Gold - A Perfect Storm For 2019

A brief analysis of the availability of physical supply points to acute shortages on any expansion of demand. Seasonal factors can have a significant impact, with the Diwali festival in India a month ago, and the Chinese New Year in early February leading to an accumulation of bullion inventories. 

The absorption of available liquidity from mine supply and scrap recycling tells us the physical market has become extremely tight. Instability in fiat currencies, particularly weakness developing in the dollar’s trade-weighted index, could, therefore, have a disproportionate effect on the gold price as a wide range of investing institutions and commercial banks try to correct their almost zero asset allocation to gold.

Paper markets for gold

As the chart below shows, gold bottomed in December 2015, since when it has been in a narrowing consolidation. Within this pattern, there is a seasonal effect, whereby gold sells off in early December and subsequently rallies. This is shown by the three black arrows on the chart.

(Click on image to enlarge)

13 Dec 3

There are reasons why this is so. The December contract is the last active contract to expire before the year-end when many hedge funds and bullion banks make up their accounts. Hedge fund managers want to present a balance sheet with less risk exposure than they normally run, and banks will wish to present shareholders and regulators with a sanitized version of their risk exposure as well.

This exposure cycle has had an extra twist this time because market speculators in futures markets have shorted a wide range of futures in order to capture a strong dollar. In the case of the Comex gold future, this has led to an unprecedented technical position, shown in the next chart.

(Click on image to enlarge)

13 Dec 4

Over the last twelve years, hedge funds (which are represented in this category of speculator) have only been net short of Comex gold contracts twice. The first time was in late-2015, which marked the end of the 2011-15 bear market, and the second was recent, marking the sell-off to $1160. The only reason it has partially corrected is due to the expiry of the December contract.

Market sentiment is still markedly pro-dollar and anti-everything else, including gold. The underlying assumption appears to be that foreigners require dollars and the dollar has the highest interest rates of the major currencies. This being the case, the first supposition is an error. There is a growing expectation that the US economic growth will slow next year, and the Fed is under pressure not to raise rates any further.

When these changing factors are taken into account, the dollar is likely to be sold, and hedge fund speculators will take the other tack. The market-makers, traditionally the bullion banks, are bound to be aware of this possibility and will, therefore, try to maintain an even book.

Conclusion

All factors examined in this article point to higher gold prices in 2019. They can be summarised as follows:

  • The world is awash with dollars at a time when markets act as if there is a shortage. When the truth emerges, the dollar has the potential to fall substantially against other currencies, leading to a rise in the price of gold.
  • The move towards gold and against the dollar in Asia accelerated in 2018, with Russia having replaced the dollar with gold as its principal reserve currency. China has laid the foundation with an oil-yuan futures contract, which can be a bridge to yuan-gold contracts in both Hong Kong and Dubai. This is a direct challenge to the dollar as a reserve currency, and likely to be attractive to oil suppliers, such as Iran, seeking to circumvent the use of the dollar and accumulate gold instead.
  • America’s trade war against China appears to be less about unfair trade practices and more about stopping China from evolving into a serious technological competitor against the US. In 2019, there is a strong possibility the tariff war will escalate into a wider conflict, with China selling down its exposure to the dollar and US Treasury debt. That would create significant difficulties for the US Government and the dollar itself.
  • With the credit cycle turning and the addition of American tariffs, markets are at a growing risk of replicating the 1929-32 crash and the economic depression that followed. This time, instead of commodities and consumer products effectively priced in gold through a gold standard, they will be priced in fiat currency. Monetary policies will ensure liquidity is freely available to support the commercial banks, government spending, and economic activity. This is a recipe for higher gold prices.
  • Demand for physical gold continues to outstrip mine supply. In 2019, risk-weighting rules in Basel III open up the opportunity for commercial banks to augment their liquidity with allocated bullion, attractive to euro- and yen-based banks who face negative interest rates on short-term cash alternatives.
  • The technical position in the paper markets looks favorable, with close to record levels of bearishness, and an established pattern of December rallies in the gold price.

[i] See Exhibit 19T on p.30, columns 6&7, and Exhibit 18 on p.29 respectively of Foreign Portfolio Holdings of US Securities (June 2017). http://ticdata.treasury.gov/Publish/shla2017r.pdf
[ii] See Treasury Bulletin on Foreign Currency Positions, p.69 Table FCP-V1-2. https://www.fiscal.treasury.gov/files/reports-statements/treasury-bulletin/b2018-4.pdf
[iii] See https://www.marketwatch.com/story/this-is-how-much-money-exists-in-the-entire-world-in-one-chart-2015-12-18
[iv] Source: World Gold Council

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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