Gold: the BIG bull, but is it?

[Zack Zarr 5]

By now, everyone is most likely aware of the big rally Gold had last week to break the $1400 level and highest level in the past six year!

And that is exactly what happens when a commodity price or a currency pair breaks our/down from a multi-year range. These events are generally indication of big macroeconomic event coming ahead. People talk about things like stock market top (every one putting their money into safe assets like Gold), Fed starting to cut rates, etc. Generally, there are two sides of to a story that people choose to believe in. The Headlines vs. the Data! This post summarizes my view on the current state of Gold price and what seems to be a statistically viable scenario.

The Headlines

As mentioned, every finance new outlet, and blog is talking about the great bullish action that is happening for Gold. There are clear evidence of governments and central banks piling up Gold in their reserves. See links such as this one and this one talking about how Russia and China have been stocking Gold for the past few years. Similar news can be found for other central banks around the world. so there is a clear evidence that Gold has been on demand for quite a while. But, is it clear that these giant entities keep piling up Gold at these current prices? 

Also, in almost all cases, the top headlines are generated by the big investment banks who have been already long on Gold way before and it is time for them to take some profit on those longs. I accept the fact that there is a case for Gold bullishness but buying it at the current level is just too risky. As someone who has been long on Gold since $1195 (see my posts here and here), I am now thinking of taking profit on the last few long trades I had left on Gold and adding shorts.

Fundamental Data

It has been somewhat understood that whenever the Fed starts cutting rates, Gold has a bullish reaction. The chart below shows examples of the past decade. And we know that the Fed has already stated their intention to cut rates and the dot plot shows the potential for two rate cuts this year. 

So from the correlation between the interest rates and Gold price, we should expect more bullish action in Gold. But, I'd still argue that the recent rally in Gold was some sort of a response to the news of Fed cutting rates. So some impact of the rate cut is already priced in the Gold price. Plus the fact that the next rate announcement is in almost three weeks. I expect a retracement in Gold price.

 

COT Data

As you all know, I am a big fan of the COT data and the actions of the large speculators. Looking at the past history of these traders' action in a graphical representation is a good way of predicting their thought process. The chart below shows the long and short positioning of the large speculators (non-commercials) vs. commercial institutions. The two graphs at the bottom are simply the relative percentage of current long/short contracts over the preceding year (for more detailed information, please see this A Deep Dive into Commitment of Traders Data Analysis).

Over the past decade, the large specs reduced their shorts down to 30% of the maximum amount in the past year which always coincides with the price topping. Based on the COT data of June 25th (now recent data released due to holidays), their shorts has reduced down to 28% while their longs is the highest level in the past year. In other word, they are extremely long with not much short positions to hedge against any drop. That is a tough position to be and very fragile.

Looking at the change in the sum of longs and short positions during the price drops and rallies indicates a typical single stage or two-stage behavior.

In a two-stage behavior, the large specs usually reduce their initial positions before adding to the opposite trade. For ex. the rally in price in the beginning of 2016 shows the initial closure of 78K shorts and adding 68K longs while the second stage shows significant long adding of 142K contacts. In the next price drop following that rally, the initial stage consists of mostly profit taking on longs while the 2nd stage has more short adding.

In single-stage scenario, they usually add a large amount of either longs or shorts and they immediately close equivalent number of same trades in the following price drop/rally. The current positioning of the large specs seems to a of one-stage type. They have added a significant amount of longs while closing more shorts on the way up. There is not much shorts left for them to hedge against the next drop and that means they have to close many longs. So the price could linger in the current levels for a while for them to build some shorts and reduce their long exposure. That could easily take up to the next Fed announcement.  Either way, adding such a large amount of longs over only a month seems a very risky to me. They will take advantage of any price rally to reduce those longs. Regardless of how careful they are, closing those large longs will create a drop in price.

Please comment below you questions and feedback.

 

Cheers,

Zack

[Dr. Winston O'Boogie 2]

Below is a 40-year chart of the M2 money supply which, as can be seen, began going parabolic in March. 

During and after the Great Recession / Financial Crisis the Fed did a lot of Quantitative Easing (QE).  People referred to this as the Fed "printing money".  Okay, fine, but "money" is actually a fairly slippery concept.  I would argue that a more accurate and helpful description is that  the Fed was printing "base money" in the form of bank reserves, not "actual, usable money" such as M2. 

On settlement day, when the Fed has to pay the primary dealers for its bond purchases, the Fed simply taps on a computer keyboard and credits (out of thin air) the primary dealers' reserve accounts at the Fed.  These bank reserves are like an inert gas - they stay at the Fed and don't DO anything unless and until banks convert those reserves into customer loans- something banks didn't do all that much of compared to the quantity of bank reserves that was being created by QE.   

What's different this time around is that the Fed and the Treasury Department are working in tandem:  The Treasury Department deficit spends (economic stimulus programs) and the Fed is in effect monetizing (buying) the debt the Treasury Department issues to finance said deficit spending.   Also, this time around the Treasury Department has provided the "equity tranche" (first-loss piece) capital for new Fed programs (such as the Fed's Main Street Lending Program) in which the Fed is doing an "end-around" the commercial banks (who have little to no appetite to lend in this uncertain environment) and lending directly into the economy.  This time around these coordinated efforts between the Fed and Treasury is resulting in the "printing" of "actual, usable" money, as is evidenced by a surge in M2 (the likes of which have never before been seen) and not just the printing of inert banks reserves.  

IMHO, this is the primary reason why gold has been rallying and (while normal market pullbacks and bouts of profit taking can be expected from  time to time) will probably continue to rally as the U.S. government continues to try to plug the economic holes caused by the pandemic. 

I like to think of it this way:  The "real / actual, / intrinsic" value of gold is a constant - it doesn't change.   That said,  nominal U.S. dollar price of gold moves higher as more U.S. dollars are created.  

 

XXX's and OOO's (virtual, of course)  from your most humble of macro servants,

Winston