Running With The Bulls: Gold Bugs And Stock Bulls Find Themselves On The Same Team—Pulling Against The Dollar
October 21, 2009 by Brien Lundin
Gold’s meteoric rise over $1,000 left even the most ardent gold bulls reeling from shock and awe. No matter what their bullish expectations may have been beforehand, few market watchers could honestly say they expected such a powerful run.
They weren’t alone. Investors and analysts were similarly surprised by the power and persistence of the rally in the broad U.S. equity market, and were left grasping for excuses.
The common denominator behind both bull moves: a declining dollar.
Bucking the Trend
Gold and stocks aren’t known as correlated asset classes, to be sure. So their almost perfectly choreographed moves in opposition to the dollar meant that analysts had to explain not only their individual moves, but why they were moving in unison.
Of course, it wasn’t too difficult to connect the stock and gold moves to the weakening dollar. But from there, most supposed experts were left scrambling.
They mentioned a growing dollar carry trade, wherein extremely low interest rates in the U.S. prompt investors to borrow dollars to fund riskier and higher yielding investments elsewhere.
This trade has, indeed, grown. And it will continue to have an impact, as long as the Federal Reserve Open Market Committee’s statements keep noting that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
If dollar interest rates are going to be low for the foreseeable future, why wouldn’t you arbitrage those low rates against higher yields elsewhere?
Another excuse put forth for dollar weakness has been the comparatively stronger economic growth rates in China and the rest of Asia. It seems obvious that Asia is far ahead of the West in the economic recovery, and this relative strength has been attracting capital to the dollar’s detriment.
But the columnists and talking heads on CNBC missed some of the most compelling reasons for the dollar’s swoon:
- The surprisingly broad push for a new global reserve currency to replace the dollar. China, Russia, Brazil, France and other nations have joined an international chorus calling for a new global reserve currency regime, one most likely based on a revamped International Monetary Fund (IMF) special drawing right (SDR).
The calls for talks on this issue have come so frequently, and the silence from the Obama administration has been so obvious, that what once seemed little more than bluff and bluster now appears to be the advance signs of an inevitable abdication of the dollar’s reign as the king of currencies.
I’ve covered this frightening development in recent columns so you know that if President Obama allows this to occur I’ll view it as one of the greatest foreign policy failures in American history. And the fact that the current administration doesn’t view it as such is what truly scares me.
- The socialization of the American economy. From bailouts to nationalized health care, from more steeply progressive tax rates to the assumption that government can dictate private sector compensation…and the myriad other assaults on capitalism and individual liberty now coming out of Washington, it’s obvious that the America of tomorrow will no longer resemble the dream of our founding fathers.
This concerns not only freedom-loving Americans, but also anyone anywhere in the world with assets in the U.S. When foundational principles are ignored as a matter of political expediency, when the rule of law offers protection only to favored classes or industries, then capital will flee to regimes that offer greater safety and certainty.
This is, in fact, a big factor behind the diminishing role of the U.S economy, and the decreasing relative value of the American dollar.
- The massive issuance of U.S. dollar debt and currency. I don’t want to belabor the point, but the world has been flooded with liquidity via the creation of unprecedented levels of new debt and currency.
The U.S. hasn’t been the only violator in this regard—only the most egregious.
Some argue that the Federal Reserve, having created much of the new liquidity with the figurative stroke of a pen, can mop it all up just as easily. They ignore the fact that if the Fed was so prescient and powerful it would have never been faced with having to create all that liquidity in the first place.
The Fed is so fearful of deflation, and has become so politicized, that it will almost assuredly overshoot the mark and leave its foot on the monetary gas pedal too long.
The bottom line is that the supply of fiat currency in the world at large has risen precipitously, but to a significantly greater degree in the U.S. While this will translate to higher asset prices generally, it will also translate to a lower relative value of the U.S. dollar.
The writing is on the wall, and investors know it.
A Battle Royale
In the meantime, the bulls and the bears have drawn the battle lines over gold and amassed on both sides what may be the most powerful forces we’ve seen for years.
Consider that the Large Commercial Net Short position in gold has risen to record levels, but on an absolute basis and as a percentage of total open interest. On the other side of the bet the speculative long position has also soared.
As long-time readers know, the large commercials are most often correct in their bets on gold. The reasons for this are two-fold: 1) Because they are so intimately involved in the gold market they understand the underlying forces much better, and 2) because they are typically hedgers who reflexively short gold in a rising price environment, their increasingly larger selling tends to create a self-fulfilling prophecy in lower gold prices.
So, again, when they pile on historically large short positions, gold usually heads south. However—and this is an important distinction—when they are wrong, they are wrong in a very big way.
As I noted last month, a prime example of this came in late 2005, when the large commercials were forced to cover their bets against gold en masse…with the result being a leap in the gold price from $450 to $700 over the coming months.
So the current situation is crucial. If the large commercials are forced to cover, they could send the price skyrocketing.
If the speculative longs are forced to sell out, gold could crater.
Ironically, some of the pressure has been let off by gold’s recent retreat below $1,000. The Commitment of Traders (COT) report for the week of gold’s highs shows that the larger commercials had added even more to their short positions, establishing a new record of 287,610 contracts net short.
However, this huge cumulative short position also acts as a cushion on any price declines. Undoubtedly, as the gold price fell from the recent heights, commercials began covering some of those short positions, helping to prevent further declines.
The physical gold market has also entered into this battle. Here we see a number of new factors coming into play…
First off, we saw the announcement by Barrick Gold that it had—finally, after a $750/ounce rise in gold from 2001—decided to buy back all of its remaining gold hedges.
Whether you think this announcement is bullish or bearish depends on your position in the market…and whether you’re a “glass-half-full” or “half-empty” sort of person.
In other words, once Barrick bought back all of its hedges (and it was rumored that they had already begun doing so in the preceding weeks), then that potential bullish factor would be removed. That’s the glass-half-empty view.
The glass-half-full view holds that Barrick’s upcoming buying will only add more pressure to an already drum-tight gold market.
Not long after Barrick’s announcement, we heard from the International Monetary Fund (IMF) that it was ready to begin the sale of 403 tonnes of gold. This didn’t have the bearish effect that similar announcements have had in the past when this issue has been trotted out to dampen gold price rallies.
It didn’t scare the market much this time because the sale would either come under the umbrella of the Central Bank Gold Agreement (where central bank sales had already slowed to a trickle), or the entire amount would be taken up by China or another central bank. The latter event would be net bullish for gold, by implication more than direct effect.
And finally, we’ve seen surprisingly strong physical demand from Asia, particularly India, despite the rising gold price. The reason? Festivals in India and government programs encouraging gold buying in China helped boost demand, and the weakening dollar meant that gold’s price rise was mitigated in local currencies.
So we can expect that any significant decline in gold, especially if it’s not accompanied by dollar strength of the same degree, will be met by increasingly large physical demand from Asia.
A Pressure Cooker About To Blow
So, the battle lines have been drawn, and it seems the gold price is destined to break strongly one way or the other.
Technically, the extensive consolidation pattern traced out by gold argues for a break to the upside. More fundamentally, the towering net short position of the large commercials seems to favor a correction, although the recent decline below $1,000 may have alleviated some of that pressure.
Regardless of the outcome, it seems safe to say that this rally has already demonstrated greater strength and resilience than anyone ever expected. Even if gold corrects, the price has spent enough time well above $1,000—setting new daily close price records in the process—to make this an important and confirming move.