Futures Still Dogging Gold

CPA, Principal & Co-Founder of Zeal LLC
September 9, 2022

Gold continues to languish near major lows after a rough summer, deeply out of favor with traders.  Oddly this leading alternative investment seems oblivious to the first inflation super-spike since the 1970s.  That should be driving big gold demand, fueling a major upleg.  But that classic inflationary response has been temporarily delayed by heavy-to-extreme gold-futures selling.  When that reverses to buying, gold will soar.

As everyone running a household or business knows, inflation is raging out of control.  Not even lowballed government statistics can hide it.  The monthly US Consumer Price Index has averaged blistering 8.3% year-over-year gains so far in 2022!  That’s 4.6x 2019’s +1.8%-YoY monthly average, the last normal year before the pandemic-lockdown stock panic and its extensive aftermath.  This June, the CPI soared 9.1% YoY.

That proved its hottest print since way back in November 1981, a staggering 40.6-year high!  That’s despite today’s CPI being way watered-down compared to the 1970s one, extensively understating real inflation.  Americans sure wish prices were only climbing 9%ish annually, but the grim reality out there is at least double to triple that.  With such extreme inflation, gold should be soaring on huge investment demand.

Gold skyrocketed during the last similar inflation super-spikes in the 1970s.  In the first the CPI blasted from +2.7% YoY to +12.3% over 30 months into December 1974.  Gold’s monthly-average prices from trough to peak CPI months launched 196.6% higher!  During the second the CPI exploded from +4.9% YoY to +14.8% in 40 months climaxing in March 1980.  Gold’s monthly-average prices were a moonshot, up 322.4%!

If today’s CPI still used its far-more-honest 1970s methodology, headline inflation would be about double reported levels.  Gold’s stunning disconnect from today’s raging inflation is troubling, leaving the great majority of traders forgetting about that 1970s precedent.  After suffering one of its worst summers in modern bull-market years, gold has largely been left-for-dead.  Instead of flocking back, investors are fleeing.

This vexing gold impotence is sure evident in this chart updated from my latest gold-summer-doldrums essay of early July.  It normalizes gold prices during modern bull-market summers, indexing price action to May closes.  Gold’s average summer performances between 2001 to 2012 and 2016 to 2021 are rendered in red.  Superimposed in dark blue are 2022’s anomalously-weak technicals, which have been ugly.

Normally gold carves a major seasonal low in mid-June, then starts marching higher as its autumn rally fueled by outsized Asian gold demand accelerates.  But instead of bottoming, gold deviated wildly from that trend this year.  Down 7.7% summer-to-date in late July, that was gold’s worst performance during all these modern gold-bull years!  The yellow metal should’ve been surprising to the upside with inflation raging.

Since price action drives herd sentiment, that fueled overwhelming bearishness that continues to fester.  Neither speculators nor investors want anything to do with gold, because its momentum has been going the wrong way.  If not even the first inflation super-spike since the 1970s can ignite big, sustained gold demand, what on earth could?  Looking broken given this super-bullish backdrop, gold has been abandoned.

But the kicker is recent months’ dreadful gold underperformance isn’t fundamentally-righteous.  It is just a short-lived anomaly driven by heavy-to-extreme gold-futures selling.  That’s what has been dogging gold, and it is inherently self-limiting and mean-reverting.  Gold-futures speculators’ capital firepower to sell is relatively-small and finite.  Once that is expended, they will have to buy proportionally to normalize their bets.

The biggest problem in gold markets is the extreme leverage intrinsic in futures trading.  That enables a tiny group of traders to wield wildly-disproportional influence over gold prices.  This week, each contract controlling 100 ounces was worth $170,000 at $1,700 gold.  Yet traders are only required to maintain cash margin in their accounts of $6,500 per contract, making for crazy maximum leverage way up at 26.2x!

Running at 26x, each dollar traded in gold futures has 26x the price impact on gold as a dollar invested outright!  So gold-futures speculators punch way above their weights in dominating short-term gold price action.  This is a serious structural problem undermining gold fundamentals, as such extreme leverage creates irresistible opportunities for price manipulation.  Recent US federal-court cases have proven this out.

