Commodities/Forex

Andy Hecht

Top 3 Ranking in Commodities, Metals & FX --SeekingAlpha

Thoughts On Gold After Another Price Failure

  • A disappointing week
  • Higher rates are toxic for the yellow metal- In the short-term
  • A big hand hovers over the dollar- Gold can move higher with the dollar
  • Europe is a basket case
  • Gold is the leader in the precious metals sector, and that will continue

Gold hit a low at $1161.40 on the active month COMEX futures contract in mid-August 2018 which was the lowest level since early 2017. While silver came within 22.5 cents of its late 2015 bottom and its critical level of technical support last year, gold remained $115.20 above its 2015 low and technical line in the sand on the downside. It is no secret that gold has outperformed silver, last week, the ratio between the two metals rose to a new high for this year, the decade, and since 1993 at over 86 ounces of silver value in each ounce of gold value.

The ratio dates back to the first Egyptian Pharaoh, Menes, who in around 3000 BC, proclaimed that two and one-half parts silver equal one-part gold. In modern times, since the 1970s, the median level for the ratio has been around the 55 ounces of silver value in each ounce of gold value level. When the ratio falls below the midpoint as it did in 1979 and 1980 and 2011 gold tends to be on sale compared to the price of silver. Today, at a quarter-of-a-century high, gold is the more expensive of the two metals, and for a good reason.  Central banks around the world hold gold as part of their currency reserves, and they have been net buyers over recent years. Moreover, sentiment has driven investors to go for gold rather than silver as a haven of safety for their portfolios.

The advent of ETF and ETN products made gold more accessible for investors who had to venture into the physical or futures markets before the new millennium for direct investment in the yellow metal. While gold mining shares offer exposure to the ups and downs of the gold price, producing companies come with a set of idiosyncratic risks.

I am bullish on gold and believe that the yellow metal will work its way to the $2000 level over the coming years. I think that the price could rise much further, but as I have learned, picking tops and bottoms in markets is a challenge that is above the pay grade for a fundamental trader or investor. I will leave exercise to the experts like Avi who have the tools that do an excellent job identifying the shift in sentiment that caused peaks and nadirs in market prices. However, my analysis tells me that the medium and long-term path of least resistance for the price of gold is appreciably higher from its current price level.

Gold could move lower over the coming days and weeks, but I would view any bearish price action as an opportunity to buy on a scale-down basis.

A disappointing week

The most recent high in gold, on a short-term basis, came on April 10 when the price of June futures hit a peak at $1314.70 per ounce. After trading to a low at $1284.90 on April 4, gold moved steadily higher, but last week the release of Fed minutes led to another selloff that has so far taken the precious metal to a higher low.

Source: CQG

As the daily chart of the June COMEX futures contract highlights, gold fell sharply on April 11 after the US Federal Reserve released the minutes of their latest meeting without any mention of a cut in the short-term Fed Funds rate. With the Trump Administration taking the Fed to task over their hawkish approach to monetary the news cycle had been overloaded with opinions that the next move by the central bank will be to lower the short-term interest rate. Moreover, one of the latest nominees for the Fed Board, Stephen Moore, has called for an immediate 50 basis point decline in the Fed Funds rate. At the same time, President Trump’s chief economic advisor, Larry Kudlow, seconded that emotion.

However, the Fed minutes last week had more of a hawkish tone than the market had hoped for and rates rose in the aftermath of the release sending the price of gold back below the $1300 per ounce level.

My bullish opinion on gold has some technical validation when looking at the longer-term monthly chart.

Source: CQG

As the monthly pictorial shows, the relative strength indicator is in neutral territory, but price momentum is rising at the upper end of a neutral condition. Monthly historical volatility in gold at 8.23% is more appropriate for an appreciating currency instead of a commodity, but gold is a hybrid of both asset classes. Perhaps the most significant sign, at least for this analyst, is that open interest is at the lower end of normal at 447,425 contracts at the end of last week. Open interest is the total number of open long and short positions in the gold futures market. On a long-term basis, the metric can serve as an excellent tool to gauge sentiment and if the market has room to appreciate. In 2008, open interest fell to a low in November around the time that gold was hitting rock bottom and before it took off to the upside and reached its all-time peak at just over $1920 per ounce in 2011. Open interest also hit a low in late 2015 when gold made its last significant low at $1046.20 per ounce. When the metric rises, the gold market tends to become overcrowded on the upside leading to a corrective move. The current level of open interest is telling me that any further corrective price action in the gold market will not take the price appreciably lower because it will run out of selling. There are not all that many longs in the market at this time that tend to scramble for an exit and trigger dramatic moves to the downside when the market gets overloaded on the long side.

