It’s hard to believe that a 3,000-year-old market can be so vital and dynamic in our current modern society. The recent batch of economists’ mantra want you to believe that gold is a static market because it pays no interest, so it has no returns just like the T-Bill market. That’s all good in the economics classroom with your PC-edited school book for the Econ #101 studies, that is, until when you enter the modern trading offices where gold is held as an underlying currency that is hedged around the globe 24/7.
Then options are structured and written against the metals underlying value as it spreads out in calendar trades spanning many years into the future to produce a yield curve on multiple exchanges.
In today’s markets, gold is as dynamic as any other asset and it certainly is as sophisticated in the trading world as any synthetic swaps trades in the bond world. The underlying difference, at the end of the day, is that you own gold, and not paper.
Peering into the looking glass at today’s global situations we are forming a broad base in the gold market after its rather percipitous fall, which shouldn’t be ignored. So, let’s take a look at what’s forming this basing action.
After what was close to a decade of battling in Afghanistan, you would have thought the Soviets/Russians would have learned their heartfelt lesson. The idea that Russian President Vladimir Putin is back fighting on sand again could really be the final straw on the camel’s back which could lead to the final break in the Russian economy. Let’s add to this lesson that the Russians just buzzed the Turkish border to announce themselves being there again, and for the effort they were promptly fired upon and had one of their jets blown out of the sky by a Turkish surface-to-air missile. Putin is by no means a foolish man but whatever the end game is here, it is helping to build a base under the gold market and drive my bullish meter into the green side again. Fear and uncertainty are still prime fundamental drivers of gold and having the main cold war combatants with uncoordinated bombing missions going on simultaneously in the same country is a concern.
On the consumption side, demand for metals in the East is nothing short of staggering. I’ve been trading metals ever since for several decades and have not even seen the consumption of gold like we have in just the last few years. Leading off with China, India and then Russia, the amounts are reported in tons every month. Russia just walked into the market and bought one million ounces of gold last month and they’re not the biggest player in metals by any stretch of the imagination. It is my belief that countries that haven’t been able to form a true recognition of their currency on modern trading exchanges--in order to trade and hedge their currency--are buying all the gold they can get into their vaults to formulate swaps in the business community to meet current and pending debt. These swaps also are forming a base or underlying zone to hold, and as of late, drive up the metals.
The final reason I’m now friendly to the metals market is the total failure of major companies to properly hedge integral risk inherently associated with market movement in the commodities arena. Glencore being on the brink of collapse with its debt estimated at $30 billion, for which Glencore claims today that it is still financially robust, presents the market with a double-edged sword. Glencore is going to have to liquidate metals in their warehouses to meet creditors debt demands. This should apply some downward pressure as product comes to the market, but in the long run it’s one less major producer, which will continue to feed the current metal shortage condition for some time to come.
Gold is one of the only commodities where its value is even or higher on the year, and the underpinnings just keep getting stronger as Western society continues to believe that printed paper
is worth more than the hard assets that come from the earth. The rest of the world seems to disagree and the consumption of gold continues to flow into the vaults of offshore depositories at record paces as the western giant sleeps.
By the first Commitment of Traders Report in August commercial traders had been buyers of gold for five straight weeks and the flush caused by that morning’s July Employment Situation Report was probably the short trap gold needed to mount a reversal. We saw $1,150 per ounce as our upside target.
Gold prices are determined by several factors, including inflation fears, the strength of the U.S. Dollar, interest rates and foreign reserves. These are macroeconomic events that require synchronicity to generate a sustained trend. We believe these processes are not currently in sync and that while pockets of fear can create spikes, these spikes remain selling opportunities for gold traders into next year.
The interest rate picture appears neutral in the wake of the Federal Reserve Board’s recent inaction. Also, the commercial trader position in the 10-year Treasury note is net long nearly 48,000 contracts, which pales in comparison to its range during the last 10 years: Long 500,000+ contracts (April 2005) and short nearly 520,000 contracts (August 2007). During the last year, commercial traders have successfully played both the long and short side of the interest rate sector as we all await the Fed. Odds favor inaction at the October meeting.
Looking out to 2016, the Fed has only raised rates four times in an election year. In spite of this, we feel the Fed will do so by the March 2016 meeting. Finally, we see a rate hike as U.S. dollar-positive as the world searches for high-quality yields.
The U.S. dollar provides a much stronger case for declining gold prices. The price of gold typically becomes cheaper as the dollar gains strength. Interest rate hike or not, we see the dollar strengthening because of a number of factors. Cash must be parked somewhere. Arguments regarding the U.S. dollar’s safe haven status were quickly resolved when China decided to devalue the yuan. Are they finished? Who knows? By the way, does anyone remember Greece? There are many reasons to own dollars in the current environment; all of these are negative for gold.
The dollar has worked itself into a bit of a pickle given its recent consolidation. In fact, we believe this may be one instance where the commercial traders may have gotten the trade wrong. Commercial traders set a new short record on the spring rally, eclipsing their previous net short record position by more than 50%. This helps to explain the buying surges we’ve seen on any dollar decline. More importantly, their August and September purchases have helped to create and strengthen the upward sloping trend line off these lows, which now comes in at 95.15 in the December contract. This consolidation is contained on the high side by the downward sloping trend line from the March highs, now coming in at 97.20 in the December contract. This pattern is beginning to project a cup and handle formation, which would be triggered by a close above the downward sloping trend line.
We often portray the commercial traders as being macro value traders. Their positions are designed into their business models and the results play out over quarters and years. Commercial miners were too early in selling their forward production as they set a record net short position of more than 300,000 contracts around the price of $1,166 per ounce in June of 2009. Commercial traders on the short side clearly became concerned, repurchasing more than 230,000 contracts between May and October 2012 as the market rallied toward $1,750. Meanwhile, those who’ve waited have seen the market return to the $1,186 level as it made the recent lows near $1,073. The recent covering of these shorts has brought the net commercial trader position to short 73,000 contracts. Believe it or not, this is far closer to their record long position of plus 88,000 contracts set in 1999 than it is to their record short position of 308,000 set in December of 2009 as that rally peaked. This places the commercial sellers in charge of capping gold spikes with plenty of reserve capacity for forward sales.
Whether looking at the surrounding factors that influence gold or the actions of the commercial gold traders themselves, we see far more evidence pointing toward a cap on gold prices through the end of the year, and will be looking for selling opportunities on spikes in this market as the $1,150 to $1,200 area that had acted as support turns into resistance.