Just a month ago, the former head of JPMorgan Chase’s precious-metals business and his top gold trader were convicted of manipulating gold prices from 2008 to 2016!  They face decades in prison when sentenced.  They did this through leveraged gold-futures trading, including spoofing.  That is unleashing huge bogus gold-futures sell orders to hammer gold, which are then quickly cancelled before execution.

During closing arguments in that trial, the federal prosecutor stated “They had the power to move the market, the power to manipulate the worldwide price of gold.”  That brings the US Justice Department’s secured convictions to ten former Wall Street traders at JPMorgan, Merrill Lynch, Deutsche Bank, Bank of Nova Scotia, and Morgan Stanley.  So there’s no doubt leveraged gold-futures trading greatly affects gold prices!

Thus it desperately needs to be reformed dramatically to eliminate this extreme leverage that inevitably attracts fraudsters.  20x to 30x should be illegal, like in the stock markets where 2x has been the limit since 1974.  Even for the vast majority of gold-futures traders who aren’t criminals, such radical leverage is so exceedingly-risky that it compresses their trading time horizons into a very-myopic ultra-short-term.

Running 26x, a mere 3.8% gold price move against specs’ positions will wipe out 100% of their capital risked!  So all they can afford to do is chase hour-by-hour momentum, which is what they did this summer to slam gold.  They can’t care about gold’s global supply-and-demand fundamentals, nor inflation, nor prevailing trends in gold and broader markets.  All that matters is whether gold is rising or falling each minute.

This chart superimposes recent years’ gold technicals over speculators’ total positions in gold-futures long and short contracts.  Those are reported weekly in the famous Commitments-of-Traders reports, current to Tuesday closes.  Gold disconnected from inflation in recent months because gold-futures specs puked out enormous amounts of selling!  This short-term-momentum chasing had nothing to do with fundamentals.

Gold started 2022 quite strong, surging 16.0% over 3.2 months into early March.  While Russia invading Ukraine was a big contributor to that fast spike to $2,051, that just extended a year-old uptrend.  Investors impressed by gold’s strong upside momentum were growing more bullish and increasingly deploying new capital.  Gold even consolidated high near uptrend resistance after that initial geopolitical shock passed.

But something changed in mid-April when gold was still running $1,977.  Over the next 3.2 months into late July, it collapsed 14.3% to $1,695.  That was despite headline CPI inflation in April, May, June, and July coming in red-hot up 8.3%, 8.6%, 9.1%, and 8.5% YoY!  It made no sense to flee gold with that kind of wildly-bullish backdrop, given the yellow metal’s centuries-long history of being the ultimate inflation hedge.

Gold crumbled contrary to fundamentals because gold-futures speculators started aggressively selling and that snowballed.  From early March to late July, they vomited out an enormous 116.9k gold-futures long contracts while piling on another 52.3k short ones.  That 169.2k contracts of spec selling dwarfed anything seen in recent years, adding up to a massive equivalent of 526.1 metric tons of gold dumped!

That was way too much too fast for markets to absorb, so gold prices collapsed.  This huge gold-futures spewing was initially catalyzed and subsequently fueled by the US dollar rocketing parabolic to hit multi-decade secular highs.  Gold-futures specs watch the US Dollar Index for their primary trading cues, doing the opposite.  Within that span gold plunged, the USDX skyrocketed an utterly-enormous-for-it 8.8% at best!

Heavy gold-futures selling and thus gold prices almost perfectly inversely mirrored the USDX’s fortunes during that time.  That leading dollar benchmark blasting to an extreme 20.1-year high in mid-July fueled great euphoria.  Like always during big-and-fast surges to lofty heights, traders’ greed flared to bullish extremes.  Despite that long-dollar trade being wildly-overcrowded, they assumed its upside would last indefinitely.

