Tom Fischer about Paper vs Physical Gold Market & The Gold-Silver Ratio

On behalf of Matterhorn Asset Management Zurich, financial journalist Lars Schall talked with German academic Tom Fischer, a financial mathematician, about the phenomenon why gold’s usual state of contango suggests central bank interference. Moreover, they took a look at the issue of the paper vs the physical gold market, and discussed other issues related to the precious metal markets, such as the gold-silver ratio.

LS: Which of the two markets do you consider to be more difficult to analyze: the gold or the silver market?

TF: Clearly silver.

LS: And why?

TF: Gold always pushes silver around, but silver is too small to do that with gold. So, for silver, you on the one side have the actual industrial demand, which is substantial, and partially gives silver the characteristic of a classic commodity. On the other side, you also have this strong influence of gold on the silver price. But gold is much more macroeconomic – a world currency, if you want, and difficult enough to analyze on its own. These two components make silver particularly tricky.

LS: Do you think silver has a fair chance to become the investment of this decade? And where do you see the gold-silver ratio heading in the long run?

TF: In May 2011, silver looked pretty much like the investment of the last decade! But then, and despite of the promptly following price decline and the much lower prices today, we had not even outdone the nominal 1980s high. Inflation-adjusted prices back then were around 140 Dollars. Of course, we all know that 1980 was a very brief and extreme situation, but it shows what silver is capable of doing. I think silver will outperform gold, based on 1999 prices, in a coming extreme, which I expect to happen before the end of the decade.

The major trend for gold-silver since 1990 has been down, but in a very volatile manner. I think that before the end of the decade we will see the gold-silver ratio go down to 20-to-1, maybe lower, for two simple reasons: One, when gold is doing very well, silver, as the smaller market, acts akin to leverage on gold. Second, during the past 130 years or so, silver has revisited this ratio when it was strongest against gold. So, when things get very heated, speculators will use this historic ratio as a reference point that can be reached and has been reached before. But undoubtedly, this is going to be – and has already been – a very rough ride.

LS: Let’s turn to a paper that you’ve authored recently, “Why gold’s contango suggests central bank interference.“ (1) Now, before we discuss the possibility that there is central bank interference in the gold market; what do you think would be their motivation to do it in the first place?

TF: The number one purpose of a central bank is to manage their corresponding currency. Obviously, too high a gold price in any currency shows weakness of that currency. Similarly, high gold lease rates would show that gold was more desirable and, for borrowing purposes, less abundant than the fiat currency in question. So, if for some reason you do not have the ability or the will to take measures that would strengthen the currency in a sustainable manner, an unsustainable short term cure could be to take it out on gold. Since the currency gold has no central bank that protects it, it makes an easy target. Another reason could be that for a lack of knowledge in – or appreciation of – financial history, a central bank would consider the gold on their balance sheet a non-interest paying drag, and they would therefore try to sell it or try to lease it out.

LS: What are your thoughts on the paper gold market? Can it last or will it ultimately be overwhelmed by the demand that will take place in the physical market?

TF: The COMEX usually raises margins when futures markets overheat. Jim Sinclair of JSMineset has always pointed to the possibility that high enough margin, for instance 100% margin, would effectively turn gold futures markets into cash markets. Also, concerns about failure to deliver could shrink the volume dramatically. If this happened, one could say that the physical demand had overwhelmed the paper market. I think it is possible in the not too distant future. But thismost likely would not mean that COMEX gold would disappear entirely. They might adapt.

LS: How do you perceive the different approach to gold by China and Russia compared to that of the West?

TF: Buying gold is the best thing these countries and their central banks can do to diversify their reserves away from Dollars or Euros. But you first need to have those reserves. Exporters such as China or Russia automatically fall into a different category than, say, the US. As such, it seems to be entirely natural what these countries do. But I am not sure if they are buying enough. Most of the West, however, simply cannot afford gold.

LS: With this as a background, would you argue for a full availability of the German gold reserves on German soil? (5) Isn’t that a question of monetary sovereignty?

TF: The argument for the German gold reserves sitting in New York or London has always been that this would allow an immediate market reaction in a crisis situation. Another reason, I suppose, was to have the gold out of the reach of the Russian tanks waiting behind the Iron Curtain. The latter one is history, and a crisis where the Bundesbank had to sell considerable amounts of gold seems to have never materialized. Given that, I would say, store maybe 75% home and leave the rest in New York and in London. And, yes, I do think this has to do with sovereignty and should be a consequence of a more independent German foreign policy.

LS: Will gold become a winner of the financial crisis?

TF: I think it is a winner already and it will continue to be one. My understanding of it would be that gold will outperform essentially most major market indices, currencies or asset classes over the duration of this crisis. It will preserve wealth. 

>> Read the full interview here