High uncertainty among hedge funds supports gold

The uncertainty about the further development of global financial and commodity markets appears to be extremely high at present. However, they don’t follow the old market adage of “if in doubt, stay out”. Instead they invest in gold as a store of value. The risk is that once these investors decide to invest again in other higher yielding assets that the price of gold might collapse like in 1980. Currently, gold appears a suitable instrument for short-term trading, but not for long-term investing.

Stan Druckenmiller, a famous hedge fund manager, announced recently that he will close his fund and will retire. It was not only the tight time budget available for pursuing other interests like playing golf with friends, which led to this decision. Also the meager performance this year played a role as Mr. Druckenmiller got the development of the US Treasury market completely wrong. By the way, he is not the only one who got surprised by the more than 1.5 percentage point drop of yields on 10yr US T-Notes.

According to reports, other famous hedge fund managers like John Paulson and George Soros have invested heavily either directly or indirectly via ETFs in gold this year, while inflation is not on the horizon. As gold does not yield any return, one has to speculate on capital gains to make a profit. The major drivers of gold are also not providing a clear picture. The US dollar strengthened during the first half of 2010 against the euro due to the crisis of government debt in the southern eurozone countries. But the euro could pare a part of the loss at the beginning of the current quarter before giving back some of the gains. Crude oil is hovering sideways and was lately under pressure as the market fears the US economy might slip into a double dip recession. Only the falling bond yields are supporting gold as the opportunity costs of holding gold declined.

If hedge funds managers and CTAs were really convinced that the fundamental outlook for gold were positive, the other precious metals should also be bought by large speculators. However, the latest commitment of traders report compiled by the CFTC shows a completely different picture. In the week ending August 24, large speculators increased their long positions in Comex gold futures by 15,290 contracts or 6.3% to 256,244 contracts. Their net long position rose even stronger by 16,963 contracts or 8.3% to 221,191 contracts. Normally, silver posts stronger percentage gains when the price of gold advances. However, large speculators reduced their long positions in Comex silver futures by almost 1,000 contracts to 42,255 contracts, a decline of 2.3%. The net long position of the non-commercials declined less as the large speculators also closed some shorts. It decreased by 765 contracts or 2.2% to 34,807 contracts. Also the net long position in platinum and palladium declined.

This divergence between the development of net long positions in gold futures on the one hand and the futures on other precious metals does not support the argument that hedge funds were buying gold as a protection against medium- to long-term inflation risks. In this case, it would make more sense to diversify holdings and to buy also the other precious metals. From our point of view, it is an increased uncertainty (the unknown unknowns as former US defense secretary Ramsfeld described it) and the relatively low opportunity costs which induce hedge funds to buy gold.    

Correction at the gold market appears to be looming

Gold might be heading towards a correction after rising for more than four weeks. The fundamental arguments for buying gold have not been convincing lately. With a slow-down of the US economic growth, there is no risk the economy would overheat and lead to inflation. As many economists even predict or fear a double-dip recession, the risk seems to be biased more towards deflation than inflation. However, gold is not a perfect hedge against deflation, contrary to the pretentions of many gold bugs. Hedge Funds and other asset managers were heavily invested in gold and are now looking for the bigger fool to sell their gold. One should always be very careful when fund managers appear on tv stations and praise an investment vehicle. This is often the best selling opportunity, not only in gold but also in US Treasuries.

Last Friday, gold started to react on the stronger US dollar, while the firmer US dollar against the euro had been ignored for about one week. The trigger was an interview of Bundesbank chief Weber with Bloomberg TV. He indicated that an exit from quantitative easing should not take place before the end of this year and might start as soon as Q1 2011, depending on the financial stability. This should not come as a surprise, even as Mr. Weber is considered to be a hawk within the ECB council. As long as the money market of the eurozone is not functioning and banks of some regions have no access to the interbank market, the ECB is unlikely to embark on exit strategies. In addition, the Euribor futures have not priced in that the 3mth Euribor would be above the ECB refinancing rate by December 2010. Thus, the renewed pressure on the euro versus the US dollar appears to be overdone; nevertheless, the impact on gold was negative.

Unlike gold, the other precious metals traded sideways in July and August. Recently, silver and the PGMs even declined while gold moved temporarily above 1230$/oz. Within the precious metals complex, gold got overvalued. If valuations get overstretched, traders will sooner or later start to sell gold and buy the other precious metals.

