Gold: Record Level Of Short Interest And Potential Triggers

Summary

• Managed money short positions is now at a record level where spikes  have indicated a reversal several times during the last few years.
• Inflation is climbing and for how long can the FED keep raising rates without causing an economic slowdown.
• Stock market valuations are lofty to say the least, was the Facebook Q2 report an early indication that expectations has gotten ahead of the market.
• Geopolitical risks are presently being ignored, but there are plenty of potential triggers.
• Sooner or later deficits will matter.

Investment Thesis

Gold (NYSEARCA:GLD) has been declining over the last four months from $1,350/oz to $1,220/oz and the sentiment is far from positive. There are however a number of potential triggers that can reverse the slide. The record level short interest in gold has the potential for a short squeeze if the market factors in any of the potential triggers.

Short Interest

We are presently at record levels for managed money short positions, which has increased during the decline i the gold price over the last few months. While in itself inconsequential, the positions have the potential to create a sharp reversal if gold were to catch a bid. We have seen similar but smaller spikes over the last few years and it has been common to see the price of gold to increase from those levels as managed money has been forced to cover.

COMEX Gold Combined Managed Money Short Positions data by YCharts

Figure 1

Uptick in Inflation

Over the last few years we have seen increasing growth rates for both consumer prices and producer prices. The below chart illustrates this trend. As both the short and long term interest rates have increased, the market has so far not been overly concerned by this trend.

Figure 2 - Source: TradingEconomics.com

We have high levels of debt across the world for Governments, Corporations and Households. When one considers the debt levels in the system, we will reach a point when interest rate hikes will slow economic growth as the portion of income required to service the debt overtakes discretionary spending. The big question is if that point is 3% for the 10-year rate, 4% or even higher than that?

Figure 3 – Source: Bloomberg.com

While it is important to point out that the overall U.S. delinquencies is far from what we saw during the last recession. We have seen an uptick specifically in consumer and credit card delinquencies which is worrying when we consider how low the overall interest rate is, coupled with the overall debt level. I view the numbers as troublesome already, but it is not a stretch to consider that if they give, the numbers could climb much steeper than what we have seen in the past due to the accumulation of debt during last decade of low interest rates.

Figure 4 - Source: fred.stlouisfed.org

We all know the FED has been wishing for inflation for some time now. I doubt trade barriers is what they wished for just as inflation has reappeared. This will naturally fuel inflation even more.

If the trade war escalates and inflation continues to accelerate, I deem the probability that the FED will be able to keep raising rates without causing an economic slowdown as highly unlikely. The FED is independent to be able to make the tough choice and focus on inflation in this scenario. Call me cynical, but I expect Trump will twitter Powell into submission if it comes down to it.

Geopolitics

President Tump certainly has his own style for dealing with foreign political adversaries. The strategy seems to be entail various threats or ultimatums. There is no denying this strategy has so far seemed very effective when dealing with North Korea, but it feels like a risky strategy.

If we consider the sheer number of potential disputes. With countries generally assumed to be allies to the U.S., China over trade, sanctions on Iran and Russia. Please note that I am not referring to war here, but it just takes one of the adversaries to fight back hard to cause an increased focus on geopolitics which would be beneficial to gold.

Stock Market Valuations

Whether we are at all time high for U.S. stock market valuations or just a very high valuations depends on the the ratio one chooses to focus on. Other factors discussed will certainly have an effect on stock market, so what I specifically refer to here is the the fact that the stock market declines from the weight of the expectations. It is more common to see the stock market decline from specific triggers, but when the valuations are this elevated we could also see a decline without a specific trigger as we saw in the year 2000.

Figure 5 - Source: multpl.com Shiller PE

The recent Facebook Q2 report is a good example of what can happen when valuations and expectations are very high. If we also factor in the increase of passive investments and program trading over the last decade, it has the potential to fuel a decline when the trend in the stock market reverses.

Government Deficits

U.S. Government Debt to GDP is at a level where increasing interest rates will not only affect consumer or corporate spending, but also government spending much more than what we have seen historically. So far the fx market has voiced little concern over the growing government debt levels and deficit spending. In part this is due to the fact that we have seen significant government debt and/or spending levels in many countries around the world.

Figure 6 - Source: TradingEconomics.com

Figure 7 – Source: Bloomberg

Many would argue the U.S. Dollar will naturally be the safe heaven when the next crisis hits and the price of gold will decline as we saw during 2008. While that is certainly a possibility. If we consider the performance of the gold price five years prior to today in comparison to how it performed up until 2008, I think the probability of gold performing well is a far more likely scenario.

Figure 8 - Source: TradingEconomics.com

Government debt levels and deficits were minor concerns back in 2008, since then we have seen what happens with countries like Greece, Portugal, Spain, Italy, Ireland, Iceland and more recently Argentina and Turkey. While I am not claiming the U.S. will be treated equally harshly, the increased attention to government finances over the last decade will likely increase the scrutiny of the U.S. debt level and deficit as well. This would work in gold's favor.

Conclusion

While gold has been trading lower over the last four months, the long term reasons for holding gold are as valid as they have ever been.

The trade barriers, geopolitical tensions, stock market valuations and increasing costs to service debts could serve as catalysts in the short to medium term.

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Tahoe Resources

Polymetal International

Analyst’s Disclosure: I am/we are long GLD. 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.