Montreal, Canada

Yesterday’s $39 decline in the August gold contract makes me wonder just who exactly is unloading bullion in this increasingly uncertain economic environment. With the EUR surging, hedge funds and trading desks at major banks might have felt compelled to unwind their gold hedges. Even after Thursday’s EUR rally, gold prices are up 24% in EUR terms in 2010.

But with the U.S. dollar logging one of its biggest single day declines on Thursday, I’m sort of confused why gold prices would fall almost 4% and not rise amid dollar weakness. The EUR rally doesn’t explain everything.

In addition to traders dumping gold, my best guess is that some government-controlled conduit, perhaps the International Monetary Fund (IMF), entered the market and sold gold. The IMF has been looking for other buyers since selling a few hundred tons of gold to India and other regional central banks in the Indian sub-continent in late 2009; I’m not convinced the IMF wants to control its velocity of gold sales so it doesn’t disrupt the market. On the contrary, I think central banks are highly concerned as gold prices topped $1,250 an ounce recently.

It’s no secret that major central banks in the world, especially in the West, have a vested interest in keeping gold prices down. In the 1980s and 1990s, in the absence of central bank agreements limiting gold sales, governments dumped an enormous amount of bullion in return for fiat money, which provided a yield. But in the 2000s, central banks transitioned to net buyers of gold bullion led by the emerging markets of China and India. Even central banks in Europe have slowed their gold sales and some have turned into net buyers again.

In the end, it doesn’t really matter who sold gold on Thursday. The big picture remains very bullish for the long-term trend because central banks have already lost control of their finances in the West; austerity measures in Europe will only exacerbate the economic pain, inflict more economic discontent and result in deep recessions in some countries – especially if the EUR recovers.

Plus, the credit crisis in Europe will eventually swarm the United States in the absence of any deficit reduction plan; on the contrary, another stimulus program, though unpopular in Congress, might be imminent if Round II of the mortgage meltdown forces the government’s hand. I also have serious reservations about state finances and whether we’re at the gates of a default or debt restructuring in one or more states.

But more fundamentally, the destruction of credit has now shifted to Europe and the next attack will focus on European bank balance sheets, which hold questionable assets that have not been marked-to-market. The next episode in this story will be a sovereign debt default in Europe, possibly others on the periphery in the Balkans. After that, I expect carnage to spread to the United States as printing goes into high gear amid total desperation to quash the rising menace coined deflation and the destruction of asset values.
Not a pretty picture. But that’s the view from Montreal on this long holiday weekend.

Happy July 4th to my American readers – have a great weekend! See you on Monday.