Submitted by Jeffrey Snider, President & CIO of Atlantic Capital Management
CME Actions Both Confirming And Contradictory
Given the actions of the CME Group, the governing body of the futures exchange, we should expect an imminent reduction in silver futures margins. Margin increases were stated to be tools of volatility suppression, yet have been nearly universal in their amplification of volatility and only in one direction (down). But now that the exchange has reduced the margin requirements for its e-mini financial sector product (XAF), should we not expect a similar move for silver or gold?
The volatility in XAF has not diminished over the past few weeks or months. As is well known today, the banking sector is in the midst of a crisis and the stock prices of banks are routinely depressing all the way back to 2009 levels. So volatility manipulation can no longer be used as a universal rationale for margin policies.
That leaves investors to begin to ponder the actual motivation and guidelines the CME might be using to “alter” the nature of the investment game of futures. Silver prices were high and therefore required margin increases. Silver prices crashed, no offsetting reductions were offered. Silver prices rose again requiring still more margin moves, then crashed, with gold, while still awaiting the same treatment as the financial sector. For all its volatility suppression ability, the massive movements in silver prices seem to describe opposite. Since the margin increases come just before or just after these large down moves begin, investors might be forgiven if they begin to conclude that the exchanges find upward volatility in metals harmful.
The December XAF contract, on the other hand, has fallen from a high of 130 in mid-September to a low around 108, a rather large 17% move. Going back further, the contract was priced at 155 in early July, for an unnerving 30% decline. Inconsistent with public pronouncements for silver or gold, this decline is met with reduced margins.
In the middle of August, the December silver contract had reached the $44 mark. It now has settled in around $29.50 (first hitting a low of $26) for a comparable 33% crash. The greatest proportion of that decline came during the exact same period as the 17% move in XAF, yet silver margins remain at elevated levels. Investors are left to their interpretations of this obvious inconsistency.
However, judging by the Commitment of Traders Report for futures positions as of September 27, 2011, the extreme volatility in silver prices despite these margin moves allowed commercial shorts the fortuitous opportunity to cover an extremely large 10,794 short contracts (close to 15% of their total from the week before). On the other side, large speculators pulled out of 25% of their long positions during the silver crash.
If we go back a year to the Commitment of Traders Report for the week ended September 28, 2010, we see that the overall number of positions has dropped dramatically. Total open interest has declined by a third, to 102,014 silver contracts from 154,219 the year before. The decline is most pronounced in the long side large speculator category (an astounding drop from 66,066 to 25,153) and the short side commercials (from 94,447 to 62,287). Small speculators have been completely marginalized, falling from a total of 47,822 contracts in 2010 to 31,813 in 2011.
Amazingly, the only category to see enlarged positions is in the long side commercials (from 29,034 to 38,025).
I have no doubt that many will argue that this was precisely the point of the margin increases – dampening rampant and undue speculation. But it is hard to square that position with the move in XAF. Is the CME encouraging speculation in stock prices of the financial sector while simultaneously discouraging it in precious metals? To date the CME has yet to pronounce a predictable and uniform standard (or any standard) for what represents arbitrary or capricious speculation (as appears to be their stance with gold and silver) and what standard is used to determine beneficial speculation (as appears to be the case with XAF).
Beyond any simple, direct relationship between futures machinations and underlying price movements, there is a larger symptom of dysfunction at play here. Whether or not you believe the CME is actively shepherding investors out of precious metals and into financial sector futures, there is a pervasive and growing perception that this is actually occurring. Perceptions matter.
This pattern of “enhancing” investment flows and price-massaging fits within the overall narrative of the centralized economic and financial control that has been emanating out of the Federal Reserve and its central bank cousins since the beginning of the crisis. The Fed, the ECB, the SNB, etc., have all moved beyond setting interest rates that “encourage” credit creation to actively managing financial expectations through manifest price manipulation. That is no small change, and in far too many places it is understated or carelessly dismissed (as the CME actions will be).
In its epic battle to foster or enforce positive expectations about the future, adhering to its rational expectations theory, the Fed has essentially changed the financial landscape to fit the narrative it wants prices to signal to the wider world. The starkest examples are US treasury and mortgage rates. September’s Operation Twist is but a determined effort by the central bank to change the shape of the yield curve to fit a pre-determined pattern described by the often-mistaken mathematical calculations of its economic models. Carrying this out operationally requires a concerted effort to manipulate the price of debt (by buying and selling US treasury securities regardless of actual financial risk/reward considerations – the rules that everyone else plays the game by).
Investment considerations of risk and reward are now displaced to fit the new role of cajoling consumers into “rational” expectations of a recovery or economic growth that those same consumers know is far-fetched to begin with. Any price signal of inconvenience, then, meets the glowering disapproval of the same authorities that crafted the artificial message. Chairman Bernanke was serious in his rather haughty dismissal of gold as a relic of “tradition”.
Precious metals have been a thorn in the side of monetary policy since 2009, replicating their role from the 1970’s. Whether or not the Fed or the Wall Street Banks or the CME purposefully engineered the crash in metals no longer really matters. The aura of the Fed and the banking system is dashed and shattered by these perceived parlor tricks. If monetary policy cannot stand the glare of rising precious metals, then it is too weak to be successful at any point. Inconsistently applying futures requirements fits this narrative all too well. Central banks and national authorities that design truly workable solutions do not need to fear opposition from investors seeking to remove themselves from such solutions.
You do not need stress tests to convince the public that the banking system is fine; you only need healthy banks. In fact, in nearly all cases the stress tests serve as a validation of the public’s mistrust. The banking regulator that conducts them is acknowledging such widespread doubt and attempting to dispel it through empirical, yet blatant and comically arbitrary, means.
If the banking system is not healthy, allowing unfettered price discovery to ferret out the bad banks would eventually bring investors back to the sector in a far more beneficial way than inviting leveraged futures speculation. Despite the short-term horror, the long-term healing that comes from culling the bad and stupid ideas from existence makes up for any disruption. Investor confidence comes from brutal market discipline, meaning those that made the worst mistakes end up paying the biggest price (finally upsetting the indoctrinated status quo).
Prices do not always equate to value and that is the biggest mistake that the monetary system of central banks and central exchanges seem to be making. In a crisis, prices rarely equate to value, so price manipulation ends up being completely counterproductive. The more prices are moved away from the perceptions of value, the greater distrust grows and spreads.
Eventually, if prices are held artificially so far away from perceived value then the fomented wariness itself becomes the universal standard of the crisis – a debilitating instability that ends up invalidating both bad policies and good ones (should one ever get proposed). Good policy can withstand fervent and determined opposition. After all, good policy typically delivers actual results, winning any debate empirically and unambiguously. The perception that authorities may be resorting to shenanigans is all you need to know about the potential efficacy of their efforts. A confident or fairly positioned central bank would outright denounce any and all manipulations like those that seem to be constantly employed at the CME.
In this age of constant intervention, with the “benevolence” of central bankers guarding us from ourselves, it is only a matter of time before continued failure is met with more determined suppression. I might not be able to eat gold or silver, but neither can Chairman Bernanke or the CME. At some point though, as this high stakes game of changing the rules suggests, they may be forced to in order to maintain their defective and tendentious grasp.