Gold Falls due to Re-Hypothecation, Counter Party, Liquidity and Contagion Risk

Gold in USD - 1 Yr (150, 200, 250 DMA)

Gold has risen nearly 1% in most currencies today after a dropping 3.5% in US dollar terms yesterday. The sell off yesterday has been attributed to more speculative players and funds selling off holdings before year end and going to cash due to alarming funding and liquidity pressures and increasingly elevated counter party risk.

The MF Global and re-hypothecation scandal and concerns regarding a bout of vicious deleveraging likely exacerbated the sell offs in gold and silver.

Gold in GBP - 1 Year (Daily)

Traders, hedge funds, proprietary desks of banks and more speculative players many of whom are driven by technicals and momentum, rather than fundamentals, have been selling gold and going to cash due to the real risk of a monetary and systemic crisis.

Fears grew about the worsening euro zone debt crisis grew after Italian bond yields hit a new high which led to selling of commodities, equities and gold.

European banks facing both liquidity and solvency issues may have again actively dumped gold into the market in a desperate attempt to get dollars.

The Financial Times reports that bankers said "that hedge funds and other investors had unleashed a wave of selling as they aimed to preserve profits - or minimise losses - ahead of the end of the year."

Technical selling was exacerbated by significant stop loss orders being triggered at key technical levels such as the 150 and 200-day moving average.

Gold's fundamentals have not changed however the technicals are very poor. Gold looks oversold but could become more so in short term due to momentum. In order for gold traders to regain some confidence the 200-day moving average at $1,620/oz will have to be recaptured.

While gold has fallen below the 200-day moving average in dollar term, it remains above the 200-dma in euros and pounds which suggests that gold's bull market in fiat currencies remains intact. Indeed, gold in euros remains above the 150-day moving average.

One London trader told Reuters that the sell off "relates to MF Global and the utter mess they have legally been able to create and the implications of re-hypothecation as a result this has seriously dented the 'paper' gold market so physical price is going up, futures going down. This is somewhat confirmed by the collapse in the EFP (Exchange for Physical) this week."

However, as of yet, there has not been any increase in premiums in the physical small coin and bar or London Good Delivery Bar market.

While tech driven speculators and liquidity desperate banks have been selling, demand for bullion from retail investors in Europe remains very high. Demand is lackluster but still continues at lower levels in Asia where gold bar premiums remained steady - in Singapore at $1/oz and between $0.50 - $1.50/oz in Hong Kong.

Holdings of SPDR Gold Trust, the world's largest gold-backed exchange-traded fund, were unchanged at 1,294.79 tonnes showing that passive buyers and diversifiers have not sold in panic.

Gold in Euros - 1 Year (Daily)

Gold's sharp fall is a further sign of the systemic fragility in the global financial system. It is very reminiscent of the period of gold weakness that was seen in the aftermath of the Lehman Brothers financial crisis.

Gold fell sharply in the aftermath and bottomed in January. There was much media coverage of non gold experts saying that the gold 'bubble' had burst and that this proved that gold was not a safe haven.

However, gold fell less than most equity indices and then recovered quicker than equities. Gold ended higher in both 2008 and again in 2009 despite short term sell offs and periods of correction and consolidation. This has been the case since 1999.

Academic research shows that gold is a hedging instrument and a safe haven. However, it can be correlated with risk assets in the short term but its hedging and safe haven qualities are seen in the medium and long term.

The appalling scandal that is MF Global may be leading to customers withdrawing funds and assets from brokers and indeed some brokers themselves are liquidating positions en masse due to distrust of the securities market.

This has the potential to create a bout of deleveraging internationally which could be catastrophic. Much of the shadow banking system, worth about $10 trillion, is dependent on the liquidity that is created by hypothecation - this is particularly the case in the UK.

The scandal will result in those invested in the many forms of 'paper gold' to reassess their investments and see an increasing shift towards allocated accounts and taking delivery of bullion. This has the potential to propel the very small physical bullion market to much higher levels however in the short term it could result in further price falls.

Cross Currency Table

Reuters reports that the ancient Mayans attached special significance to 2012 - possibly the end of time. That has spawned a rush of apocalyptic literature for the holiday season. But you don't have to believe the world is about to end to realise that next year contains perhaps the widest range of political risks to the global economy in recent history.

2012 is likely to be even more volatile and turbulent than 2011 and those who remain diversified or become diversified and own physical gold will again be protected financially.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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