More thoughts on speculators versus commercials in the gold market

August 15, 2014

In the gold market, the Commercials are NOT the proverbial “smart money” with respect to forecasting price direction. If they were then they wouldn’t have been net-short gold futures, to one degree or another, during the entire 2001-2011 upward trend in the gold price.

The Commercials are also not the “dumb money” with respect to forecasting price direction. This is because, as a group, they do not bet on price direction. Instead, they generally attempt to make money on spreads and commissions, regardless of price direction. Furthermore and as previously explained, the Commercial position in the futures market is simply the inverse of the Speculative position. In order for speculators, as a group, to increase their long exposure and drive the price upward, the Commercials, as a group, MUST increase their short exposure. A rise in the Commercial net-short position to a high level is therefore a function of basic mathematics — a necessary offset to a rise in the speculative net-long position to an equivalent high level. We realise that this assessment has the disadvantage of being nowhere near as interesting as the idea that Commercial traders are conspiring to keep a lid on the gold price, but it has the advantage of being factually correct.

Recently, the relatively high speculative net-long position (and the offsetting relatively high Commercial net-short position) in gold futures has been acting as a bearish hook. The problem for the short-term bears who are ‘hanging their hats’ on the COT data is that while it is correct to view a sharp rise in the speculative net-long position as a sign that the market is short-term ‘overbought’ and vulnerable to a significant pullback, there are no absolute benchmarks when it comes to the COT sentiment indicator (that’s all it is: a sentiment indicator). So, although the recent peak of 166K contracts in the total speculative net-long position in Comex gold futures is high relative to where this indicator has been over the past year, it could be low relative to where this indicator goes over the next two months. It’s possible, for example, that a rally in the gold price to the low-$1400s within the next two months will be accompanied by a rise in the total speculative net-long position to 250K contracts. Imagine how bearish the COT-focused analysts will be if that happens!

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Speculators versus Commercials in the gold market

August 12, 2014

Speculators, not commercial traders, drive price trends in the gold market. The proof of this is the simple fact that the speculative net-long position in gold futures almost always trends in the same direction as the gold price (an increase in the speculative net-long position almost always accompanies an increase in price and a decrease in the speculative net-long position almost always accompanies a decrease in price). It is therefore fair to say that in the gold market, speculators are price makers and commercials are price takers.

An example is the 2-week period ended 1st July 2014. During this period a definitive upward reversal in the short-term price trend coincided with a large increase in the speculative net-long position. Specifically, the price quickly rose from $1272 to $1328 while the speculative net-long position in COMEX gold futures jumped by about 80K contracts.

As dictated by basic arithmetic, the 80K-contract increase in the speculative net-long position during the 2-week period ended 1st July went hand-in-hand with an 80K-contract increase in the commercial net-short position. These changes in the speculative and commercial positions are two sides of the same coin. One would not be possible without the other.

In general terms, speculators, as a group, could never increase their long exposure to gold futures unless commercial traders (primarily bullion banks), as a group, were prepared to take the other side of the trade and increase their short exposure to gold futures, and speculators could never reduce their net-long position (or become net-short) unless commercials were prepared to reduce their net-short position (or become net-long). This means that those commentators who rail against the short-selling of gold futures by bullion banks and other commercial traders are effectively railing against the buying of gold futures by speculators.

Moving on, a superficial comparison of the gold price and the commercial net-position in gold futures could lead to the conclusion that the commercials are always on the wrong side of the market, except at short-term price extremes. For example, ‘the commercials’ were relentlessly net-long during the final six years of gold’s 1980-2001 secular bear market and have been relentlessly net-short since the beginning of gold’s secular bull market. Looking only at futures positioning could therefore lead to the impression that the commercials have lost a fortune trading gold, but such an impression would be wrong. The reality is that the bullion banks (the biggest commercial traders) generally don’t care which way the gold price trends, because they generally don’t make their money by betting on price trends. Instead, their goal is to make money regardless of price direction by taking advantage of spreads (for example, spreads between the cash and futures prices and spreads between different futures contracts) and the charging of commissions.

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Evidence of manipulation?

August 11, 2014

The following chart from shows how gold traded during three 24-hour periods: 4th August, 5th August and 6th August. The green line shows the 6th August trading and is the line in which we are interested.

