Commodities | Jun 27 2007
By Greg Peel
Gold is supposed to be the safe haven of safe havens. While the US dollar has largely taken over the role of safe haven of choice in recent years, a falling US dollar has helped push gold up from its lows in the (US$) two hundreds to the six hundreds now. Not a bad run for gold. Global excess liquidity and and a raft of new investment products have aided in this rise.
But we are supposedly now facing a financial market crisis of at least some degree of magnitude. It may all blow over, but either way the uncertainty created by the US sub-prime mortgage scare should really be enough to send investors running for cover – into something that will prevent the erosion of their wealth. That should, by rights, be gold.
But that hasn’t happened. Indeed, the opposite appears true. When the first US mortgage scare hit in February, gold fell US$40. This seems somewhat counterintuitive. As the second scare begins to engulf us, gold has begun to slip again and is in real danger of breaking down. Why is this so?
The more recent woes in gold began when US bonds made a sharp jump in yield to above 5% for the first time in a long time. While there are various influences suggested for this jump, including renewed inflation fears and foreign portfolio diversification, none were considered anything other than bearish for gold. Yet if inflation really is rising, then gold is a hedge. And if foreigners are divesting of US dollar assets, then the dollar should fall and thus gold rise.
Firstly, fears of wholesale foreign diversification have so far proven unfounded. Secondly, a rise in inflation will lead to a hike in the Fed funds rate, which is bullish for the US dollar and such bearish for gold. Thirdly, as bond rates rise the cost of holding gold (which provides no income) becomes greater. What an investor really needs to consider are both the micro and macro scenarios.
As smaller, short term movements occur within the financial markets gold will react accordingly. It is only when the macro picture becomes influential that gold will begin to act more like “the barbarous relic” that it is often called. This may occur if there a threat of nuclear attack perhaps, or World War III, or oil runs out, or California slips into the sea, or some such significant event. But it might also occur if the threat of financial calamity moves from short term to long term, or code orange to code red, such as if, for example, fiat currencies were under threat of becoming worthless due to the sheer extent of financial market collapse. It may also occur if the threat of global inflation became so great (which is tied into the previous example) that gold “decouples” from the US dollar and no manner of interest rate rise can save the dollar in the end.
It is for the latter reasons that the world currently contains many (patient) uber-bulls.
But in the short term the situation is different. When the Chinese stock market plunged, setting off the sub-prime scare and a brief yen carry trade scare as well, it was not a good time to be in gold. That is because the first reaction of the investor who is losing money in another asset class – the stock market for example – is to liquidate whatever he’s got to avoid ruin, or at least avoid heavy losses. Or maybe he needs to meet margin calls. The latter can be very much the case in these highly leveraged times.
Hence gold holdings are dumped. It has long been a mantra that a portion of gold should be held against any stock portfolio as the safety net in a crash. While this is still the case, the fact is that safety net can only be exploited by selling the gold. In the case of the Chinese stock market, so fond of gold are the Chinese that there was no doubt plenty to sell when it looked like the Chinese stock market – full of first time investors – might crash.
And as we now face another potential wholesale sell-down in equities and other assets, gold is falling once more. It is now teetering at the significant technical support level of US$635-640/oz. The feeling among many a gold observer – bulls included – is that it will break. When it does, US$600/oz is next and that’s looking breakable as well.
The sharp fall in gold overnight was aided by options expiries in the futures market. The silver market copped even more of a pasting for the same reason. The problem is that there were large positions in short put options that had been established on the upswing. If these became “in the money”, then the put sellers would need to sell silver futures to cover – quickly. This is not lost on the rest of the market, so the game becomes “who can set off the stops”.
That gold might fall to below US$600/oz has not deterred the longer term bulls. Certainly, if the current financial crisis accelerates then the expectation is that a short sell-off will be replaced by some pretty serious buying. The sort of buying that might see gold testing that magical US$850/oz level sooner rather than later.
But for now, it’s a waiting game. Bottom picking can be dangerous.
