Using data from the LBMA and Bank of England on gold stored in London vaults and net UK gold export data from HM Revenue & Customs, we estimate that the “float” of physical gold in London (excluding gold owned by ETFs and central banks) has recently declined to +/- zero.

If we are correct, the London Bullion Market is running into a problem and is facing the biggest challenge since it collapsed from an insufficient supply of physical gold in March 1968.

Besides the growth in physical gold demand from existing sources (see below), there is more than US$200 Billion of trading every day in unallocated (paper) gold. If buyers lose confidence in the market’s structure and ability to deliver actual bullion, the market could become disorderly (via an old fashioned “run” on the vaults) as it seeks to find the true price of physical gold.

Eoin Treacy's view

Here is a link to the full report. 

The argument often cited by gold bugs is that the derivatives market for gold dwarfs the size of the physical market. That is also the case in the equity, bonds and other futures and options markets because most people wish to benefit from volatility in prices rather than holding the physical asset. This only becomes a problem when someone attempts to corner the market, by buying up available futures contracts then taking delivery and refusing to have their holdings lent against.

Right now there is no evidence this is occurring in the gold market. There are a range of reasons to be bullish about gold which include continued physical demand, declining mine productivity and purity levels, negative interest rates in Europe and Japan and increasing demand from ETFs. However we need to ensure the bullish story gels with the price action.

Gold rallied to test the $1300 level two weeks ago but failed to hold the move to new recovery highs and is now pulling back. If medium-term recovery potential is to be given the benefit of the doubt, it will need to find support in the region of the trend mean, currently near $1200.

The NYSE Arca Gold BUGS Index more than doubled from its late January low and is susceptible to some consolidation of that impressive move. Today’s decline was the largest pullback in the course of the short-term advance and, while the progression of higher reaction lows is still in place, a clear upward dynamic will be required to check potential for a further pullback. Medium-term recovery potential is dependent on prices finding support in the region of the trend mean.