost $200 million on his SPDR Gold holding and an extra $15 million in Anglogold. Paulson’s modus operandi however per his bet on the MBS collapse are time and patience, we guess reasoning that there is plenty of time to let inflation pick up.

In our view Paulson’s long position on gold is sound. Quantitative easing theoretically leads to higher inflation and thus, one would expect, higher gold prices. The problem with this standpoint at present however is the debt overhang in the major economies that is acting as a counterforce to the massive money printing – the money multiplier effect is quite simply not happening – yet.

Under normal conditions, when the monetary base rises (due to central bank bond buying programs), the amount of money in circulation (money supply) rises in tandem. But for that to happen banks need to lend money. The problem is that they are still not willing to lend and businesses and households are largely not willing to borrow. If the problem persists, monetary policy will continue to be ineffective and so won’t lead to generalised inflation. It will only inflate stock prices and make it costly to hold gold which is unuseful to say the least for Mr Paulson!

To learn more about the legnedary hedge fund manager John Paulson and 4 others, click the image below to download our Best Hedge Fund Managers of All Time book.