Notice the near-vertical surge beginning at 8.00am NY Time on 6th August. This represents a sudden increase in buying from ‘out of the blue’.

When this type of price action happens in the opposite direction, that is, when a sudden increase in selling pressure causes a near-vertical price drop, it is always cited by some commentators as evidence of manipulation, but when the sudden price change or price acceleration is to the upside it is never cited as evidence of manipulation. Instead, it is supposedly due to gold’s bullish fundamentals coming to the fore. The logic (using the word very loosely) goes something like this:

1. Markets that are free of manipulation always move in synch with the fundamentals. (Reality: No, they don’t.)
2. Gold’s fundamentals are always bullish. (Reality: No, they aren’t. For example, gold’s fundamentals were bearish from mid-2012 through to mid-2013 and only turned unequivocally bullish in April-2014.)
3. Therefore, whenever the gold price falls it must be due to manipulation. (Reality: Two wrongs don’t make a right.)

The fact is that there are just as many sudden, ‘inexplicable’ price rises in the gold market as there are sudden, ‘inexplicable’ price declines, but the manipulation-centric bloggers and newsletter writers only tell you about the latter. Also, experienced traders know that these sudden and often-unpredictable price moves happen in ALL commodity futures markets.

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Future “inflation” and the Fed’s madness

August 10, 2014

Prior to 2002 the Fed would tighten monetary policy in reaction to outward signs of rising “price inflation” and loosen monetary policy in reaction to outward signs of falling “price inflation”, but beginning in 2002 the Fed became far more biased towards loose monetary policy. This bias is now so great that it seems as if the Fed has become permanently loose.

The following chart comparing the Fed Funds Rate (FFR) target set by the Fed with the Future Inflation Gauge (FIG) clearly illustrates the change in the Fed’s tactics over the past two decades. The Future Inflation Gauge is calculated monthly by the Economic Cycle Research Institute (ECRI) and should really be called the Future CPI Gauge, because it is designed to lead the CPI by about 11 months.

The chart shows that prior to 2002 the FFR tended to follow the FIG. After the FIG warned of rising “price pressures” the Fed would start hiking the FFR, and after the FIG started signaling reduced upward pressure on the CPI the Fed would start cutting the FFR. (Note: My chart begins in 1994, but the relationship between the FFR and the FIG that I just described goes back much further.) During 2002-2004, however, the Fed not only didn’t hike its targeted interest rate in response to a sharp increase in the FIG, it continued to cut the FFR.

The Fed’s decision to maintain an ultra-loose stance during 2002-2004 was the fuel for the real estate investment bubble and set the stage for the collapse of 2007-2009.

There was a lesson to be learned from what happened during 2002-2007, but the Fed clearly learned the wrong lesson. The lesson that should have been learned was: Don’t provide monetary fuel for bubble activities, because the eventual economic fallout will be devastating. Unfortunately, the lesson that was actually learned by the Fed was: An economic bust can be avoided forever by keeping monetary policy loose forever. The result is that the divergence between the FFR and the FIG that arose during the first half of the last decade is nothing compared to the divergence that is now in progress. The FIG has been working its way higher since early-2009 and just hit a 5-year high, while the Fed’s ZIRP (Zero Interest Rate Policy) remains firmly entrenched.

Zooming in on the shorter-term fluctuations, last year’s small decline in the FIG suggested that there wouldn’t be a significant increase in the CPI’s growth rate until at least the final few months of this year, while the rise in the FIG that began late last year suggests that “price inflation” will start to become apparent in the CPI during the final quarter of this year and could be perceived as a serious problem during the first half of next year. This probably means that by early next year the T-Bond bears will start to look correct and the Fed will start to feel irresistible pressure to begin a rate-hiking program. Unfortunately, the US economy is now so rife with ‘bubble activities’ (businesses, projects, investments and speculations that are only viable due to artificially low interest rates and a rapid stream of new money) that a severe downturn is likely to follow an attempt by the Fed to ‘normalise’ its monetary policy.

By ignoring investment bubbles and erring far more in favour of “inflation” than it has ever done in the past, the Fed has set the stage for the mother-of-all economic busts. If the bust doesn’t begin earlier it is likely to begin soon after the Fed starts to raise its targeted interest rate.

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