What Is Driving Gold At The Moment?

A Major Misconception

Recently gold has traded between roughly $1280 and $1320, whereby the former is a major technical support level, and the latter a minor level of resistance. As we have previously argued, there are certainly a few gold traders who trade gold based on headlines, lately mainly geopolitical headlines.

This really makes no sense, unless one lives in one of the countries that are in conditions of war. In that case, one might try to hedge against the devaluation of one's home currency and also to transform some of one's wealth into an easily portable form (that can also be used to bribe the border guards if need be). For anyone residing thousands of miles from the action, the only reason to buy gold based on such headlines is if it can be reasonably concluded that the far away war will lead to more government spending and looser monetary policy at home.

Nevertheless, a great many people seem to think that gold is a useful gauge of the whims of Mssrs. Putin and Poroshenko, and there is a contingent of traders who buy and sell gold based on the news of the day related to this conflict. This is mainly an excellent way to lose money. One might as well base one's decisions on a throw of the dice.  A recent example of this kind of thinking can be found in an article posted at Marketwatch, in which the author asks“Is gold wrong and oil right on Ukraine and Russia?”

Of course, neither oil nor gold have any volition or opinion. If anything, this question should be reformulated to include market participants in some way, such as  e.g., “are gold traders or oil traders wrong”. However, even then it wouldn't make much sense, because it glibly assumes that the prices of oil and gold both are driven by nothing but perceptions about events in Ukraine. It should be pointed out to this that oil and gold are actually completely different markets, largely driven by entirely different fundamentals and for the most part traded by different traders to boot.

Oil is an industrial commodity, so geopolitical upheaval (not necessarily in the Ukraine, but certainly in the Middle East) can indeed be of direct relevance to its price, if such upheaval is held to threaten a supply interruption. If the newly mined supply of gold were interrupted, the effect on the gold market would essentially be zero. More gold is traded in the world in the space of two or three trading days than is mined in an entire year. Most of this trading involves gold that has been mined in the past: gold is a monetary commodity first and foremost and isn't “used up”, hence its above-ground stock is vast relative to the annual additions to it from mining. Geopolitical upheaval can never be adirect fundamental driver of the gold price. As noted above, only indirect effects stemming from inflationary policy related to war may be regarded as legitimate drivers of its price in this context. The author of the above mentioned article writes:

“The chart shows that oil has underperformed gold by over 10.5% in a short time. Clearly, the oil market does not think that there will be an invasion of Ukraine by Russia in the near future. This is entirely opposite to the reason for the momo crowd buying gold.

Who is right, oil or gold? In this corner, based on the algorithms of ZYX Change Method, oil is most likely correctly predicting that there will be no full scale invasion of Ukraine by Russia in the near future. As the media frenzy dies down, gold is likely to pull back.”

Again, neither the oil market nor the gold market “think” anything. The thinking, if any, is done by traders. It is certainly true that a certain percentage of traders bases decisions to buy or sell in these markets on news headlines. It makes a lot more sense in the context of oil than in the context of gold, but we may concede that a number of traders are also motivated to trade gold based on news headlines. These traders will sell their positions if the news “get better”.

However, neither the oil nor the gold market actually “know” whether Russian troops will invade Ukraine. Since the conflict began, it has always been extremely unlikely that Russia would invade. The only piece of territory in the Ukraine that is of strategic interest to Russia's government is the port of Sevastopol.  It annexed the port and the surrounding province of Crimea without firing a single shot, with the full support of the local population. Case closed, one would think.

However, given what has happened since then, this doesn't mean a Russian invasion of Eastern Ukraine can be completely ruled out. At present, Ukraine's new ruling oligarch Poroshenko isn't even allowing a convoy with humanitarian aid through to Donetsk, in spite of agreeing to allow it to pass only 24 hours ago. It would presumably be very easy to check the convoy's cargo to ensure that it only brings  goods to help the trapped civilian population, but Kiev's government may not really have much interest how the local population fares. It doesn't want to rescue it, it mainly wants it to pay taxes (the survivors, at any rate). You can read about the event and the associated back and forth and accusations and suspicions here. NATO general secretary Fogh Rasmussen meanwhile has recently warned (for the umpteenth time) that Russia might invade – this time under the guise of “humanitarian aid”. He should certainly know, given that “humanitarian interventions” are currently a highly popular pretext for entering wars. After all, this is exactly what is currently happening in Iraq. 