We have pointed out the unusual positive correlation between gold and the 10yr US T-Note future. Last Friday, this correlation was another negative factor for gold. Since the beginning of April, the price of the T-Note future gained more than 10 full percentage points. The yield on 10yr T-Notes has fallen by 1.5 percentage points to 2.5% and traded even below the level recorded after the collapse of Lehman Brothers in September 2008. Even with a CPI inflation rate of 1.2%, the real yield is unusually low and not in line with the US economic situation. The past week, the 10yr US T-Note future showed first signs that the rally is coming to an end. The market traded sideways after reaching a new high at the start of the week. In a week over week comparison, the market even closed slightly lower. A new high but lower close is regarded as a key reversal pattern by chart technicians. Also other technical indicators point to a potential reversal. The ADX in the daily chart reached the 60 mark and has declined already slightly. Readings above 50 are a harbinger that the trend is going to exhaust and to reverse soon. Also the MACD and the stochastics are close to trigger sell signals. A correction in the US Treasury market would then have probably also a negative impact on gold.

But not only the intermarket relationships of gold turn negative, also the gold chart sends warning signals that the rally might come to an end. The candlestick pattern of a hanging man has emerged last Friday. This pattern has a high probability to indicate a trend reversal. The ADX is declining, which points to a weakening of the trend strength. In this environment, more emphasis should be put on oscillators like the stochastics instead of trend following indicators. The two lines of the stochastic have already crossed in the overbought zone. However, to trigger a sell signal, a return back into the neutral zone is required.

All in all, the odds are increasing that the rally in the gold market is coming to an end and that a reversal might be around the corner. However, before selling gold short, the technical indicators should provide more confirmation for a reversal.  

Irrationality in metals markets

John Maynard Keynes once stated that markets could stay longer irrational than one could remain liquid. Currently, it seems we are in such a situation. Gold continued its rise after founding support at around 1,160$/oz three weeks ago. Silver traded further sideways, but ended the week lower, while the PGMs suffered again stronger losses. Base metals also had a negative week on balance with the exception of tin, but trading was rather volatile with larger swings up and down. The driving forces behind these moves in the metals markets were the Fed policy and fears that not only the US might head towards a double dip recession but also a stronger slow-down in China would lead to global economic weakness.

 The correlation between gold and the US T-Note future became positive recently. And again last week, one could observe that gold rallied in line with the US Treasury market after the announcement of the Fed following the FOMC meeting. Furthermore, the behavior of the markets demonstrated that they are not information efficient, contrary to academic theories. After the semi-annual testimony of Fed chairman Bernanke and the Beige Book, it should have been already priced in that the Fed is unlikely to embark on tightening monetary policy. Some bond investors even betted the Fed would start another round of quantitative easing at the FOMC meeting last week. However, all the Fed is doing is just not to drain liquidity from maturing bond holdings. All proceeds will be reinvested, thus, the balance sheet will not be expanded but the Fed is just putting a floor on its balance sheet. Furthermore, the Fed clearly stated that “inflation is likely to be subdued for some time” (see FOMC statement). With no inflation on the horizon as far as the eye could see; there is also no reason to buy gold as a hedge against inflation. Some gold bugs argue that the metal would also be a perfect hedge against deflation. During periods of deflation, fixed income bearing assets perform better than real tangible assets like gold. Thus, this statement of the gold bugs makes as much sense as pretending that gasoline would be perfect for lightning and extinguishing fire.

In the case that the positive correlation between the gold price and the 10yr US T-Note future should prevail, the question arises, how far could both rise further. Usually, there is a close correlation between the 10yr T-Note future and the 3mth Eurodollar future, which matures one year later. This implies that the bond market rallies if also falling short-term interest rates are expected. The Fed is likely to keep the Fed Funds target rate at the current level for an extended period. With the Dec 2011 3mth Eurodollar future already trading above 99.0, the potential for further rise appears to be rather limited. Therefore, also the upside potential for the 10yr US T-Note future seems to be capped, but this does not exclude new all-time highs could be reached. In the current environment, this might also be supportive for gold.

