Gold has staged a spectacular rally over the past few days and there are a few important things to note:
- The precious metal bounced after dipping below $700
- On Thursday gold strengthened alongside the dollar. Friday then saw a massive jump with follow through buying today.
- Gold's role has reversed from safehaven focus to dollar focus - it has been rallying along with the market.
Role Reversal
As the crisis unfolded, it was common to see gold strengthening alongside weakening equities - now we are seeing the opposite. Why? Well simply because we are not rallying on fundamentals but rather the prospect of government bailouts. In other words, the markets are only being supported through inflation. Another inflationary development over the weekend saw several OPEC members calling for massive production cuts to support the price of oil - another positive for gold. All of this has led to a massive rally in gold.
Gold Shares
Gold mining shares have significantly underperformed gold year-to-date. In my opinion this is largely a reflection of the massive run-up in energy prices - a major input in the mining process. With the gold/oil ratio back to a justifiable ratio, gold shares may have a lot of room to run here, should gold continue up.
click to enlarge images
However, there are a few things to take into account here. Firstly, should gold rise for the reason of a weakening dollar, global bailouts and currency debasement, then oil should rise as well for the same reasons. Oil also has another non-market force - OPEC. These guys are going to do whatever possible to support oil prices. Then there's the general theme of risk aversion and the pressure that it puts on equities and the fact that many gold miners are debt burdened. If you choose to pursue the gold miners, do your research.
Gold Miners Hedge Books
There has been a lot of de-hedging going on and the following chart, courtesy of timingcharts.com, shows what's been going on with the gold producers' (commercials) hedge books. The commercials (who are almost always short), are less short than they have been for a long time. In other words they are bullish.
At the height of the gold bull market, commercials were VERY short. When the World Gold Council released its last quarterly report, it was obvious why they were so short - Gold demand was down significantly. Obviously the gold producers have extra insights into demand patterns. When the World Gold Council released the most recent quarterly report, demand was back on the rise again (mostly due to retail investment demand) and the trend in global de-hedging over the past few months reflects this insight.
As you can see in the chart above, the past few times that the commercials held such small short positions, the market rallied.
Back to Inflation/Deflation
I have been arguing for gold to come down significantly as its purchasing power over other real assets had increased significantly. I first made this argument with gold in the high 800's and when the precious metal failed to break 700 I largely abandoned the position from a trading perspective. I am now more neutral - indecisive is a better word.
Bloomberg reports that the Fed has pledged $7.4 trillion thus far, that's enough to scare anyone shorting gold and should also be enough to avoid deflation. James Hamilton argues that the Fed doesn't need to worry about deflation because they can simply continue to inflate.
I have also been arguing about the existence of a liquidity trap where the Fed pumps money into the banking system but the banks don't lend it out. According to TradeTheNews, the Telegraph reported that the UK Treasury officials may be mulling draconian laws which could limit the interest rate charged by banks. That's one possible solution, but I don't see the U.S taking similar action. They will try to monetize the credit that they are pumping into the system but they are more likely to do so by monetizing government debt. By buying long term government bonds, the Fed is ultimately printing to cover the expense of the bailouts. Obama's proposed stimulus focusing on infrastructure, alternative energy and modernizing public schools will likely be the way that this credit makes it out to the markets and gets diluted in the pool of fiat money. They can continue giving money to banks, but anything short of the strategy suggested by the Telegraph will likely not result in the monetizing of that credit.
Conclusion
For now I will remain somewhat neutral but watching closely for year end swings. As Ashraf Laidi points out, we could expect to see seasonal reversals heading into the final stretch of the year. The prime candidate for such a reversal is the dollar and the catalyst could very well be the automakers. The story of the past few months has been the rest of the world weakening to catch up to the U.S. Now it may be America's turn to take the lead again as we head into what could be a disastrous holiday shopping season. How gold will respond to these events remains to be seen, but it will surely be a volatile ride.
Disclosures: Author holds OTM gold calls
