Precious Metals Market - Where I Was Right And Where I Was Wrong

Summary

• In this article, I am discussing where and why I was right or wrong about the precious metals market.
• Shortly: I was right about the US dollar and US 10-year Treasury notes.
• Despite being right about these important (for the precious metals market) instruments, I was too optimistic (or even wrong) on gold/silver prices.
• In the final section of the article, I am suggesting that gold prices are at their inflection point right now.

I want to start this week’s survey in a different way and revert to my article published on April 1, 2017 (titled "Gold Market - A Big Change in the Making"). At that time, my optimism on gold/silver prices was founded on two patterns delivered by the US dollar and the prices of 10-year Treasury notes.

US dollar

In April 2017, big speculators were very optimistic on the greenback and hold very large net long positions in US dollar futures (43.0 thousand contracts). I summarized this situation in the following way:

"Generally, strong rallies in the US dollar begin when speculators are bearish and hold net short positions in the greenback. Now we are very far from that so, in my opinion, the US dollar is poised to remain unchanged or go down. Both alternatives are supporting gold prices."

According to the last Commitments of Traders report, on June 27, 2017, the big speculators were holding a net long position of 5.5 thousand contracts. Simply, they were quite pessimistic about the greenback. What is more, the sentiment index (invented by Simple Digressions) calculated for the US dollar index is close to zero now:

Source: Simple Digressions

The chart also shows that it was the change in speculators' mood (from optimism to pessimism) a factor responsible for dragging down the US dollar from 100.6 on March 31 to 95.6 on June 30 (a decrease of 5.0%).

What about gold prices? On March 31, gold was trading at $1,247.3 per ounce, and on June 30, the price was $1,241.4 per ounce, so, generally, there was no change in gold prices.

Well, I am baffled because the common knowledge is that gold prices and the US dollar index go in the opposite directions. This time the US dollar went down but gold prices did not go up (fortunately for the gold bulls, they did not go down either).

10-year Treasury notes

Apart from the US dollar, in April 2017, I was confident that gold prices were supported by 10-year Treasury notes:

“Another - BIG - support for gold prices comes from US 10-year treasury notes. Over last four weeks big speculators were aggressively cutting their short bets on the prices of these notes. Over last month the net short position held by these traders went down from 409.7 thousand to 69.4 thousand (a decrease of 340.3 thousand contracts in just four weeks!). As far as I remember it is one of the largest and most rapid decreases in history. In most cases the result of such a change in sentiment was very positive for US treasury notes prices and, of course, negative for US market interest rates (expressed by US 10-year treasury notes yields).

Now, although it is real interest rates that control gold prices, in the short-term the US 10-year treasury notes yields may be considered as a nice proxy for real interest rates. If I am correct and we are ahead of a big drop in these yields, it may be a turnaround event for gold prices in 2017.”

Well, since that time the big speculators had reverted their net short positions in Treasury notes futures and now (June 27) they hold a large net long position of 302.1 thousand contracts. The prices of 10-year Treasury notes are also up (by 0.7%) but, as I noted in the section on the US dollar, the prices of gold remain generally unchanged (look at the arrows marked in violet):

Source: Simple Digressions

Summarizing - Despite positive developments in the US dollar and 10-year Treasury notes futures, gold prices have been very week since April 2017. In other words, although I was right about the US dollar and 10-year Treasury notes, I was wrong about gold prices. Simply put, it seems that there is a factor preventing gold prices from renewing its march up, initiated in the beginning of this year. However, the one million dollar question is “What is this magic factor?”

Physical markets

Before I try to answer this fundamental question, let me discus this year’s developments in the physical gold and silver markets.

Gold physical market

The chart below shows the changes in gold holdings reported by two large gold holders: the SPDR Gold Trust (NYSEARCA:GLD) and the iShares Gold Trust (IAU):

Source: Simple Digressions

Note: The rows marked in blue depict gold price changes in each month of 2017

The basic pattern emerges from the IAU chart - whenever gold prices were up, the ETF was adding fresh ounces to its vaults. The only exception to this pattern was June, when, despite lower gold prices, as many as 237 thousand ounces were added to IAU (the largest increase reported this year).

GLD was only a little bit different from IAU - in January, despite a significant jump in gold prices, 743 thousand ounces of gold were withdrawn from GLD. In June, similarly to IAU, GLD holdings went up by 162 thousand ounces.

Totally, this year both vaults added the following amounts of gold:

• IAU: 468 thousand
• GLD: 975 thousand

Interestingly, this year IAU added relatively more gold (an increase of 7.4% compared to the end of 2016) than GLD (a 3.6% increase).

