There Will Never Be A 'Commercial Signal Failure' In The Gold Market

| About: SPDR Gold (GLD)

Editor's note: Originally published at tsi-blog.com on August 2, 2016.

Some commentators have been anticipating a "commercial signal failure" in the gold market for more than 15 years. Moreover, whenever the gold price experiences a large rally, the same commentators routinely cite the potential for a commercial signal failure (CSF) as a reason to maintain a full position, the argument being that the coming CSF is bound to result in massive additional price gains. The reality, however, is that whereas a CSF is an extremely unlikely event in any commodity market, in the gold market it is an impossibility.

A CSF theoretically becomes possible in a commodity market after the price has been trending upward for some time, and speculators, as a group, have built up an unusually large net-long position in the commodity futures. Naturally, if speculators have a large net-long position, then "commercials" have an equivalently large net-short position, since one is a mathematical offset of the other.

Commercials are generally hedging or spread-trading, so once they have established a position, they will usually be indifferent with regard to future price direction. Whatever they lose on the futures, they will make in the physical, and vice versa. However, in some commodity markets, it is possible for the supply or demand in the physical market to undergo such a sudden and dramatic change that exploding margin requirements on the futures side of a commercial trader's hedge or spread-trade could force the commercial to exit (buy back) the short futures position, even though the short position in the futures is "covered" by a long position in the physical. For example, take the case of a wheat farmer who has locked in the price of his yet-to-be-harvested crop by selling wheat futures. If extreme and unexpected weather suddenly causes a moonshot in the wheat price, then the farmer might - depending on how his price hedging has been structured - be faced with a huge margin call on his futures position and forced to exit his hedge, even if his own crop is unaffected by the extreme weather. Exiting the hedge would involve buying wheat futures into a sharply rising market, which would only exacerbate the price rise.

If it happens on a marketwide scale, the hypothetical case of the wheat farmer described above could be part of what's called a "commercial signal failure". The so-called signal failure involves commercial traders being forced, en masse, to cover their short futures positions at large losses, despite the short futures positions being offset by long positions in the physical commodity. By definition, it can only happen when speculators have built up a large net-long position in the futures market (meaning, when commercial traders have built up a large net-short position in the futures, thus generating the bearish warning signal), a situation that will usually only arise after the price has been in a strong upward trend for several months. Due to the CSF, speculators on the long side make more money more quickly than they were expecting.

However, even in a market where a CSF is technically possible, a prudent speculator would never bet on it. The reasons are that: 1) a CSF requires a sudden and totally unpredictable change in either supply or demand; and 2) CSFs almost never happen. In the rare cases when a CSF happens, it tends to be the result of an unexpected supply disruption. In agricultural commodities, the most likely cause is an unforeseeable bout of extreme weather.

Major supply disruptions are possible in the markets for all agricultural and industrial commodities, but they are not possible in the gold market. This is primarily because almost all the gold ever mined still forms part of the supply side of the equation, which means shifts in the current year's mine production will always be trivial relative to total supply. In other words, in the gold market there is no chance that a CSF could be caused by a major supply disruption.

Although a major supply disruption is not possible in the gold market, there could at some point be a large and unanticipated demand disruption (note that the bulk of the world's gold is demanded (held) for investment, store-of-value, speculative or monetary purposes). However, such a disruption would not cause a "commercial signal failure" - it would be the effect of a total monetary system failure.

A "commercial signal failure" is, by definition, an event that results in bullish futures speculators making large and rapid gains, but bullish speculators in gold futures could not profit from a total monetary system failure. In fact, they would be big losers, because the futures market would shut down in such an outcome.

The bottom line is that it is not a good idea to bet of a "commercial signal failure" in any market, because the probability of it happening is extremely low. It is, however, a particularly bad idea to make such a bet in the gold market, because in the gold market, the event has a probability of zero.