Futures Magazine: Before we go into your outlook on the metals markets why don't you talk a little bit about your background and what you do for Alliance Financial?
Frank McGhee: I am the head precious metals dealer for Alliance Financial. I have been involved in the markets for most of my adult career and I am in my mid 50s. We make markets in over 400 different physical metals products from investment-grade coins to exchange deliverable warrants to industrial products such as the casting grade for making rings.
We are very active in both the cash and futures markets involved in deliveries in any U.S. market. We launched and developed one of the first Internet precious metal dealing systems in 2002 called the OTC desk.com. It is a system fully automated as to the pricing availability of product. It provides a unique quote for each client based on the specifics of the orders, current market conditions, available prevailing interest rates, shipping costs etc. Two different clients can be on with similar orders but going to different places and seeing individual prices. We have two sister companies: Integrated Brokerage Services, which is an FCM and there is IBS Securities. We provide a specialty metals environment for both our wholesale counterparties as well as for retail investors where you can deal in just about every component of the metals complex whether it be physicals futures, exchange-traded funds, across the board.
FM: Gold is perhaps the most interesting commodity, if you can call it that. Do you view gold as a commodity, currency, bellwether of global stability or something else entirely?
McGhee: Gold is a currency. It is one of the oldest forms of money. It has provided a store of value and a settlement vehicle for various governments throughout the years. The unique nature of gold is that it is not issuer specific. Gold is unbiased, that is the reason that it developed the exchange process and was the original form of currency. There actually was a euro before the euro. That was the 20-franc piece. For 200-300 years, major European governments all issued a [gold] coin within a fraction of each other and if you were doing a transaction inside of Europe you might get back a French 20, a Swiss 20, a Belgium 20 and two German 20 marks. It really was a unifying currency across differing issuing mints.
FM: How should investors view gold?
McGhee: You have to look at the history of gold over the last 25 or 30 years. After the inflation bubbles of the late 1970s, the central banks tried to do just about everything they could to demonetize the metal and to that end it helped to create a fairly protracted bear market. At the same time, you had the rise and development of the lease market for precious metals with extensive multi-year forward hedging operations and this continued to keep pressure on the price of gold. Ultimately though it failed with the accords in 2002 when the central banks agreed to limit both their forward and spot sales of gold, as well as their leasing activities. As soon as that accord came into place, you had the beginnings of the current rally that is going on its eighth year. Gold has done, in the past several years, what it should normally do. It has been helped along significantly by the advent of the exchange-traded funds (ETFs). That probably has added $400-$500 an ounce to the price of gold that would not normally be there if it was just an industrial commodity. There are almost 1,100 tons of gold that have come off of the marketplace that are in long-term hands that generally do not tend to get rid of it. When gold goes into to GLD, because it has to be backed by gold, it doesn't tend to come out. Even in the most sever breaks, you only see a modest redemption. That has changed the overall face of the market. The [ETF funds] have distorted the historical [fundamentals] of the jewelry business and the Christmas buying season. [These things] have become less important than the accumulation of investment grade metals. And the ETFs have replaced or consumed the metal that the Central banks have sold over the years. Absent the ETF, we would be probably in the $600 to $700 range, as opposed the $1100 range. It has gotten to a point that because GLD has to have physical bullion that there are shortages in depository locations in the city of London that meet the requirement of the trust. It is difficult to get storage for a new bullion account.
FM: What is your opinion on the current obsession with gold?
McGhee: It is certainly reflecting a distrust or fear of the current conditions both domestically and internationally. At the height of the financial meltdown in 2008-09, the cash and carry markets almost tripled their normal premiums with people physically taking possession of gold and that directly showed the anxiety of a growing number of people. Prior to that meltdown, we would routinely get calls saying I have $50,000 I want to put into the gold market. In the midst of that, we were getting calls from investors saying 'I have $1 million I want to put in the gold market. The concept here is not only has gold maintained valued but gold has gained value relative to the other currencies and you have to view gold as a currency.
FM: Do you subscribe to the notion that gold is an essential hedge against inflation?
McGhee: Gold is absolutely a hedge against inflation, but in many cases inflation is
something that is occurring after the fact in the change in the currency rate rather than before the fact. I am a major supporter of having a significant portion of an investment portfolio in precious metals. I am also a supporter of most people doing a dollar cost averaging purchase. You take a certain amount and routinely and mechanically
acquire metals. You buy gold on the 15th of the month each month. You acquire more gold in breaking markets and you acquire less gold in a rallying market. It acts virtually as a savings account. Six months, a year, two years into it you've got this nice piece of your portfolio in something that is counter cyclical to most of the rest of the markets.
FM: Giving the current market environment in March 2010, is gold, at about $1,100 per oz., cheap, expensive or about where it should be?
McGhee: We are fairly valued right now. We've got the context that gold is holding up tremendously well against the onslaught of a rising dollar and breaking euro. The one downside element to gold would be a knee-jerk reaction if the euro does not hold the lows that were put in place recently, but makes a run into the 120s. Then gold would have an initial sell-off as it is valued in dollars and then turn around.