The US economy is loosing steam compared to Q1 this year, there is no doubt. However, will this lead also to a double dip recession as more and more economists predict and markets fear? We remain skeptical or more positive formulated; we stay more optimistic for the US economy than the market consensus. The US consumer is not the driving force of the economic recovery. Given the balance sheet repair work of the private consumers, i.e. reducing indebtedness and increasing savings, the high unemployment rate and slow creation of new jobs, the private consumption will grew, but not at the rates seen in the past. However, inventories are still low relative to sales, thus, building up stockpiles is probably remaining a supportive factor and business investments are also likely to contribute to GDP growth in coming quarters. This also argues against strong gains of US Treasury futures and gold. And a continued growing US economy, even at a slower pace, should remain a positive factor for the PGMs and the base metals.

Asian investors already reacted disappointed on the FOMC statement, but their reaction in the markets for base metals and the PGMs was even more severe after the release of the Chinese trade data. While the trade surplus increased from $20.0bn to $28.7bn and the consensus expected a slight decline, the markets reacted negative on imports, which were only up 19% in July, far below economists’ predictions. This has been regarded as another signal for a sharp slow-down of the Chinese economy and weighed on metals markets. However, the rising trade surplus still indicates that the Chinese as well as the global economy is growing. Markets also reacted negatively on the German GDP, which grew by 2.2% qoq in Q2, the strongest growth rate after the unification in 1990. The pundits fear that this would not be sustainable. As construction spending made a bigger contribution to the German GDP growth, this expectation is probably right. Nevertheless, the ifo business climate and the PMI indices all indicate that the biggest economy of the eurozone will expand further at an elevated level. Thus, the negative reaction on surprisingly strong growth is not justified. It underlines the bearish sentiment in global equity and metals markets. This sentiment is currently the major thread for further market trends and could have a self-fulfilling impact on the global economy.      

Mixed signals in the metals markets

All six base metals traded at the LME posted a gain last week compared to the close of the preceding Friday. Also gold and silver advanced and reversed the short-term downward trend. Only the PGMs pared earlier gains and ended the week with a loss. At a first glance, one might attribute the rise of base metals and gold to an improvement of economic sentiment, however, this is not the case. And in addition, it would not explain the reasons why the PGMs turned lower by the middle of the week and closed in the red. From our point of view, the various segments of the metals markets are dominated by different scenarios.

The driving force for the base metals was the manufacturing PMI indices. The market got already surprised by the official Chinese PMI which remained above the 50 threshold. Only the HSBC manufacturing PMI dropped from 50.4 to 49.4 but this decline was also less than the market consensus expected. In Europe, the final PMI had been revised up to 56.7 from an initial estimate of 56.5 after 55.6 in the previous month. Europe is driven particularly by the German economy. Also in the US, the ISM manufacturing PMI declined less than the consensus of Wall Street economists predicted and did decline only from 56.2 to 55.5 while the consensus expected a drop to 54.2. In addition, US construction spending increased in June by 0.1% whereas the consensus predicted a 0.4% decrease, which is another positive factor for copper.

All in all, the PMIs indicate that the Chinese economy is cooling down, but not sliding into a contraction. The eurozone economy is even gaining speed in the manufacturing sector and in the US, the slowing down slightly, but is still far above the critical 50 threshold. Thus, the demand for base metals is likely to increase further. Also the ADP estimate of private sector payrolls in the US surprised to the upside, which was another positive factor for base metals.

Gold and silver got some support from a weaker US dollar, which depreciated not only against the Japanese yen, but also against the euro. However, what appears to be more important for the development of these two metals is the US Treasury market. It has been quite obvious that gold and silver made stronger moves to the upside, when the 10year US T-Note future rallied on economic data which fueled speculation that the Fed would embark on a new round of quantitative easing. This has been the case after the release of the US personal income and consumption figures, which indicate that the consumer would not be the driving force of an economic upswing in the US. However, a much stronger impact had the labor market report released last Friday. While the unemployment rate remained unchanged and the hourly work week as well as average hourly earnings increased, the dominating figure was the stronger than expected fall of non-farm payrolls.

 The gold bugs and bond vigilantes expect that the Fed would pump more money into the economy after this labor market report. However, the Fed is likely to have a closer look at the details. Employment in the private sector increased as the ADP estimate indicated. The fall of non-farm payrolls is the result of the public sector. The job loss is not only the result that temporary workers had been laid off after the census poll, but also the states, which are not allowed to run a budget deficit, had to reduce their work force, in particular in the education sector. However, the Fed can do very little to improve the fiscal situation of the various states. Thus, it is not already a done deal that the FOMC will announce more quantitative easing at its meeting this week.

