Gold’s Breakout

Gold’s Breakout

Here’s what I wrote two weeks ago:

‘Fundamental, technical and macroeconomic analyses all point to higher gold prices in the months ahead as weaker economic growth and lower interest rates combine with solid demand for physical bullion to trigger another breakout to the upside for gold as happened in early 2016. The current US$1,200 per ounce level looks like an attractive entry point for the coming rally.’

Well, that was quick.

No sooner was the (digital) ink dry on this piece than gold finally broke out of its narrow trading band of US$1,185–1,215 per ounce and surged from US$1,186 to $1,235 per ounce as of today.

That’s a solid gain in just two weeks after trading in such a narrow range for three months.

The gold price break out

The gain has been nice, but what was more important was that gold broke out of its range to the upside, exactly as I expected.

Of course, the question is where do we go from here?

Source: The Daily Shot

Gold finally broke out of a narrow trading range and moved to the upside last week. Gold rallied 3.8% from 10 – 15 October and has maintained that new higher level since then.

Before forecasting the gold price, it’s critical to understand why gold broke out when it did.

The simplest explanation was that gold got a bid from those looking for a safe haven amid extreme market uncertainty.

Before October, the stock market had been rising steadily after the correction of last February and March. Volatility reached near all-time lows. Stocks looked like a sure thing and gold was out of favour.

Suddenly, stocks fell over 6% in a few trading days from 3-11 October.

The Dow Jones index fell from an all-time high of 26,828 to 25,052, a 6.6% plunge. In some ways, this plunge looked like a replay of the plunge earlier this year from Dow 26,616 to 23,533 by 23 March, a full-scale 11.6% correction.

Viewed in a broader perspective, stocks on 19 October were back at the levels they first achieved last 11 January: almost a full year with no gains to show but lots of thrills and spills along the way.

Hedge funds on the wrong side of the gold trade

Normally in such volatile stock markets, bonds offer a safe harbour. But not this time. The bond market has also been crashing as yields on 10-year Treasury notes surged from 2.76% on 29 May to 3.20% on 19 October.

That 44-basis point yield spike from such low nominal levels does more damage to bond prices than the same spike from a higher level of rates.

Markets expect this surge in yields to continue, although my view is that this spike has run its course and a new bond market rally is in the cards.

With cash offering low yields, stocks and bonds both in retreat and emerging markets in turmoil, investors turned to gold as the one sure bet that would retain value.

This safe-haven demand combined with strong supply/demand fundamentals in the physical bullion market was enough to give gold a spike out of its recent trading range.

Another factor supporting gold, which is still in play, is the fact that hedge funds are massively short gold (as measured by gold futures contracts), as shown in the chart below. Futures contracts are highly leveraged instruments.

Source: Lohman Econometrics; CFTC

Hedge funds mark to market daily and are highly sensitive to fluctuations in their profit and loss statements.

When gold begins to rally, losses show up in the hedge fund accounts immediately.

Traders have to cut those losses, which they can do by closing out their futures contracts or hedging with physical gold.

A rush to close out futures contracts can do more harm than good; so many hedge funds bought physical gold (or ETFs) to hedge their short futures positions. This was one more boost for the gold price.

The hedge fund shorts have not yet been unwound, so the prospect of short covering remains.

Central banks go shopping for gold

Crashing stock and bond prices, surging volatility and massive short gold positions were a perfect storm that caused a sharp spike in gold prices. Will the storm continue?

The fundamentals won’t change much in the short run.

Gold mining output is flat, at just over 2,000 tons per year.

The basic supply/demand situation continues to favour higher gold prices, or at least a floor on current levels.

Demand for physical bullion from China and Russia is still strong, but they are not alone. New demand is coming from EU members Hungary and Poland, for example.

In 2018, Poland became the first EU nation to buy gold in the 21st century. And Hungary’s central bank has bought gold for the first time since 1986.

Hungary’s new gold stash

Asian countries are also buying gold as ways to diversify their reserves.

Overall, central banks are set to increase their purchases of gold in 2018 for the first time in five years. Net central bank purchases of gold are expected to increase to 450 metric tons this year.

That’s up from 375 tons last year.

This is another tailwind for gold.

But the headwinds for gold prices also continue.

The Fed is raising nominal rates. In the absence of persistent inflation, that means real rates are going up also. This makes cash a more attractive safe harbour than gold because gold has no yield.

The fundamental tailwinds and interest rate headwinds are in rough balance, as they have been recently.

The determining factor will come from the stock and bond markets as they continue to wrestle with political and economic uncertainty.

The other wild card is geopolitical uncertainty, as displayed recently in the Khashoggi affair and intrigue in Saudi Arabia.

Because political uncertainty will continue through Election Day, and certainly beyond if Democrats take the House of Representatives, safe-haven demand will also continue and gradually push gold toward the US$1,300 per ounce level in the weeks ahead.

A gold entry point of US$1,235 per ounce is still attractive, but it may not be available much longer.

All the best,

Jim Rickards Signature

Jim Rickards,
For The Daily Reckoning Australia