Higher rates are toxic for the yellow metal- In the short-term

Higher interest rates tend to be toxic for the price of gold in the short-run as they increase the cost of carrying long positions. Contango is a term a commodity trader uses to describe the premium of deferred over nearby futures contracts. In the gold market, the price differential for future delivery months is a function of interest rates, storage, and insurance. In other commodities, the price structure can swing from contango to backwardation which is a condition where deferred prices trade at lower than nearby prices and is a sign of tight supplies or a deficit in a market. Gold rarely moves into a backwardated state because central banks and other market participants hold the metal in vaults around the world and would sell nearby and buy deferred gold to earn income on their holdings in a backwardated market. Therefore, the ample stocks of gold prevent the market from moving out of contango.

Additionally, gold is hard money. Currencies like the dollar have a yield unless we are talking about the euro or yen, but that is a condition that has been engineered by central banks which have provided liquidity to stimulate economic conditions. The stock of currency can expand infinitely as governments can run the printing presses. Gold is a finite resource. Until someone figures a way to create gold in a lab or with a three-D printer, the only way to increase the global stock of the yellow metal is to extract it from the crust of the earth or maybe far-away planets if there are reserves out there in the universe.

The bottom line is that the market’s kneejerk reaction to higher real interest rates is to sell gold. However, when rates rise because of higher inflation, it creates a different story that can be explosive for the price of gold.

In today’s environment, we must remember that a Fed-Fund rate at 2.25-2.50% is historically low. 30-year mortgage rates at 4% are cheap. I took my first mortgage in the 1980s at, what I thought at the time, was an attractive rate at 14%. Then again, the price of gold was trading at over one-third the current price in those days.

The price weakness over the past week came as the market shifted from concerns that the economy was slowing and that the Fed was prepared to cut rates to the exact opposite after the experts read between the lines in the latest Fed minutes.

Another significant factor the gold market loves to watch is the level of the US dollar which is sitting at just below its recent high.

A big hand hovers over the dollar- Gold can move higher with the dollar

The dollar traded to a high at 97.705 on the dollar index in mid-December, but since then each trip above the 97 level has failed. Currencies trade at low volatility levels compared to stocks, commodities, and other assets, because governments manage the foreign exchange markets in the interest of stability. The dollar and euro are the reserve currencies of the world these days, meaning that the US Treasury and EU have more than a habit of manipulating the levels of their currencies against other foreign exchange instruments. Moreover, as the US negotiates new frameworks for trade with China, Europe, and other nations around the globe, the Trump Administration does not want to see the dollar appreciate. A higher dollar makes US exports less competitive on global markets which would put those negotiating trade deals in a challenging position when dealing with their counterparts. It is likely that Secretary of the Treasury Steve Mnuchin is selling dollar each time it attempts to move to the upside and repurchasing the greenback after it corrects to keep the US currency in a narrow range. In 2019, the dollar index has traded between 94.645 and 97.665 on the nearby futures contract. It is probable that the Treasury is more active selling when the dollar probes above the 97 level. On the campaign trail in 2016, President Trump said he favored a lower dollar, and Secretary Mnuchin did the same during his confirmation hearings. The price action in the currency markets validates that the administration is active putting words into action.

Meanwhile, gold tends to move higher when the dollar declines and lower when the greenback rallies. Gold fell to a low at $1161.40 in August 2018 when the dollar index traded to a high at 96.865. However, the move in the dollar to a higher high at 97.705 in December only sent gold to a low at $1234.10 as the metal was rallying at the end of last year despite the strength in the dollar.