Silver physical market

The chart below shows the changes in silver holdings reported by the world’s largest private holder of silver, the iShares Silver Trust (SLV):

Source: Simple Digressions

Here the pattern is much different than that delivered by IAU and GLD. Generally, each month SLV was reporting silver outflows, no matter whether silver prices were up or down. The only exception was May when a small increase in silver prices was accompanied by a large inflow of silver bullion (10.7M ounces).

Summarizing - This year the silver and gold physical markets behave differently. Gold is generally accumulated but silver is distributed.

What is going on with gold prices?

Now it is the highest time to present my thesis on gold. First of all, I have to disappoint my readers. In my opinion, it is impossible to predict financial markets. The only people, which are able to do it are charlatans and...I am not a charlatan.

Secondly, I think that the following four factors have the biggest impact on gold prices:

• Sentiment
• Real interest rates
• Physical demand/supply
• Fear

Of these four factors, the physical demand/supply seems to be the least important. For example, during the last bear market phase in gold, the Chinese withdrew vast amounts of gold form the Shanghai Gold Exchange, but this big demand had no impact on gold prices. I know somebody could say that this high demand was standing behind the end of the bear market in gold (in December 2015) but…well, the predictive nature of the relationship between demand and supply is very limited, in my opinion.

As for the fear factor - well, it is very, very hard to define it so...let me leave it now.

On the other hand, sentiment seems to be a nice tool to put a thesis on the direction of the gold or silver market. However, the question is how to construct an appropriate indicator of investor’s sentiment. At this point, I am sure that my readers are able to find a number of analysts offering various sentiment indicators. I also have my own tools as, for example, the US dollar sentiment index (discussed in the section on the US dollar) or the gold sentiment index:

Source: Simple Digressions

The chart above shows my gold sentiment index. The red circle points to the current reading. Well, generally, we are in the middle of nowhere or, in other words, the indicator’s reading is neutral now (or in its lower range of readings) so it cannot deliver a reliable message for medium-term speculators.

Real interest rates

In the long-term, the real interest rates seem to be one of the best indicators for gold analysts. Generally, when real interest rates are going down, the prices of gold are going up. And vice versa. Let me look at the appropriate chart:

Source: Simple Digressions and multpl.com

I think these charts show where the problem is. Since the beginning of 2014, the real interest rates remain generally unchanged (the blue, horizontal line on the upper panel of the chart) and the prices of gold follow this pattern and remain unchanged as well (the blue, horizontal line on the lower panel of the chart).

A short-term perspective seems to be less valuable for speculators:

Source: Simple Digressions and multpl.com

The yellow areas indicate the periods when real interest rates were going down and the red areas indicate the periods when real interest rates were going up.

Between November 2013 and March 2015, the real interest rates were in their downward trend, but gold prices, instead of going up, continued their bear market. I would say that at that time it was the sentiment that was the most important factor influencing the entire precious metals market.

Then, since March 2015 (up to now), the sentiment lost its luster and it was the real interest rates that became a leading indicator.

Now real interest rates are close to their higher trading range (0.8%), so, if the pattern repeats, gold prices should revert their ultra short-term downward trend soon.

Summarizing - There is the interesting interplay between sentiment and real interest rates. In my opinion, these two factors may be very helpful in determining the direction of the precious metals market. However, investors/speculators should keep in their minds that it is not easy to determine which factor is a leading one at the very moment. That is why it is impossible to predict financial markets…

Last but not least - let me show the GolDollar index chart:

Source: Simple Digressions

To remind my readers:

“The GolDollar Index was invented by Tom McClellan (www.mcoscillator.com), and is calculated by multiplying the price of gold by the U.S. Dollar Index. (We divide the result by 10 to keep the numbers from getting too big.) Its purpose is to cancel the effects of currency fluctuations on the price of gold. By comparing it with the spot gold index we can determine if there is inherent strength/weakness in the price of gold.”

The chart above indicates that the GolDollar index is at an inflection point, close to its very strong support (the violet line). Since 2005, this trend line was violated only once (at the end of 2015, shortly ahead of another bull market phase in gold).

Note: On Saturday, I launched a new segment on my Marketplace service called “Unorthodox Mining Investing”. This time the service is directed to medium-term traders in gold, silver and a few other markets (the list of financial instruments is still open). At the end of each week, I am going to publish a number of sentiment indices (constructed by Simple Digressions), which can be helpful to identify interesting entry points for opening long or short positions. If any of my readers are interested in this tool, please visit my Marketplace service.

Additional disclosure: I hold a long position in gold futures.

Analyst’s Disclosure: I am/we are long GDXJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.