Dumping Gold to Pay Off Debt
In almost 15 years of working in the markets, the 42 days between 21 February and 3 April were some of the most exhilarating and exhausting I’ve ever experienced.
And despite global markets having the bottom ripped out from them, I’d argue that what was happening in the gold markets was perhaps the most disruptive of all.
Today, Jim Rickards expands on what the underlying drivers of that were back in March.
More importantly, Jim says there’s a chance a similar disturbance is building in the COMEX once again.
By the way, if you want to hear Jim’s views on the Australian economy, register here for a free webinar run by our friends at the DG Institute.
Read on for more.
Editor, The Daily Reckoning Australia
The Impending COMEX Disruption
The past few weeks have witnessed a tug of war between gold bulls and bears centred around the US$2,000 per ounce line. It’s a fun spectator sport, but it doesn’t mean all that much in the long run.
Gold is on its way to US$15,000 per ounce in the next few years.
It must hit US$2,000 (and US$3,000, and US$4,000, and so on) before it gets to US$15,000, so the US$2,000 level is a forgone conclusion.
Whether it settles there tomorrow or next week or next month is less important than the long-term trend. And to borrow a cliché, ‘the trend is your friend’.
Gold traded at US$1,470 per ounce as recently as 19 March 2020.
That date was close to the date of the lows of the stock market crash from late February to late March when it became apparent that the SARS-CoV-2 virus was out of control and the world economy was heading for a lockdown.
By the way, gold investors are often baffled by the fact that gold does go down during a market crash of the kind we saw last March.
The conventional wisdom is that gold is a safe haven and if stocks are crashing, then hot money should be flooding into gold for protection.
Why is it the case that gold was going down alongside stocks?
Something similar happened in October 2008 during the worst part of the global financial crisis following the bankruptcy of Lehman Brothers.
The reason is that a lot of gold positions are held by hedge funds on a leveraged basis. Hedge funds do not buy physical gold; they buy COMEX gold futures (or similar over-the-counter derivatives).
These contracts require ‘initial margin’ of about 5% of the US dollar value of the gold represented by the futures contracts.
This means a hedge fund that puts down US$5 million in cash margin can control US$100 million in gold futures, roughly equal to 1.5 metric tonnes of physical gold.
Leverage is a two-way street. It can amplify gains, but it also amplifies losses.
If gold dropped just 1% in the situation described above, the loss to the hedge fund would be 20%: the US$1 million loss on the price of gold (1% of US$100,000,000) would translate into a 20% loss on the US$5 million of margin money.
This puts hedge funds on a continual hair trigger.
They have to get out of losing positions quickly to avoid large percentage losses on invested capital (the margin money).
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Margin calls shakeout hedge funds
Hedge funds trade stocks and mortgages the same way — on margins using futures or other derivatives contracts with high leverage.
When those positions start to lose money (as they did in March 2020), the hedge funds face margin calls from their brokers.
The easy way out of the situation is just to close out the contract and take your lumps. But markets can become completely illiquid and it can become extremely difficult to close out positions.
Hedge funds often prefer to meet the margin call, hang on to the position, and wait until markets calm down before exiting.
If markets recover enough, they may remain in the position indefinitely to recover lost profits.
Where do hedge funds get the cash to meet the margin calls to stay in the stock and mortgage positions?
The answer is gold! Gold can go up or down, but it is always liquid.
Hedge funds will dump gold positions not because they don’t like gold, but because it’s an easy way to get cash to meet margin calls on their stock positions.
Once a few hedge funds sell gold, the price drops and other hedge funds exit quickly to avoid large losses on their leveraged positions.
This dynamic gathers momentum and explains why gold prices drop in the early stages of stock market panics.
The good news is that such drops are strictly temporary.
While the weak hands (hedge funds) are selling gold, the strong hands (wealthy individuals and some central banks) stand by until the price drops enough. Then they pounce. A rally begins quickly and builds until gold hits a new higher plateau.
There’s a good lesson in this pattern for retail investors.
