Gold’s strong rebound upleg this year has been driven by big gold-futures buying. After abandoning gold last year, American futures speculators are returning to the yellow metal in droves. These capital inflows are a very bullish harbinger, as major futures buying is the primary fuel for young gold uplegs before investors return to take the baton. And this big gold-futures buying is likely less than half done!
From a pure fundamental supply-and-demand standpoint, gold’s crushing losses last year were solely attributable to record gold-ETF selling by stock traders. The World Gold Council’s comprehensive 2013 data showed that global gold-ETF outflows from epic share selling was actually a third greater than the total worldwide drop in gold demand! Without those extreme gold-ETF liquidations, gold wouldn’t have plunged.
Thankfully stock traders are just starting to buy gold-ETF shares again, resulting in capital inflows from the stock markets to gold for the first time in over a year. This critical mean reversion of investor interest in gold has barely even begun. So far, the flagship American GLD gold ETF has only recovered 1/25th of its bullion hemorrhaged in 13 months ending in January! Investors are driving this new gold-ETF holdings recovery.
But a major secondary factor in gold suffering its worst loss in a third of a century last year was record futures selling. In the first half of 2013, American futures speculators dumped gold at blistering sustained rates. Provocatively as soon as their outsized selling peaked mid-year, gold prices stabilized even though the heavy gold-ETF liquidations continued. Futures trading dominates global gold-price action!
There are multiple reasons for this. While gold trades universally in physical form, the actual prices vary slightly. The American gold-futures market provides one centralized price quotation that the rest of the markets can cue off. Actual gold bullion is costly and cumbersome to trade, but futures allow instant leveraged gold-price exposure to large hedgers and speculators. And gold futures have been around for decades.
American gold futures started trading in late 1974, when gold ownership finally became legal again for Americans after being banned for four decades by a Democratic president. Meanwhile GLD wasn’t born until late 2004, three decades after US gold futures started trading. So from a real-time-price and trader-sentiment perspective, American gold futures remain the only game in town. They truly are the gold price.
So just as extreme gold-futures selling slaughtered the gold price in the first half of 2013, heavy gold-futures buying is lifting it this year. The implications of this critical shift are very bullish. Based on multi-year averages, this gold-futures buying is likely only half done at best. As futures buying continues to push gold higher, more and more investors will be enticed back to strengthen and amplify gold’s new upleg.
It’s important to remember that futures are a zero-sum game. Every futures contract has one trader on the long side and another on the short side. The former is betting the underlying price will rise, and the latter that it will fall. Every dollar won by the winner is a direct dollar loss for the loser. Because of this core structure, the total number of longs and shorts outstanding in gold futures are always perfectly equal.
But there are two distinct groups of futures traders, hedgers and speculators. Hedgers actually produce or consume the underlying commodity, so they simply use futures to lock in their future selling or buying prices to minimize market risks on their businesses. But speculators trade futures solely in the hunt for profits, they have no commercial dealings in gold. Their highly-variable buying and selling drives the gold price.
Every week the main US futures regulator releases a great report called the Commitments of Traders that breaks down the futures positions held by both hedgers and speculators. The charts in this essay are built from that CoT data, revealing how American futures speculators are betting on gold. And they have been buying it aggressively, which is why the gold price has surged so nicely in the past few months.
This chart may look complex, but it’s quite simple. The green line shows the number of gold contracts that American futures speculators hold the long side of on a weekly basis. These are leveraged bets the gold price is going to rise, so the higher this metric the more bullish traders collectively are on gold. And the red line shows their bets on the short side, where higher numbers mean they are more bearish as a herd.
In order to grasp the implications of the big gold-futures buying this year, understanding the context of the big gold-futures selling last year is essential. Gold plunged 26.4% in the first half of last year, in three distinct selloffs that all had major futures-selling components. Last February, it all started when gold fell on a futures bear raid while most Asian traders were away for week-long Lunar New Year celebrations.
American speculators triggered this 6.7% 2-week decline by aggressively selling short gold futures. They effectively borrowed gold from other traders, sold it, and then hoped to buy it back cheaper later to repay their debt after its price had fallen. Speculators’ total short-side bets on gold surged about 50k contracts in that time! This is truly a vast amount, as each futures contract controls 100 troy ounces of gold.
The equivalent of 5m ounces of gold hitting the markets in a couple weeks, or 155.5 metric tons, was brutal. By that point in 2013, the total gold-bullion outflows from differential GLD-share selling was just 51.6t over 7 weeks. This pushed gold down near critical multi-year support at $1550, setting it up for April’s shocking panic-like plunge. Once that technical line in the sand crumbled, all hell broke loose.
As $1550 failed in mid-April, gold plummeted 13.8% in just 2 trading days! Gold hadn’t seen anything remotely close to that for three decades, it was crazy. That critical-support break triggered stop losses on speculators’ long gold-futures contracts, so they were forced to liquidate. This sparked margin calls on other traders, spawning a vicious circle of selling. Unfortunately the weekly CoT data masks this anomaly.
The CoT reports are current to each Tuesday’s close. Gold’s panic-like plummet in mid-April happened on a Friday and Monday, right in the middle of a CoT week. While many traders were getting stopped out of long contracts, many other traders were buying them aggressively since gold’s selloff was so extreme. So despite the minor weekly CoT changes, there was massive volume and churn within that week.
That event was so scary that it galvanized futures speculators into a hyper-bearish outlook. Just like at all extremes, they assumed that anomaly was the start of a new trend that would persist for some time. This led them to continue dumping gold futures relentlessly, making their bet a self-fulfilling prophecy. Between late April just after that plummet and early July, speculators fled gold futures at an unprecedented rate.
You can see this on the chart, the falling green line showing long positions being sold while the rising red one shows short bets growing. In futures trading, the price impact of selling an existing long position and selling to create a new short position is identical. The shorting accelerated as gold plunged again in June after Ben Bernanke laid out the Fed’s best-case timeline for slowing its QE3 debt monetizations.
Next page: Not a normal year