Some Comments on Gold

During the course of a week, we receive some e-mails with comments on precious metals markets. Normally, those comments will not be commented in this blog. However, this week, we decided to write about two articles.

The first article was titled “Will gold break its negative correlation with dollar?” and was written by the head of research employed by a gold investment company. She wrote about the market action on Monday and noted that the US dollar index was up and gold continued to climb higher. Furthermore, she wrote that now many analysts were asking if the yellow metal were breaking the negative correlation with the US dollar. In addition, this possibility would displease Deutsche Bank which reiterated that they were bullish on the US dollar and a firm dollar would cause headwinds for gold.

First, one swallow does not make a summer and one day off opposite movements between the US dollar index and gold does not imply that the negative correlation is breaking down. Correlation is a measure of linear co-movement of two variables, measured by their deviation from the respective mean. Even a high correlation (positive or negative) does not imply that every pair of observation would have to show the same sign. Furthermore, the correlation coefficient does not provide information how many times the two variable move in the same or in opposite direction.

Second, this head of research confuses correlation with causation. The US dollar is not the only fundamental factor having an impact on the price of gold. Crude oil is an important factor for headline consumer price inflation. Therefore, crude oil also has an impact on the gold price. The development of major stock markets, money market interest rates and bond yields also have an impact as many econometric analyses show. Thus, on some days, the other factors could more than compensate the impact of the US dollar on the price of gold. For example, a rise of crude oil prices due to the tensions in Egypt could be sufficiently strong to push gold higher while the US dollar index declines.

Third, in our quantitative fair value model for gold, the US dollar index has a negative regression coefficient. For other variables, there has been a change of the sign in the period starting January last year compared with some years before. However, the sign of the US dollar remained unchanged. Thus, the hope for a break of the negative correlation between the US dollar and gold is probably in vain.

The second article is titled “The hidden agenda behind the bear raid”. Of course, this is another article on a conspiracy theory about gold being manipulated. The author wrote that after the December 2012 FOMC meeting “…gold was driven back below the key psychological $1700 level during an unnaturally high volume hit in the middle of the night. No normal trader seeking to maximize returns would dump that kind of volume into the thin overnight market.” The author completely overlooks that gold is traded not only in the US, but also in Asian and European financial centers. Thus, physical gold is traded around the clock. When it is night time in the US, then it is already morning of the next day in Tokyo and Shanghai. For many Asian investors or traders, this is the first opportunity to react on events in the US, which are important for the price perspectives of gold. One should also keep in mind that the USD/JPY exchange rate is trading with higher volumes during Asian trading hours. Furthermore, with the election of PM Abe in Japan, there was a landslide shift in Japanese economic policy. The target of ending deflation and reaching a 2% CPI inflation rate within two years had consequences for the yen exchange rate. We showed in this blog that the downward move of gold was mainly driven by a firmer US dollar against the Japanese yen.

Furthermore, the author highlights that Goldman-Sachs came out on April 10 with a public recommendation to sell gold short. Goldman-Sachs’ gold analyst was bearish for quite some time before he gave this recommendation. Thus, it was not really new for those reading reports on the gold market at Bloomberg or ThomsonReuters terminals. For an investment bank, it is normal business to make trade recommendations to clients and to send those reports also to the media. The author concludes that “It seems much more likely that Goldman Sachs traders were already short the gold market and were looking to juice the downside as they already knew a stop run was coming.” It cannot be ruled out that traders at Goldman-Sachs were already short gold before this paarticular research recommendation was published in April. However, there are strict rules research departments have to obey. Analysts are not allowed to inform traders about their trade recommendations before they are send out to clients and are in the public domain. Compliance departments have a close eye that analyst do not violate the law because the company can be punished heavily. The fact that this recommendation had a strong impact on the price of gold is due to the reputation of Goldman-Sachs’ analyst who earned his reputation by making many correct calls on gold. Only if an analyst has a good track record or convincing fundamental arguments, then hedge funds or other institutional investors take a story seriously and put money on a recommendation. Thus, also the second argument for a manipulation of the gold market is not based on sound reasons.

The third indication for a manipulation would be the accumulation during April and May of unusually large positions in GDX puts with expiration in June. Those positions would have prevented gold from closing and holding above 1,400$/oz. And miraculously (from the author’s view point) gold collapsed another 125$ before the expiration in June and thus, send the puts deep into the money. However, there is no hidden conspiracy, but these moves could be explained in hindsight after quarterly releases of SEC filings.

There has been much talk in financial markets about JP Morgan and the London whale, which led to a loss of $6bn for the US bank. But there was – or better still is - also a whale in the gold market and his positions were well known due to the quarterly reporting of positions to the SEC. Many hedge funds invested in the SPDR Gold Trust ETF, but the largest stake holder is John Paulson and his hedge fund. After suffering already severe losses in the first quarter of 2013, Mr. Paulson had to react. Hedge fund sponsors could force the manager to take actions even if the manager remains convinced that he holds the right positions. This week, the SEC published data showing that Mr. Paulson has halved his holdings of the SPDR Gold Trust ETF in the second quarter.

Knowing the sheer size of his position and which impact it would have to sell 50% of the position, it is natural that a hedge fund manager would apply several instruments to limit the losses. Accumulating a position in puts is a smart strategy in this context. The puts secures a price for at least a part of the position, which has to be sold. Mr. Paulson lost $736m in the second quarter and his PFR Gold fund is down 65% in the first half of this year. Therefore, cutting the losses and liquidating part of the holdings could hardly be regarded as a market manipulation. The gold bulls also did not complain and called it a market manipulation when the accumulation of Mr. Paulson’s position pushed the price of gold higher.

Thus, all the arguments for a gold market manipulation could be rejected by sound explanations. However, it is a characteristic of all conspiracy theories that their devotees deny the facts. But as the case of Mr. Paulson and his hedge fund demonstrates, it is not only dangerous to swim with sharks but also with a whale.