$62 Trillion Credit Default Swaps Threaten U.S. Government Bonds

By: Mark_OByrne

Gold experienced sharp falls on Friday but was still up by more than 3% on the week. This was a very impressive performance considering that major equity indices crashed some 20% to 25% for the week (see Performance table).

Asian and European shares have rallied in early trade this morning, bouncing from last week's crash, after euro zone and international governments announced guarantee measures for banks and central banks moved to boost liquidity by injecting “unlimited” amounts of dollars into the global financial system. Unfortunately, this looks set to be another short term panacea and another in a long line of dead cat bounces hailed by many as capitulation and the market bottom. Market's will only bottom when there are little or no “bottom callers” and there is real volume in the sell offs.

The scale of gold's sell off on Friday was surprising but it may have been the result of the huge hedge fund Citadel receiving a massive margin call due to serious losses on Lehman Brothers credit default swaps which came to market on Friday (sold at some 10 cents on the dollar). Citadel may have had to liquidate all of their positions and gold and silver may have got caught up in their need to unleverage and close very large positions in all markets.

Leveraged players have been massacred and will continue to be so due to the unprecedented volatility in these markets. Trading is nigh impossible in such an environment and thus gold should be invested in passively in a buy and hold strategy.

The massive $62 trillion worth of credit default swaps ($62 trillion in the Unites States alone, according to the International Swaps and Derivatives Association) may be on the verge of a collapse and this would make the subprime issues and asset backed securities associated with subprime look like a picnic. We have warned for some years regarding the threat posed by the humongous unregulated derivatives market and Buffet's “financial weapons of mass destruction” phrase seems more apposite by the day.

With the Federal Reserve having agreed with the European Central Bank (ECB) and Bank of England to lend “unlimited” quantities of US Dollars into their local money markets in order to prevent a systemic collapse it looks likely that government bonds may soon come under severe selling pressure. The US 10 year bond fell sharply last week and the yield rose from 3.42% to close at 3.861%. The “safe haven “ of government bonds will be severely tested in the coming weeks and months.

The Comex gold price and the leveraged futures market is becoming less relevant by the day to the actual price of physical bullion with rationing, shortages and premiums on all coins and bars rising very significantly – rising even on a daily basis. Bullion coins that once retailed at some 5% over the spot price are now being traded at 10% to 15% over the spot price. Most wholesalers and retailers internationally are out of Krugerrands and other popular bullion coins and much of the public are now seeking to buy bullion on Ebay where prices are also surging (see FT article in news section).

In recent weeks there have been little or no bullion sellers and nearly all buyers and bullion owners will have to be incentivized by and are waiting for far higher prices prior to even a minority of them selling. Many are “buy and hold” investors and savers and will not be “taking profits” even at higher prices as their motivation is not profit rather wealth preservation.

It seems increasingly likely that gold and silver will have to rally to over $1,200/oz and $25/oz before there is some selling and liquidity returns to the bullion market.

By Mark O'Byrne, Executive Director

Gold and Silver Investments Ltd. have been awarded the MoneyMate and Investor Magazine Financial Analyst of 2006.

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