You have had gold appreciate against all asset classes and all currencies value classes, so on that level it is not only doing what it is supposed to, which is to be a storehouse of value but it is in fact gaining value. The value of gold can go up by simply not going down in the face of everything else.
FM: Are there better inflation plays than gold right now?
McGhee: When you go back to the 1970s when gold made its initial spectacular run from $250 to $800, there were very few alternatives to investing in gold. You couldn't invest in crude oil. At that time, many currencies had exchange controls on them and money could not freely move, so investing in foreign currency was limited. We have such a different marketplace not that I think the metals have to hold their own and to a large extent they have. I can't think of another vehicle that allows investors of all sizes to acquire a position that is appropriate to their size of investing. They can buy an ounce of gold or 10,000 oz of gold. It is the multitude of ways to buy gold that makes it attractive at this point in time. It is much easier to own a metal now than it was before. And the metal markets, especially the futures markets having gone electronic, are much more efficient than they were before. Back in the 1970s bid/ask spreads were $10-$15 wide and we would go through daily trading ranges of $50 to $75.
FM: You have been involved in gold for 30 years. How is the recent surge in gold different from that of the late 1970s and early 1980s?
McGhee: The biggest [difference] is the efficiency and the variability in how you can invest in gold. If you go back to the 1970s-keep in mind that prior to 1975, unless you owned pre 1933 gold coins, you couldn't own gold legally in the country. Forget the concept that there is a futures contract, you simply couldn't own it. So in the '70s, you had the advent of either being able to trade futures (there were no options) you could trade mining stocks, you could trade physical bullion in the form of coins or bars and that was it. Each one of those has its own unique component and each one of them, especially in terms of futures and stocks, were all done in voice open outcry markets and the dealing physical bullion was either done through an exchange delivery or was done over-the- counter in many cases in a coin shop or at a bank. If you fast forward 35 years with the advent of electronic markets you can now trade futures, futures options, exchange traded funds, mining stocks, physical metals all of it electronically, all of it online, all in a fraction of a second, and have absolute certainty your transaction is done and confirmed. In the '70s there were days that you would not find out an execution price for hours if not days and that was just [part] of the market so the efficiencies that have come to the marketplace, as well as the explosion of products, and variations of products has made investing and capturing the benefits of gold much easier for a broader number of investors. What that has done is put an underpinning into a long-term bull market. You go back to the GLD, when it goes into the GLD, it generally doesn't come out. People put it in their IRA, they might buy two or three ounces but you might have 40 million people who now own gold as opposed to 200,000. That is the sort of sea change you have had in the market between the '70s and now. That is also why we have ultimately come to a much higher level, even though there are alternatives to gold that can do many of the same things that it does. You cannot discount that since 2002, gold has reflected exactly what it should do. It has shown the change of the dollar, it has reflected a change in attitudes that the investing public has and it has shown the element of fear that is in this market place towards the overall [notion of the piling on of additional spending has to impact the value of the currencies]. If you look at gold as a currency, then what is occurring here is that it is by far the best performer, and that most paper currency is in question and which is least bad. Even the funds that moved in to the dollar has only been a reflection that the dollar is going to hold better than other currencies, but ismoved in to the dollar has only been a reflection that the dollar is going to hold better than other currencies, but is
not going to hold up in and of itself.
FM: Fundamentally how is it different?
McGhee: The fundamentals at that point were an unprecedented inflation shock that took crude oil from $4 to $40, which occurred over a short period of time on the back of food price inflation and wage inflation. We were reflecting those changes. We had a major crop failure in 1972-3 right at the time that the Russians came in and did major international purchases. The inflation picture got so screwed up that you had wage and price controls. The futures contracts were bumping up against imposed limits above which they could not go. Anybody who has ever traded a limit market knows that whenever you have an artificial limit put in place it tends to increase the likelihood of the market continuing to move in that direction. The wage price controls exacerbated the type of food price inflation and monetary inflation you got as a result of oil and crop failures. If you look at the incredible moves you had in the '70s and then the '80s, ultimately became the period of the equity and not the period of commodities as the main movers that came through were all equity based. You had a couple of major spikes late 70s early 90s and now you come into a decade of commodities as opposed to equities. The fundamentals are somewhat similar but with their own unique differences. We fought an eight-year war that has not been on the balance sheet. You've got the financial meltdown that has required a quantitative easing point that initially had to deal with a deflationary cycle. From there, once we start reflating, the question is can the Fed withdraw these funds quickly enough without putting us in a double dip recession? Personally I am in the double dip camp. I think that is very likely no matter the extent of the rally so far. It is a jobless recovery at this point and there is going to be real problems if that can't get cured.
FM: It is assumed that gold and the U.S. dollar are negatively correlated, which is true most of the time but not all of the time. Talk a little bit about the relationship between gold and the dollar?
