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Turk:  “What we are seeing today, Eric, is another attempt to break the back of the precious metal markets.  Both gold and silver are near the lows they made last Monday....

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“The shorts no doubt think that if they can drive the precious metals lower by piling on with new positions, and thereby keep the pressure on, they can force more weak hands to part with their physical metal, which is the key point.  But the shorts need to get their hands on physical metal because there is an ongoing scramble for physical metal as both gold and silver keep flowing from West to East.

But the central planners are not letting gold and silver prices jump up to normal levels that would be needed to clear the market by bringing supply and demand into balance for both physical metal and the related derivatives.  The reason of course is that the bullion banks and central banks would incur huge losses because they are short. 

I would like to explain this point because it is of critical importance:  When it comes to dealing in physical gold and silver, it is possible to be short in two ways - price and the delivery obligation.  This double risk doesn’t happen when the banks are short currencies because the central bank is always ready to bail out the banks by just printing more currency if a bank needs it to meet its obligation to deliver currency.  That’s why you see currency swaps ballooning from time to time on the Federal Reserve’s balance sheet.

Right now the Fed has $23.8 billion of currency swaps on its balance sheet.  It has been bigger in the past, and as big as this number is, it pales in comparison to the imbalance in the precious metals market.  But the Federal Reserve cannot print physical gold.  They can, however, print paper-gold - but only up to and until that moment in time when someone says they want physical metal, and not some paper promise.

The bullion banks may be hedged so that they are not exposed and will not take losses from rising prices - assuming their counterparty does not blow up like Lehman.  But even if they are hedged against price swings, their counterparty needs to deliver physical metal to them when the bank asks for it. 

And here is where the problem lies:  There is a mountain of interlinked derivatives that form a huge daisy-chain of promises stacked upon more promises.  The small amount of gold backing this mountain of paper is still often called ‘fractional reserves,’ although the term has lost its original meaning in that reserve requirements have been essentially eliminated for banks.  Unfortunately, we don’t know the size of the fraction of available metal backing delivery obligations, but the backwardation that prevailed through most of the summer indicates that the short position is unmanageable.

What we do know is that the attempt to shake out physical metal by driving the price lower is a suicidal strategy.  It increases the demand for physical metal more than the weight of metal sold on to the market.  We know that to be the case because of the drawdowns of visible inventories of the ETFs and on the Comex.  These inventories would be increasing if the strategy of central planners was working.  The metals are therefore poised and ready for a huge short covering rally.

The picture for the mining shares is somewhat different.  On a relative basis, both the XAU and HUI are weaker than the metals themselves.  I suppose that result should not be surprising as this pattern of relative weakness has been in place for some time now.

This relative weakness will change, but for that to happen, the miners now need higher prices.  Their balance sheets have been cleaned up to a large extent as they deal with the excesses and bad decisions of previous years.  In the aggregate the mining industry has taken more than $30 billion of write-offs over the past year or so.  That’s a huge amount of burden removed from balance sheets.

But in my mind, here is the most important point that KWN readers should be focusing on:  Over 5 months have now passed since the metals made their low in the correction this past summer.  Putting it another way, a huge base is being formed.  All we need now is a spark to light a fire under gold and silver to send them - and the mining shares - higher.”

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© 2013 by King World News®. All Rights Reserved. This material may not be published, broadcast, rewritten, or redistributed.  However, linking directly to the blog page is permitted and encouraged.

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Eric King

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