The Golden Force

Gold versus paper money
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If you want to try and work out what’s going on in the markets right now, focus on the currencies. That’s where all the action is.

In US trade on Friday, the non-farm payroll numbers for the month of October came in weaker than expected (although still decent at 214,000 jobs created). This set off considerable volatility in the foreign exchange markets.

The US dollar weakened against a range of other currencies, including the Aussie dollar, and gold surged more than 3%. There’s reason to think that, for the time being at least, the US dollar may have topped out.

The chart below explains why. As you can see, the US dollar index made an initial high in early October. This high coincided with very strong momentum, as shown by the indicators at the top and bottom of the chart. For example, the ‘relative strength index’ at the top of the chart was in ‘overbought’ territory for over a month (see shaded green area), indicating very strong buying support for the greenback.


Greenback rally stalling?



Following a minor correction throughout October, the index went on to make new highs in early November. But note how the momentum indicators didn’t make new highs at the same time? This is a type of ‘non-confirmation’ and suggests the US dollar rally may be done for now. And the price action on Friday was bearish too.

Far more interesting though was the response from gold. It surged around US$40 an ounce, putting in a bullish reversal on high volume. It closed just below its long term support level around US$1,180. You’ll want to see the rally continue through this level before getting excited, but even if it does, the best you can say for gold is that it’s back in its long term trading range.

Also, keep in mind that big moves like you saw on Friday are often the result of short covering. Shorting gold (betting on a falling price) has been an easy trade since the price peaked around $1,340 back in July.

Last week’s rapid fall below long term support at $1,180 would have attracted plenty of new short positions. But then the employment data came out, which spooked the shorts and forced many out of their positions. When this happens, short sellers have to buy gold to exit their position. It’s this panic buying behaviour that often causes vicious rallies.


Gold bounces higher



The other point to note about this gold trading is that I’m not talking about people buying and selling physical gold. In fact, according to goldresearcher.com, physical gold trade accounted for just 1.2% of total volume traded in 2013.

The vast majority of trading in the gold market is gold derivatives, or paper gold. Nearly 76% of total trade in gold takes place in London. This trading occurs between members of the London Bullion Market Association (LBMA) and takes place on an ‘over the counter’ (OTC) market, meaning trades occur in secret between members…and not on a public exchange.

While there is no doubt some of this trading volume does include physical gold changing hands, the huge size of it indicates much of it consists of gold trading as foreign exchange. Just like the US dollar trades under the symbol USD, or the Australian dollar under AUD, gold’s currency symbol is XAU.

So foreign exchange traders can sell gold simply by selling XAU/USD, or XAU/AUD. They don’t need to own any physical bullion. They just conjure up the units on their trading screen and press the sell button.

Because the US dollar has been so strong over the past few months and the new narrative is that the US economy is strong and rates will rise there in 2015, shorting gold versus the USD has been an easy trade.

This is pretty much how modern finance has ‘evolved’ in recent years. The derivative market beast controls the price of the physical product. It’s the tail wagging the dog. This situation can continue for some time too…or at least as long as there is still a ‘flow’ of physical gold changing hands at the level produced by paper trading.

But there is a catch. A functioning derivatives market needs the existence of physical metal to give it legitimacy. For example, if the paper traders pushed the price of physical gold so low that no one was prepared to sell at such a level, the flow of physical would dry up. If you couldn’t buy physical at the paper set price, the market would cease to function. Everyone would know the price was fraudulent.

Are we getting close to such a price now? I don’t know, but we’re closer than we’ve been in a while. Prior to Friday’s price rally, gold traded at a level below the average cost of global production. In other words, at around US$1,150 an ounce, it costs more to dig up and refine an ounce of gold than it does to go into a mint and buy one off the shelf.

There’s no incentive to produce, but every incentive (for the rational person) to buy as much as you can. Moreover, there’s no rational reason to sell at such low levels.

Of course, this isn’t a rational world and you might need to see the price fall further to flush out the ‘weak hands’ before the flow of physical gold stops completely.

I have no idea which way things will go. But having followed gold closely for over 10 years and having spent countless hours trying to understand the market, I do know that gold remains at the heart of the financial system. Try as they might, governments and bureaucrats just can’t get rid of gold.

Gold fascinates me because throughout history it’s acted as the ultimate ‘BS detector’. It’s the enemy of kings, despots, powermongers, socialists, world improvers, central bankers, fraudsters, and manipulators.

But gold is just a useless piece of metal. It’s not gold that fascinates me; it’s what gold represents. And I believe gold represents the will of the people in favour of freedom over repression…it rewards hard work and innovation over laziness and short cuts.

It reminds us that, ultimately, you don’t get something for nothing.

And while there are currently more people in the world getting something for nothing (and many, many more getting nothing for something), I remain confident that gold will again break its shackles and assert its force on the global financial system.

After all, that’s the way it’s been (on and off) for thousands of years. Why should it be any different now?

Greg Canavan+
For The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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