Russia's government may therefore well be tempted to emulate the Obama administration and invade Ukraine under the same pretext. However, it remains far more likely that it won't, simply because it doesn't want to become the owner of the territory concerned. Russia's government is no doubt concerned about the fate of ethnic Russians in the Ukraine in the wake of the coup in Kiev – but from all we have seen thus far, it would very likely vastly prefer some sort of federalization/devolution of power deal between Kiev and the rebellious regions over becoming their new owner (as that would involve a major financial commitment and invite all sorts of trouble beyond that).

Still, an intervention cannot be ruled out entirely, but neither the oil market nor the gold market “know”. Market participants would presumably react if it were to happen, but it can be argued that neither market reflects much of a “war premium” at present. There are more then enough legitimate reasons for gold to rise, so its current price can be easily explained by those as well. There is really no need to engage in guessing games about future events in the Ukraine.

As this chart of gold and silver shows, gold continues to outperform silver on a short and medium term basis. This reflects waning economic confidence, which is also evident in credit spreads. The recent short term uncertainty (short term rallies in gold are quickly given back, but support also continues to hold) may well be driven by headlines, but the true fundamental drivers of the market consist of entirely different things (a list of these drivers can be seen in this article) – click to enlarge.

Gold Stocks Still Suggest that Gold is Likely to Rise

A major reason why we believe that gold's current show of strength – moderate though it is – it not just a fluke or another flash in the pan, is that gold stocks continue to indicate that gold is immersed in a bottoming phase. This phase is an almost exact mirror image of the topping period seen in 2011-2013. The chart of the HUI and the HUI-gold ratio below confirms this assessment so far:

The HUI and the HUI-gold ratio. It is the ongoing strong uptrend in the ratio that supports the conclusion that gold is more likely to rally than decline over the medium term – click to enlarge.

The next chart shows a proxy for credit spreads, the JNK-TLT ratio. A decline in this ratio means that credit spreads are widening, an increase means they are tightening. What is noteworthy about this chart is that after a lengthy topping period, the ratio has recently declined below what appears to be an important support area. It is now rising back to this area, which has  a very good chance of turning into resistance. If so, it will lend additional support to the gold price.

JNK-TLT ratio – currently rising back to a recently broken major lateral support area- click to enlarge.

Gold Stock ETFs

Lastly, here is a quick glance at the two gold stock ETFs GDX and GDXJ. The question is, what should traders do? The probability that a breakout will occur is very high, but we can of course not be certain whether it will occur immediately, or if there will be another pullback first. The chart gives a few pointers on what actions one may want to take if one has no position at present or considers adding to an existing one. Always keep in mind that gold stocks tend to be highly erratic and volatile, and that technical “head-fakes” are unfortunately a frequent occurrence in both directions.

GDX and GDXJ both are approaching an important resistance level. A breakout would likely be quite meaningful, but there could easily be another pullback first. Either event should be regarded as a potential opportunity – click to enlarge.

What about the risks? There is still a possibility – even though we think the probability is very low – that the cyclical bear market in gold and gold stocks is not over yet and that another leg down will be required to end it.

The reasons why we regard that possibility as low are the following: 1. the fundamentals for gold have improved. 2. they are likely to improve further 3. the types of technical divergences frequently encountered at major lows have all been put in place between June 2013 and June 2014. We have documented these events as they occurred in numerous previous articles.

However, there are never any guarantees. There may be future developments that will force us to change our assessment. In markets one always deals with probabilities – one cannot wish the omnipresent fact of uncertainty away. The future is always uncertain. It follows from this that one also needs to have a plan of action in the event that the anticipated events fail to unfold as expected.  How one decides to limit this risk depends on one's individual approach to risk management, we only mention this point in order to stress that one needs to have such a plan in place before taking a position.

Conclusion:

So far, the market data continue to indicate that a bottoming process is underway in gold. As long as gold and silver stocks remain strong relative to the metals, the probability of that a medium to long term rally in the metals will begin this year must be regarded as very high.

Keep in mind that the gold market is highly sensitive and often discounts future events far in advance. While this lead time varies, we know from experience that it can sometimes be very long. In our opinion, the geopolitical backdrop is mainly a distraction in this context. We suspect that medium to long term oriented buyers are in the market because they want to obtain insurance against the highly likely future bursting of the bubble in risk assets. Their activities were probably the main factor in halting the market's decline in mid 2013, and are likely continuing to provide major support to the gold market to this day.

Charts by: StockCharts