Safe haven gold hit by a tsunami

Over the last few years, not only gold bugs but also analysts at serious banks stated that gold would be a safe haven in the case of recession and deflation. Many of those analysts also pretended that gold would be a good hedge against inflation. Already economic logic indicates that gold could not perform well in both cases. And the development of precious metals during this past trading week underlines that it is not compatible to serve as a safe haven in the case of inflation and deflation.

On Wednesday, gold plunged with the start of trading in the US. Ross Norman, the CEO of Sharps Pixley (a UK based gold trading house), was the first who pointed out that futures representing 24 tons of gold had been sold within a few minutes at the start of gold futures trading at the CME. Also on Friday, gold and other precious metal came under selling pressure with the start of trading in the US. One explanation for the losses on both days was that investors sold gold on worries about the possibility of a looming fiscal cliff as talks to find a compromise made no significant progress. But is it really rational to sell 24 tons of gold within a few minutes if the US economy will fall over the fiscal cliff?

Let’s assume that no compromise to avoid the automatic tax hikes and spending cuts from kicking in. What would be the economic consequences? Only a few European economists, among them probably the former chief economist of the ECB, would argue that this fiscal austerity would lead to higher growth rates as the multiplier effect of fiscal policy measures is below unity and the reduction of the budget deficit would encourage the private sector to increase economic activity. However, most economists and investors at Wall Street fear that the fiscal cliff would lead to a pronounced recession of the US economy. The unemployment rate would rise again, which would induce the Fed to lift the size of quantitative easing. Many investors regard an inflated Fed balance sheet as positive for gold. Furthermore, a deep recession would also lead to some stress for the financial system and the number of bank failures could increase again. The core inflation rate would head lower and might flirt again with deflation in this scenario.

If increasing the magnitude of quantitative easing or the risk of deflation or the combination of both is really positive for gold, then it would be irrational to sell 24 tons of gold on worries about a failure to reach a compromise avoiding the fiscal cliff. However, if the sellers of the gold acted rationally, then the arguments for gold as a safe haven have no sound footing. From our point of view, the latter is the case. As the development of last week showed, if investors fear a recession or deflationary tendencies, instruments with a fixed nominal income like the conventional US Treasury notes and bonds, offer the better risk and return profile. Furthermore, we pointed out that quantitative easing by the Fed is not a necessary condition for rising gold prices.

Another argument for the plunge of gold and other precious metals prices at the start of trading in the US on Wednesday was that of the usual fat-finger suspect. We are also not convinced by this argument. The fat-finger describes an error at entering the order. In this case, it would imply that the number of contracts to sell has been a multiple of the intended size, often by a two or three digit factor. Usually, fat-finger orders leave a typical trace in the tick or one minute charts. After the order had been worked through and had been fully executed, the market normally rebounds for two reasons. First, the error will be detected by the seller sooner or later. If the exchange will not cancel the erroneous order, the seller would have to correct his error by buying back futures, which lift the price higher. Second, if the market still regards the drop as not justified by market fundamentals, bargain hunting sets in, which also pushes prices higher again. Fat-finger orders often lead to a rebound of the price close to the level before this erroneous order was placed and executed. This was not the case in the gold future, which pared only a small fraction of the loss on Wednesday and Friday and only some hours after the plunge occurred.

High frequency trading plays a more and more important role also in the electronic trading of commodity futures. In the grain markets, commercial hedgers already complained that HFT has increased volatility and makes commercial hedging more difficult. Thus, one possible explanation might be the combination of a fat-finger order triggering the drop, which was aggravated by algorithms of HFT companies switching to selling futures too. However, it appears as rather unlikely that this happened on Wednesday and on Friday.

During the last few weeks, it has been pointed out in this blog, that our base line scenario is a final hour compromise to avoid the fiscal cliff, but the road to such a compromise would be a bumpy one. Thus, the strong declines on Wednesday and Friday might be just the result of higher risk aversion among investors. Nervous investors fearing a failure to reach a compromise sold gold but due to the political uncertainty other investors were only willing to absorb the supply at far lower prices. As long as there are no signs for a compromise being reached, the downside risks prevail, even in the case that the fiscal cliff will be avoided.