Blog 2 Columns

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.

The following chart from Kitco.com 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.

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.

A lot of nonsense has been written over the past several years, and continues to be written, about a general shift away from the US$ towards alternatives such as the euro and the Yuan. For record purposes, here are some facts:

1) Shares of global trade settlement, according to SWIFT (Society for Worldwide Interbank Financial Telecommunication):
- In June-2014 the US dollar’s share was 40.2%, which is UP from 29.7% in January-2012
- In June-2014 the euro’s share was 31.3%, which is DOWN from 44% in January-2012
- In June-2014 the Yuan’s share was 1.5%, which is UP from 0.3% in January-2012

2) Shares of global FX turnover, according to the BIS:
- In 2013 the US dollar’s share was 87.1%, which is UP from 84.9% in 2010
- In 2013 the euro’s share was 33%, which is DOWN from 39% in 2010
- In 2013 the Yuan’s share was 2.2%, which is UP from 0.9% in 2010

So, the US$ has gained in popularity over the past few years as an international medium of exchange for use in both trade and investing. The Yuan has also gained in popularity, but none of its gain has come at the expense of the US$ and its share of global trade and capital flows remains trivial. The euro has been the big loser.