Gold: Extreme Conditions Draw The Opposite Scenario

by: Simple Digressions


Gold is in its medium-term downward trend, driven by a strong US dollar and weak treasury note prices.

These days the speculators trading US dollar futures are extremely optimistic about the US currency.

On the other hand, the speculators trading US treasury notes futures are extremely pessimistic, heavily betting on lower prices. What is more, they demonstrate the highest pessimism in modern history.

History teaches that extreme conditions create the opposite scenario. If this thesis is correct, a medium-term bear cycle in precious metals should be close to its end.

However, as discussed in the article, I am not recommending to take a long position in gold or silver just now.

In my opinion, a strong US dollar and weak treasury notes prices are a poisonous mixture for the precious metals market. And vice versa. In this article, I am trying to look at the relationship between the US dollar, US treasuries and the precious metals market. Although the recent pattern printed by these instruments are highly negative for gold and silver, history teaches that extreme conditions create a totally different scenario than everybody thinks.

Positive scenario

The chart below shows three instruments: the US dollar (upper panel), 10-year treasury note price (middle panel) and gold (lower panel):

Chart 1

Source: StockCharts

Now, the red arrows point to the periods of a weak US dollar while the blue arrows point to the periods of strong treasury note prices. The final outcome is visible on the lower panel of the chart: During these periods, gold was in a strong upward trend.

Now, let me see what happens when the US dollar is strengthening and treasuries are weakening.

Negative scenario

Chart 2

Source: StockCharts

This time the red and green arrows point to the periods of weak treasury note prices and a strong US dollar, respectively. The result of this poisonous mixture is on the lower panel – it is easy to spot that during these periods, gold was in a steep downward trend.

What is more, what we see today is a negative scenario in action (Chart 2 - the area marked in pink). Since the beginning of April 2018, the US dollar has strengthened by 7.1% while the treasuries weakened by 2.8%. As a result, gold went down from $1,350 per ounce to $1,192 (a drop of 11.7%), making the gold bulls unhappy and wondering whether the last bull market in gold was just a fading memory.

Well, as usual, my first answer is always the same: I have no idea. Financial markets are unpredictable and, unless somebody has a crystal ball, there is no one to give the right answer. On the other hand, there are some tools that can help to “read” the market as, for example, the Commitments of Traders reports. Let me look at the recent data disclosed in these reports – in my opinion, there is a light at the end of the tunnel…

What happened most recently?

Before I raise my readers’ hopes, I have to cool them down once again. Amid rumors of another rate hike a few days ago, the prices of US 10-year treasury notes broke below their bottom (established in May 2018) at 118.2. It means that the negative scenario discussed above has got additional support.

Interestingly, this time, gold did not follow the typical pattern – instead of breaking down, it holds pretty well above its short-term support at $1,170-$1,180 per ounce. And, in my opinion, it is the first indication that a negative scenario may be close to its end.

Now let me refer to the Commitments of Traders reports. The charts below show the current net positions held by big speculators trading the US dollar index and US 10-year treasury notes futures:

Chart 3

Source: Simple Digressions and the COT data

Note: A net position held by speculators is measured against the total open interest.

I guess it is easy to spot that:

  • The speculators trading US 10-year treasury note futures hold an extremely large net short position. It means that they are extremely pessimistic about US treasuries. What is more, their pessimism has reached a level never seen in modern history (the green circle).
  • The speculators trading US dollar index futures hold a large net long position. In such a case, I am saying that they are extremely optimistic about the greenback. In other words, every speculator bets on a stronger US dollar.

Now, in my opinion, each time everyone is in the same camp, the market turns in the opposite direction. In our case, it means that there is a good chance that the US dollar is going to weaken and the treasuries to strengthen. If I am correct, a negative scenario (for gold) is very close to its end. Let me check this thesis looking at what happened in December 2016.

At that time, since middle 2016, gold was in its steep downward trend (look at the Chart 2), driven down by a strong dollar and weak treasuries. As usual, each speculator was betting on the continuation of this pattern:

  • The speculators trading US dollar index futures were holding a large net long position (65.9%; today their net long position is 69.4%).
  • Other traders in US 10-year treasury notes futures were holding a large net short position of minus 11.2% (minus 18.6% today).

The final outcome was totally different than everybody thought – over the next few months, gold went up 20%.

What is the takeaway for investors?

I guess the general takeaway is pretty simple: if everybody is in one camp, do the opposite.

Today everybody is betting on a stronger dollar and weaker treasuries. As a result, gold is prone to go lower. As discussed above, in such a case, the best idea is to go against the market.

However, I prefer a bit different, less risky, approach:

  1. If everybody is in one camp, do not do the opposite (do not go against the market). It is too risky because in the short term, even a market driven by high pessimism/optimism may still go a bit lower/higher.
  2. However, stop trading in the direction set by the mob. In other words, if everybody is in a bull camp, close long positions. And vice versa.
  3. Further, when the market turns, it very often enters a very boring, trading range pattern. In our case, it looks like these days, gold is trading in such a range (between $1,170 and $1,220 an ounce). Therefore, I think it is a good idea to wait and do nothing until gold breaks above $1,220 per ounce. If that is the case, a contrarian speculator may think about taking a long position in gold.

Now, this approach is not a trading manual. It is just my personal view on the market supported by a few verifiable tools as the Commitments of Traders report. Interestingly, although these reports are not perfect tools, they work pretty well at extreme conditions. And today, these conditions are “extremely” extreme – everyone is in one camp.

Finally, in weekly reports published on my Marketplace service, I am trying to “read” the markets and provide my subscribers with an unbiased approach to a few financial instruments related to the precious metals market. If anyone is interested, please, try me. It costs nothing.

Disclosure: I am/we are long CEF, GDX.

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.