FM: What does a breakdown in the normal correlation indicate?
McGhee: What you are seeing is that gold, after the concerted attempt to demonetize the metal, has the ability to perform across national or transnational function. It puts it in a situation where the central bankers no longer trust each other’s issuing capacity. In other words, they don’t want to hold each other’s paper, then gold is a beneficiary of that and you see that over the last 12 or 13 months as you’re probably going to see the central banks turn to net buyers. That hasn’t happened in 30 years.
FM: You follow the activity of the central banks. What do you expect them to do vis-à-vis gold?
McGhee: The more established economies are going to try and push to eliminate gold from their reserves. That transfers the gold from their reserves into either the long-term investor’s hands or the central banks of emerging economies, in this case India or China. At the end of the day, it creates a type of redistribution that ultimately is going to keep gold in demand and is going to push that price ultimately higher. We took this last leg up when we came through $1,000 on the run to $1,200 on the basis of India announcing they bought 200 tons from the IMF. China is another major buyer. They’ve certainly got the reserves. Their societies are such that their perspective is that gold is an important monetary vehicle, more so than a commodity. The West has tried to commoditize gold for a long time and what we are seeing now is a capitulation that gold is and will be part of the monetary system for a long time.
FM: Will it be part of the monetary system in any official capacity?
McGhee: The context becomes which of the central banks starts yielding more and more influence. As you see the power of both the Chinese and Indian central banks increase and as you see the Western central banks lose some of their influence then gold is a beneficiary of that just for cultural conditioning.
For the Chinese to maintain a currency peg, they have to have a certain amount of U.S. dollar-denominated assets and at the end of the day, the [United States] needs to be extremely careful about pushing too hard to get a revaluation. And the point and time the Chinese no longer need to hold as many dollar assets because they are no longer pegged or the peg is at a different level, they will be the first ones to liquidate those and there will be things like gold that will benefit from any type of revaluation of the yuan against the dollar.
FM: How does this affect your trading activity?
McGhee: What we are seeing in terms of the creation of the ETFs and the reentry of the central banks on the long side [is] it tends to keep the bull components of these markets going. That will continue to bring in retail and longer-term investors. Nobody likes to put money into declining markets. The positive side is that you have more business, the negative side is that higher prices make it just that much harder for the industry to function properly. When you have a $250 per oz. product it takes X amount of dollars to do a certain amount of volume, that volume has gone up five or 10 fold at the same time that the cost has. The overall industry can be somewhat underfunded in terms of liquidity and gold is one of the first things that can be turned into other currencies quickly, so it is also one of the things that will be liquidated in the first asset liquidation waves as other paper currencies run into problems. If you have a stock market stall out or if you have another crisis like the Dubai crisis gold can be subject to these very violent breaks and start the march forward again.
At the end of the day, if you thought that gold was going to come back and become a hard reserve currency again, where would you have to price it for that to occur? $5,000-$6,000 an oz. Why? Simply because the amount of gold around against the number of financial transaction, it will need to be backing in its essence. If it moves towards becoming a universal reserve currency again [it] will have to be at much higher prices than it is now.
FM: Talk about your trading activity.
McGhee: Most of what we do is market making. We do a certain amount of speculating. We have seen a tremendous pick-up at times in various sectors. We have seen a decline in the industrial side of our business and an increase in the retail side of our business. In the past, that would have been troublesome, in that normally it would indicate a top or an exhaustion of a move, however, the ETFs as in other markets have created a very long-term buy side bias. When it goes into the trust it generally stays there. That takes supply off the market. That means that you have more dollars chasing less available product. That is going to create some interesting movements.
I am like any other trader, my opinion is as good as the time we are having the conversation. If you are trading in these markets, you need to be nimble enough to understand what the market is trying to tell you at any given time. I could have this discussion with you and you could walk away thinking I think the market is going to the moon and 20 seconds later I am going short. That is just the nature of the trading.
What used to be long-term isn’t long-term anymore. Long-term in these markets at these levels can be 10 minutes. Things that used to take weeks to unfold are compressed into hours and literally you can see the entire beginning, middle and end of what would have been moves that would have taken forever before, all done in a single session.
FM: The Commodity Futures Trading Commission is contemplating putting speculative limits on metals. Is this possible considering the numerous contracts and products available, particularly with gold?
McGhee: The concept of speculative limits, if not done uniformly by multiple jurisdiction regulators will simply allow the business to go where there is less regulation. Generally, I tend to think that the speculator gets a bad rap when it comes to their impact. If you take a look at crude oil when it ran to $147 and the world was howling for the speculators’ heads, if there hadn’t been speculators, those markets would have gone to $250 because the speculators provide the absolute grease that keeps the markets going. They are there to be buyers when there are no other buyers and they are there to be sellers when there are no other sellers. A market where you limit the level of speculation is a market that is less efficient, has significantly a wider bid/ask spread and that will have significantly higher and more violent swings.
The markets themselves are not what they were before. The ability to come in and move a market quickly by being able to electronically trade has changed these markets forever. Once you provide somebody with a level of access to markets [their volume will go up]. As electronics have come out and cost of execution has gone down, volume has gone up. Once that genie is out of the bottle, you can never take it back.
Speculative limits certainly in deferred months do not make any sense at all. I can understand a speculative limit coming into a delivery month only because of the capital levels that the FCMs have and what is involved in the physical delivery. Physical delivery is probably the most important function of a futures market. I am totally against cash-settled contracts because they don’t do what the physically delivered contracts do, which is ultimately bring the price of the future and the cash in line. Speculative limits put into affect solely in the United Stats would simply drive business away.
[Limits applied globally] is the only thing that would dampen overall trading, but dampening overall trading is not necessarily a good thing. You are looking at markets that have fundamentally changed and you will never go back to the type of markets before. You have very large pools of money and in many cases those pools are passive. They are simply benchmarking to something and they can overwhelm any individual group of speculators or traders at any given point in time. The real context becomes that you have fewer participants having to deal with much larger volumes of transactions.To limit the size of well capitalized speculators just hurts the liquidity base and that increases pricing for everybody. Let’s look at the other side. In a commodity that is a currency not a commodity, what purpose does a speculative limit provide? I don’t see one in gold. You go into silver, platinum, palladium, copper you can make a better argument for a speculative limit in those because those are physical consumption commodities, but gold is a currency and they are trying to view it as a commodity.
FM: Do you think that they will place limits on it?
McGhee: Yes. And to some extent it will push trade into the OTC arena, then the question will be how much they try and push the OTC arena trading back to the exchanges.