At the same time, all of the liquidity in markets since the global financial crisis in 2008 has caused the value of all currencies to decline as central bank balance sheets swelled, and they released more currency into markets. Gold is finite, and that is why the price has not traded below $1000 per ounce in dollar terms in a decade since 2009 and why it is not likely to move towards that level anytime soon. I would argue that measuring the dollar against other currencies to determine the price direction of gold is a mirage these days because of the massive amount of currency floating around the globe and that manipulation in currency markets is not an exception, but a norm.

Europe is a basket case

The Fed is the leading central bank in the world and often sets the example for monetary policy as it did in the aftermath of the 2008 financial crisis. The EU is number two, but they are mired in a financial mess which is a function of the short-history of pan-Europeanism and long-histories of its members. The devil-may-care approach to managing economies in southern Europe compared with the austerity in Germany and the other northern members is, in most ways, incompatible unless one side exerts its influence on the other. Bailouts of Greece, Italy, Spain, Portugal, and the potential for more in the future is a sign that the EU is an experiment with shaky economic and cultural underpinnings. The Brexit issue is particularly significant for the powers of the EU who struggle to keep the union intact because they cannot afford to set a precedent for an easy exit from their club. When it comes to Brexit, the EU leaders aspire to be like mafia bosses where members can only depart to the trunk of a car with a bullet in the head. The EU showed its hand last week after the UK requested an extension for Brexit to the end of June and the leadership of the EU went one step further extending the period until October. It is likely that they are hoping that the UK changes its mind, holds another referendum, and eventually remains within the union. The current state of negotiations with the EU leadership reminds of a classic Eagles song about the Hotel California, the UK may have checked out, “but they can never leave.

Recently, Italian political parties are attempting to put a velvet rope around the nation's gold holdings which are the fourth largest in the world. Despite its economic woes, a growing majority in Italy does not want the EU to get its hands on their gold reserves. Claiming the gold is the property of the citizens of Italy rather than its central bank has been a ploy to protect the yellow metal which is the country's national treasure along with its delicious food, wine, art, and culture. 

So, what does this all have to do with the price gold?

Source: CQG

Since the turn of the century, the price of gold in euros steadily appreciated in a sign that the euro currency has lost value against the yellow metal.

Source: CQG

Over the same period, gold has appreciated dramatically in dollar terms.

Source: CQG

Gold’s appreciation in Japanese yen terms has been even more dramatic over the same period. The yen is the third leading reserve currency in the world.

The bottom line is that the ascent of the gold price in all of the world’s leading currencies is not a reflection of the value of gold, but reflects the decline of fiat currencies.
The trend is more than likely to continue which, in my humble opinion will lead gold to higher prices than most believe possible.

Gold is the leader in the precious metals sector, and that will continue

Government around the world may be destroying the value of fiat currencies with their policies, but they have done an excellent job maintaining a level of stability within the narrow scope of the foreign exchange markets. Central banks hold gold for a reason which is that the yellow metal is the oldest and most secure means of exchange in the world. Long before there were dollars, euros, and yen, there was gold. Long after the paper currencies are gone, gold will continue to be a hard asset that is a store of value.

While silver, platinum, and palladium are all precious metals, gold will always be much more. The yellow metal is the leader when it comes to the sector, and it is also a leader when it comes to the currencies of the world.

The US is the world’s leading economy with the largest gold reserves. Chinese gold buying by the public and the government is a sign that the baton will pass to the Asian nation which is continuing the tradition which is sewn into the fabric of society for thousands of years.

As humans, we only live for a small percentage of time when it comes to the history of the world. We can own gold for our lives, but it outlives us all and it passes to our heirs or others upon our death. Gold is a constant across history. The odds of a rising gold price in dollar, euro, and yen terms is high as the value fiat currencies decline. The trend is your friend in markets. A stronger or weaker dollar is meaningless in a world where all currencies depreciate.

I am a scale-down buyer of gold on any price weakness over the coming days, weeks, and months alongside the Chinese. To me, the fundamentals of the global currency markets are compelling and bearish.

Andy Hecht covers Commodities and Forex as one of the original contributing analysts at FATRADER. A former senior trader at one of the world’s leading commodities trading houses, Philipp Brothers (now part of Citigroup), Andy has worked and consulted for banks, hedge funds, and commodities producers and consumers around the world for over 35 years.
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