More and more commentators state that gold would be a perfect hedge for deflation. However, these persons are snake-oil salesman. There is no empirical evidence that the price of gold is rising with deflation. Quite the opposite is the case; falling inflation rates are negative for gold. And the best example to illustrate that quantitative monetary easing does not necessarily lead to surging inflation is Japan. For almost the whole decade, the BoJ tries to combat deflation by keeping the interest rate near zero and quantitative easing. However, a falling CPI still leads to positive returns of holding cash. Those, who follow now the siren calls of those snake-oil salesmen that buying gold as a hedge against deflation risks, might be the last fools buying gold according to the bigger fool theory.  

Is the correction in the gold market already over?

Within one month, spot gold has lost around 100$ and reached the 1,160$/oz mark. Last Friday, the price of spot gold rebounded and closed at 1,181.50$/oz, a gain of 13.45$/oz on the day. Thus, the question arises, whether the correction of gold is already over. All in all, we still don’t see all signals flashing buy signs. Thus, the increase of last Friday might just be a bull trap.

The technical situation of spot gold is ambiguous. On the positive side is that gold found support at 1,160$/oz. At this level, gold found resistance before on its way up and it already served as a support at the beginning of May. However, those levels of support are seldom taken out at the first attempt. Thus, the rebound might just signal that the bears take a breather before making the next attempt to surpass this support level.

During the recent downward move, gold has fallen below the major pivot low, which marked the start to the ascent of gold to the all-time high at 1,264$/oz. Also on the way down, gold made some smaller corrective moves to the upside, but all these moves did not reach the preceding correction high. Therefore, in terms of the Dow Theory, gold is still in a downward trend as long as it has not made a new series of higher highs and higher lows.

Furthermore, the technical indicators don’t argue for buying gold currently. Spot gold is still trading below the moving average of the Bollinger band and this average often acts as a resistance. The MACD line is below its signal line and thus, has not triggered a buy signal. The stochastics is also in the oversold zone and only a return into the neutral range would be a buy signal. But even in the case that either the stochastics or the MACD trigger a buy signal, we would like to see at least a close of gold above the moving average line of the Bollinger band to go long from a technical perspective.

 Also an analysis of money flows does not provide a clear buy signal for gold. According to the latest CFTC report on the “Commitment of Traders”, the non-commercials have increased their long positions in Comex gold futures by 288 to 228,251 contracts but reduced the short positions by 10,306 to 39,350 contracts. Thus, the net long position of large speculators soared by 10,594 to 188,901 contracts. However, this is still far below the recent peak of 244,725 contracts at the end of June. Small speculators also increased their net long position by 1,297 to 38,654 contracts. As the small speculators have the reputation to get it wrong, this increase of the net long positions is not a strong argument for buying gold. The commercial hedgers appear to expect further losses of gold and thus have increased their net short positions. Furthermore, gold holdings of the biggest gold ETF, the SPDR Gold Trust, have declined further to 1,282.3 tones.

Looking at the intra-day chart of gold, it is striking that gold made the major part of the daily gain after the release of US GDP figures. However, the US GDP growth in Q2 was the least convincing figure for buying gold. The US economy expanded at an annualized rate of 2.4% while the consensus of Wall Street economists was looking for a growth rate of 2.5%. However, a difference as small as 0.002 percentage points in the quarter on quarter GDP growth rates could lead to the difference between the actual and the expected annualized growth rate. Nevertheless, as the markets in the US are already nervous and fear a double dip recession, the lower than expected growth rate triggered a flight into US Treasury paper. But it is not rational to buy gold on economic weakness. In the case that the bond vigilantes were right, then the risk for the US economy would be deflation and not inflation. But real assets like gold are not among the winners during periods of deflation. And those who buy gold because they expect the Fed to return to another round of quantitative easing in order to prevent deflation should have a look at Japan, which still struggles with deflation despite all the quantitative easing by the BoJ.

We do not expect a double-dip recession of the US economy. And our most likely scenario for the Fed policy is a continuation of the current policy. However, also a strong expansion above trend growth is less likely for the US economy. Thus, from our point of view, the Fed policy provides no smart reason for being long in gold.