The geopolitical ramifications of the revolution in Egypt and the likelihood that it will spread throughout the Middle East, North Africa and possibly further afield is leading to volatility in markets. Equity indices in the Middle East and Far East were mostly down (except for China) overnight. European bourses were under pressure this morning but have recovered somewhat.

Gold and silver are marginally lower after their strong showing Friday which resulted in silver closing the week 1.7% higher and gold being tentatively lower (-0.14%). Remarks by a People's Bank of China advisor that the Chinese should diversify into gold and silver are very important (see below).

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(Click to enlarge) Gold in USD and CFTC Gold Open Interest - 2 Years (Daily)

NYMEX crude is up some 0.4% to just over $90.00 (see long term chart below) and Brent crude remains close to $100 a barrel this morning. Oil's nearly 5% surge on Friday to end the week higher was ominous and the possibility of unrest spreading to other oil rich dictatorships such as Saudi Arabia is making investors nervous. The Middle East and North Africa produce more than a third of the world's oil and OPEC has warned of a possible oil shortage.

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Oil in USD - 5 Years (Daily)

Any speculative froth seen when gold recently rose above $1,400/oz has been removed from the gold market as can be seen in the gold futures open interest numbers. Open interest has fallen by more than a third since early September. Those short the market have once again managed to flush out the weak paper longs who have been shaken out of positions.

Open interest levels are now well below those seen after the last period of correction and consolidation in the first quarter of 2010 (see first chart above) and we may now have seen capitulation.

Short positions remain high and concentrated with a few market players, especially JP Morgan, and they are vulnerable to a short squeeze, should prices begin to move up again. This seems likely given the tight physical demand situation in the market internationally.

Further evidence of this was seen in the fact that premiums for gold bars in Hong Kong are at their highest levels in 17 years (since 1994) as Chinese, Indian and wider Asian buying continues. Deepening inflation has led to strong demand and the geopolitical instability in Egypt and the possibility that it could spread throughout the Middle East and North Africa will lead to safe haven buying. 

China Should Buy More Gold, Silver for Reserves - Chinese Central Bank Advisor

People's Bank of China adviser Xia Bin told the Economic Information Daily today that China should steadily increase its holdings of gold, silver and other precious metals. In an interview with the paper Xia said that holdings of gold and silver can help establish the yuan as an international currency by increasing China's final payment capacity. He advised buying precious metals on the dips and while gold and silver are marginally lower today, the remarks are another long term positive for the gold market.

Only last month, Xia made similar comments saying that the People's Bank of China should diversify their massive $2.7 trillion foreign exchange reserves away from US dollars and increase their gold reserves as a long term strategy in order to help internationalise the yuan. The Chinese wish to make the yuan an accepted international reserve currency and establish it as a currency that will be used for payment and settlement in international trade.

China's gold holdings, at 1,054 tonnes, remain miniscule compared to the over 8,000 tonnes held by the US Federal Reserve (gold only accounts for 1.6 percent of China's massive currency reserves). With the supply and demand equation already tight due to international investment demand and central banks having become net buyers rather than net sellers, even a small amount of diversification out of their US dollar holdings and into gold should lead to much higher gold prices.

The reference to silver was important as it marks the first time in modern times that a central bank advisor or official has spoken about diversifying currency reserves into silver. It shows how the Chinese view silver as money rather than as simply a commodity to be consumed. Indeed, the Chinese like most of the world, used silver as currency for most of their history.

The comments may signal the start of a growing shift from seeing silver purely as an industrial commodity to seeing silver more like gold - as both an industrial commodity but more importantly as a store of value and as money. As Milton Friedman pointed out, the major monetary metal throughout history was silver, rather than gold.

Gold

Gold is trading at $1,326.87/oz, €970.57/oz and £835.14/oz.

Silver

Silver is trading at $27.71/oz, €20.27/oz and £17.44/oz.

Platinum Group Metals

Platinum is trading at $1,782.00/oz, palladium at $803.50/oz and rhodium at $2,450/oz.