When the next stock market panic arrives (probably soon), you’ll see the price of gold drop for the reasons described above.
Don’t panic and don’t sell your gold. Just wait.
After about 30 days, you’ll see the turnaround. That’s the time to jump in with both feet, buy gold, and enjoy the gains.
The next round number
That’s exactly what happened after 19 March 2020. After hitting an interim low of US$1,470 per ounce, gold staged an impressive rally to US$1,810 per ounce on 8 July, a 23% gain in just over three months. But the best was yet to come.
Gold then took off like a rocket, going vertical and reaching US$2,000 per ounce on 2 August, a 10.5% gain in less than one month, bringing the total gain since 19 March to 36%.
Since 2 August, gold has traded back and forth around the US$2,000 per ounce level closing at about US$1,990 per ounce yesterday.
The US$2,000 per ounce level is not a big deal compared to the current level (it’s just a 0.5% gain from Monday’s price).
But, it could be a huge deal psychologically. There were a lot of headlines about a week ago when gold reached a new all-time high of US$1,938 per ounce; the highest level since September 2011.
But, that seemed technical to most casual observers or those just paying attention to gold for the first time. US$2,000 per ounce is a much bigger deal.
There’s something about human nature that loves a round number.
Remember the initial frenzy around ‘Dow 20,000’, then ‘Dow 25,000’, and so on. They must have some ‘Dow 30,000’ hats ready to go in the storage room at the New York Stock Exchange, but they haven’t had to break them out yet.
Gold at US$2,000 per ounce puts a different spin on things. It gets attention and is easy to digest. Investors immediately focus on the next round number, which is gold at US$3,000. That could take a while, but don’t underestimate the power of psychology when trying to understand market trends.
With solid momentum established and important psychological price milestones within reach, what are the prospects for even larger gains for gold in the weeks ahead?
Crossing the Rubicon
Right now, my analysis suggests the gold rally will continue with even greater gains than we have seen recently.
The psychological momentum described above is revealed in Chart 1 below, which shows US dollar inflows into gold funds on a rolling six-week moving average basis.
Those inflows were over US$2.6 billion in the most recent reporting period. That tops several similar weeks of inflows in the past few months and is far in excess of levels seen during other spikes in 2011, 2012, and 2016.
Average inflows to gold funds — six-week moving average, billions of US dollars
Source: The Daily Shot
Chart 2 below shows another kind of flow of gold.
Gold futures traders on the COMEX have three choices when their contracts come up for settlement (once per month).
They can close out the contract (longs sell and shorts buy back), they can rollover the contract to a future month, or longs can put in a notice that they want delivery of physical metal, in which case the shorts have to obtain the gold and deliver it to a COMEX-approved vault.
Most professional traders simply rollover their positions.
They are using arbitrage strategies involving costs of storage, insurance, and a rising market to make steady if unspectacular profits.
As you can see from the chart, something unusual happened at the end of July.
Notices for physical delivery hit 32,732 contracts, the highest delivery notice in history.
Gold physical delivery notices on the Commodity Exchange (COMEX)
Source: The Daily Shot
The COMEX emphatically tells traders that the exchange is not a source of supply.
That notice is in their rulebook and they will invoke the rule to halt physical deliveries if a disruptive market appears.
That didn’t happen this time and the deliveries went off smoothly.
But COMEX clearing members had to divert enormous amounts of physical gold from London to meet the New York delivery demands.
That won’t happen again because London is almost picked clean. COMEX is headed for a crack-up where they may have to order traders to ‘trade for liquidation only’, which means they can rollover or closeout contracts, but they cannot take physical delivery.
We’ll see what happens in August, but a near panic to get physical gold seems to be underway.
Whether one looks at fundamentals (basic supply and demand from miners to central banks), technical (chart patterns), or psychological aspects (crossing the US$2,000 Rubicon and the mad scramble for physical), all signs point to much higher gold prices in the near future.
All the best,
Strategist, The Daily Reckoning Australia