That deluge of capital into the extraordinarily-overbought US dollar was in turn driven by the Fed’s most-extreme hawkish pivot ever.  That included aggressive official jawboning on coming rate hikes, multiple massive 50- and 75-basis-point ones executed, and ramping up the biggest-and-fastest quantitative-tightening monetary-destruction campaign ever attempted!  The dollar soared with the Fed blasting rates higher.

It was boosted by a cratering euro, as that dominates the USDX at 57.6% of its weighting.  Just like the Fed, the European Central Bank had redlined its monetary printing presses since March 2020’s scary pandemic-lockdown stock panic.  So inflation was raging in the Eurozone too, but the ECB was dragging its feet on hiking rates.  With American yields soaring way faster than European ones, the euro was sold hard.

Exacerbating that long-dollar short-euro trade, Europe is facing a severe recession if not a depression due to its heavy reliance on Russian natural gas.  European countries joined the US in sanctioning Russia extensively for its brutal war on Ukraine, so Russia responded by slashing its natural-gas exports to Europe.  Thus electricity prices have shot stratospheric, threatening increasing social unrest and political turmoil.

These dynamics have left the USDX extraordinarily-overbought while the euro is extraordinarily-oversold.  But extreme trades can only move in one direction so long before they have sucked in everyone willing to buy or sell.  With available capital firepower exhausted, they soon reverse sharply in proportional mean reversions and overshoots in the opposite direction.  The parabolic US dollar is overdue to plunge back to earth.

That unsustainable extreme euphoric dollar surge is what sparked, fueled, and intensified that huge gold-futures selling in recent months.  That also proved anomalously-extreme, leaving specs’ positioning exceedingly-bearish and overdue to reverse.  To normalize their collective bets, these hyper-leveraged traders will soon have to do enormous proportional gold-futures buying.  That will catapult gold sharply higher.

Speculators’ total gold-futures long and short contracts have their own trading ranges, which are rendered on this chart.  Since spec longs now outnumber shorts by 1.9x, they are proportionally more important for gold’s near-future direction.  As of the latest-reported CoT week ending last Tuesday, total spec longs had collapsed to a 3.3-year low of 274.2k contracts!  They hadn’t been lower since way back in late May 2019.

Specs can only do so much selling until their capital firepower is spent, their longs will never go to zero.  The original purpose of futures markets was hedging for actual producers and consumers of real physical commodities.  Speculators take the opposite sides of those hedging trades.  So once extreme bearish sentiment has driven spec longs down to major multi-year lows, massive mean-reversion buying soon erupts.

After that last time spec longs fell this low, gold blasted 21.5% higher in just 3.3 months as these traders normalized their gold-futures positioning!  A similar mean-reversion blast out of late July’s deep low would catapult gold up near an all-time high around $2,060.  That would work wonders for psychology, restoring gold’s strong uptrend and enticing back speculators and investors in droves.  Gold’s fortunes really turn fast.

In addition to today’s unsustainable extreme bearish positioning in speculators’ gold-futures longs, their shorts soared to their own in late July.  That CoT week gold bottomed, total spec shorts rocketed up to 176.1k contracts.  That was their highest in 3.7 years, since late November 2018!  That mean-reversion buying already started, which is why gold rallied into early August before more uber-hawkish Fedspeak.

After that prior extreme, gold surged 10.4% higher over the next 2.8 months.  A similar normalization rally today would power gold back up near $1,872.  Even that would easily slay this bearish sentiment, starting to bring speculators and investors back to gold.  Just like downside momentum, upside momentum soon becomes self-feeding.  Buying begets buying as traders chase gains, amplifying gold’s upside as they return.

Gold uplegs unfold in three stages.  They are ignited and initially fueled by gold-futures short covering, which is legally required to close out those bets.  That pushes gold high-enough for long-enough to fuel larger gold-futures long buying.  That accelerates gold’s upleg to decisive-enough gains to start attracting back investors with their vastly-larger pools of capital.  Their far-bigger buying eventually drives major uplegs.