McGhee: From a purely mathematical standpoint, the negative correlation is a logical condition. Gold priced in dollars would move to the opposite level of the dollar. However, the most explosive price points have come through when there has been a disconnect between the gold and the dollar. That has occurred three or four times over this move and has always put us in a situation where we've seen major rallies in gold when that has occurred because at that point in time you have gold rallying or breaking against all currencies. You have had that again the last six months to a year. That could set up - even if we get a break to the $800-$900 level, which I am not anticipating - a divergence between gold , the dollar and all the major currencies, signaling another major up leg.
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-`a-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.
FM: How big is the threat of regulation to gold investors and traders?
McGhee: At the end of the day, unless the regulation is uniform and global, it will simply move the people who can access other markets outside the regulated markets so far from protecting the people that the regulation is designed to protect [it will harm them].
If you drive the qualified market participant out of the regulated market by virtue of putting regulations in place to protect Ma and Pa who have you hurt? Ma and Pa. What ends up happening is that the markets that Ma and Pa can participate in are less transparent, less representative of the rest of the market and less efficient. That means that they are paying more through illiquidity and mispricing than they would have been if they were participating in a more unified market.
FM: It used to be illegal to own gold in this country as recently as the mid 1970s. Could that happen again?
McGhee: It is unlikely. If the U.S. government determines that it will stay off of a gold standard, then it is unlikely that they would confiscate gold. If, however, the government were to readopt a gold standard, then yes I would see a case where they would make individual ownership illegal.
FM: Why would they need to do that?
McGhee: Because individual ownership allows you - when governments misprice things - to act with your dollars, in this case gold. A standard in many cases requires a price peg. What ended up happening was we were still trying to value gold at $35 an oz. when the real world value of gold was $40 or $50 an oz. That is an [arbitrage]. People are going to figure out how to arb it. If it is a redeemable currency and it's $10 mispriced, what is going to happen? All the gold is going to come out of the government vaults and into private hands, so it is really only the fundamental process of where gold is in the financial system. If it is a commodity, which is why they reallowed ownership, then it doesn't matter; if it is a currency - one of many - probably still doesn't matter. If it is the reserve currency, I see a lot of arguments to why they could do a confiscation again.
FM: Why is it important to view gold as a currency?
McGhee: There are limited number of industrial uses for the metal. All the gold that has been mined is around. It is a uniform store of value. At the end of the day, when people do not accept the value placed on what people call fiat currencies, gold is gold is gold. It doesn't matter if that gold is issued by the U.S. government, whether that gold is issued by the British government, by the EU, by the Chinese; it is the ultimate level playing field. Other metals at times will have a dual hat. Silver is the most famous one. At times it acts like a precious metal and at times it acts like a base industrial. It makes it very schizophrenic because there are times when you are looking at the market and think it should be acting like a base metal and it decides to have its precious hat on. You then get over into the purely industrial metals and they act entirely different.
FM: Give us your outlook on gold and other precious metals.
McGhee: Gold suffers the potential to have a correction only in relation to what happens with the euro. If we take out the 120-125 level then you could see gold back down to the $800-$900 range. I'm relatively skeptical that that will happen. The euro probably will tip under 130 and then hold and start moving forward. $1200 was my initial target [for gold], I set that back in 2002. We are doing a tremendous amount of work in the $1050 to $1120 range.
Ultimately the next upside target is $1,500 to $1,600. That occurs as the dollar starts to erode against the overall size of the deficit. And potentially occurs after a correction based on us entering into the second leg of a double- dip recession, which is what I think is going to happen.
The other base metals are all based on China, period. The Chinese out-consume everybody else and it is only a question of how robust their economy continues to be, whether or not they have to slow things down significantly or whether they allow their economy to expand at the rates they are expanding.
FM: Gold has rallied, in large part, due to anticipation of a spike in inflation, which we still have not seen a large degree of? When and if inflation actually hits in earnest, will it be time to get out or pare back gold positions? In other words, how much is a future spike in inflation already priced in to the market?
McGhee: old in the last 18 months has gone to being predictive as opposed to being reactive. Through 2008 and 2009, we were purely reactive. There is some element of forward anticipation in the market, which market prices should tend to do. The ultimate answer to that is when U.S. interest rates do start climbing, whether or not we do a full disconnect. If we give up the predictive gains as the quantitative easing comes out, then we have seen the move. However what I think is going to happen is the removal of quantitative easing, after an initial knee jerk, is going to project us into new highs.
You can have some sharp short-lived asset liquidations. The initial context is that because we are valued in dollars, when the Fed does start raising rates, in the very short term, [it will be] negative, but at that point it is how much money is out there. Where is it going to come from to pay that off, what's the job climate at that point. Those are the things that will ultimately determine whether or not we have a hyper inflation stage set in. If we were to get a run back up above $100 in crude, then we are likely to go over $200. Those are the things that we don't know now and won't likely know for six months.
I am definitively one that says looking at core inflation is an economic way of jiggling the numbers. Real out-of- pocket inflation, the things that people have to pay for day in and day out is significantly higher than the numbers being reported.