In one of those recent federal cases against traders illegally manipulating gold prices with futures trading, a prosecutor made a profound argument about why that is so damaging.  Investors look to price trends for clues on how gold is actually faring fundamentally.  So spoofing, or even leveraged selling snowballing like recently, sabotages crucial price signaling.  Gold doesn’t reflect underlying real-world supply and demand!

The greatest tragedy of this irresponsibly-extreme leverage allowed in futures trading is it heavily distorts gold prices.  That greatly affects investor psychology, greatly impacting capital flows necessary to balance global supply and demand.  Because of recent months’ unsustainable hyper-leveraged futures dumping, investors have abandoned gold thinking it is totally broken disconnecting from this raging inflation super-spike.

While global gold investment-demand data is only published quarterly, an excellent high-resolution daily proxy is the combined holdings of the world’s largest and dominant gold exchange-traded funds.  These are the mighty American GLD and IAU.  According to the World Gold Council, at the end of Q2 their massive gold-bullion holdings accounted for 41.1% of those in all the world’s physically-backed gold ETFs!

The distant-third-place ETF ranks just 7.5%.  The quarterly swings in GLD+IAU holdings alone are often responsible for most if not all of the changes in overall world gold demand!  During that 14.3% gold plunge between mid-April to late July, GLD+IAU holdings fell 6.9%.  And that was part of a worse 9.9% total draw from late April just after that gold-futures selling erupted to this week, pounding them back to 1,465.0t.

Because extreme gold-futures selling on an even-more-extreme parabolic dollar surge has dogged gold so hard in recent months, investors have fled.  They assumed the false gold-price signaling driven solely by colossal unsustainable gold-futures selling was fundamentally-righteous.  They worried gold really had decoupled from this raging inflation.  Watch what happens once they figure out all this was just an illusion!

Even with crazy leverage, the relatively-small gold-futures-trading tail can only wag the vastly-larger gold-investment-demand dog for so long.  When massive gold-futures mean-reversion buying inevitably erupts out of spec-positioning bearish extremes, resulting sharply-higher gold prices soon attract back investors.  Their self-feeding buying greatly amplifies and extends young gold uplegs, growing them to major sizes.

Speculators’ gold-futures longs can’t stay near extreme 3.3-year lows for long, such excessively-bearish herd bets never last.  Soon some news or market catalyst arises that ignites big proportional mean-reversion buying.  Another one is coming, likely the radically-overextended US Dollar Index falling from its unsustainable multi-decade highs.  Once that futures buying gets underway, gold will be off to the races again.

As stage-one spec gold-futures short covering fuels stage-two spec gold-futures long buying which in turn drives stage-three investment buying, gold will rapidly power higher.  Within a few months of this getting underway, it will be back into the $1,900s or even $2,000s!  The biggest beneficiaries of gold normalizing to reflect this super-bullish inflationary backdrop will be the gold miners’ stocks, which have been brutalized.

While gold fell 14.3% at worst between mid-April to late July on that extreme futures selling, the leading GDX gold-stock ETF plummeted a horrific 43.5% from mid-April into last week!  The sentiment damage from the false gold-price signals was so severe that the entire gold-mining sector collapsed.  So the gold stocks are in for a colossal mean-reversion rally far exceeding gold’s as fundamentally-righteous prices return.

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The bottom line is heavy-to-extreme gold-futures selling has really dogged gold prices in recent months.  Speculators dumped massive amounts of hyper-leveraged gold-futures contracts since mid-April, which slammed gold prices sharply lower.  That fueled increasingly-bearish psychology, scaring investors into fleeing in concert exacerbating gold’s selloff.  They worried it had disconnected from this raging inflation.

But the resulting low gold prices are a temporary futures-distorted anomaly, not fundamentally-righteous.  The huge gold-futures selling driving them has already been exhausted.  Gold blasted dramatically higher on proportional mean-reversion buying after similar past bearish extremes of spec gold-futures positioning.  Th

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Adam Hamilton, CPA, is a principal of Zeal LLC, which he co-founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Hamilton is a lifelong contrarian student of the markets who lives for studying and trading them.


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