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July 10, 2015

Gold vs. Grexit

The Everything is Fine Meme 

Initially, we were also a bit surprised that the gold price didn’t rise when the threat of a Greek exit from the euro area became more palpable following the breakdown in negotiations and the outcome of the Greek referendum. After all, it was to be expected that “risk assets” would suffer and so-called safe haven assets would be sought after, at least temporarily.

However, upon giving the matter some thought, we have concluded that gold’s lack of a response (in fact, it went slightly down rather than up, so there was actually a response) could actually be explained quite easily. For one thing, speculators increased their net long position in gold futures by more than 20,000 contracts net in the week before the negotiations broke down, apparently in anticipation. While they did so, the gold price barely budged, so in a sense it was “wasted firepower”.

Prior to the breakdown in negotiations between the troika and Greece, speculators increased their net long position in gold (above the net hedger position is shown, which is the inverse of the speculative position) – click to enlarge.

When no large increase in prices occurred on the Monday after the referendum had been announced, these new positions were quickly liquidated again. The downturn in prices in turn emboldened speculators to add to their short positions, pressuring prices even further.

There are other reasons for the reaction as well. One is that in spite of a bit of a wobble in stocks, the essential “everything is just fine” story hasn’t really been derailed. The dangers of a “Grexit” are probably underestimated and up until recently, no-one believed it to be a likely outcome anyway (it still isn’t, although it is more likely than it once used to be).

If the underlying fundamental situation is held to be essentially unchanged, this also implies that the Fed’s often announced rate hike – i.e., the most heavily advertised and most often postponed baby step rate hike in the history of central banking – will actually be implemented. This is held to be bearish for gold, but of course rate hikes are not bearish per se – it all depends on inflation expectations at the time they are enacted.

A 30 minute chart of August gold futures over the past week

A Grexit Would Initially be Deflationary

Moreover, an actual “Grexit” would have mildly deflationary consequences for the euro area, negating the ECB’s monetary pumping efforts to some extent. This is so because the deposit money remaining in Greek banks would be subject to a severe haircut. If the ECB withdraws ELA financing, Greece’s commercial banks will be instantly insolvent (this is to say, the inherent insolvency of Greece’s fractionally reserved banks would become manifest very quickly). All their creditors would lose a sizable part of their claims and depositors could at best hope to regain a small proportion of their deposits. Most likely whatever they would be able to get back after the deflationary confiscation of the bulk of their savings would be redenominated in a fast plunging new currency (essentially equivalent to the Argentinian post-default playbook).

It must be kept in mind though that this deflationary effect would be very short-lived, as the ECB must be expected to redouble its money printing efforts if Greece indeed exits the euro area involuntarily, so as to avoid a too strong increase in peripheral sovereign credit spreads. Looking at the 5 year bond yield of Portugal as an example of a small peripheral euro area country, we can see that the prospect of a Greek exit has hardly exercised market participants. This time, euro redenomination risk has not (at least not yet) propagated from Greece to other countries. This is also part of the “everything is fine” meme, which is a bit curious considering that one of the most influential central banks in the world – the PBoC – apparently has just lost control of a market it clearly wants to manipulate.

5 year government bond yield of Portugal – no redenomination paranoia yet

Furthermore, the recent plunge in the Chinese stock market has put great pressure on industrial commodity prices, as market participants were suddenly reminded of China’s ongoing economic slowdown. Gold is already trading at a very high level relative to industrial commodities, and one suspects that the sudden plunge in oil and copper prices has caused a small tsunami of margin calls to hit assorted speculators (the same holds for currency carry trades in e.g. the yen). In such scenarios gold often serves as a source of much needed liquidity. The gold market is one of the most liquid markets in the world, which means that huge amounts can be bought and sold without influencing prices much. A similar scenario could be observed during the 2008 crisis: in spite of its safe haven status, gold sold off along with “risk assets” as it served as a source of liquidity.

As an aside, this also explains why the assertion by many gold bears that “if not even the Greek crisis can induce gold to rally, nothing will” is actually nonsense. They were saying exactly the same thing in 2008 of course – and then the gold price almost tripled from its lows at the peak of the crisis over the ensuing three years.

This is by the way not meant to indicate that the same thing will necessarily happen this time, especially as long as the crisis situation doesn’t get out of hand. In 2008, the Fed and other central banks immediately started printing money with gay abandon in order to bail out the banking system, governments and other debtors. Currently the Fed isn’t actively adding to the US money supply and is even thinking of tightening monetary conditions slightly further.

Gold Sentiment 

 Lastly, we want to add a few words regarding the current sentiment backdrop in gold. The gross short position of speculators in COMEX gold futures has just hit an all time high, (this is not the case with the net position though, which remains slightly net long), closed end bullion funds like CEF can be bought almost at a 10% discount to their net asset value, Rydex precious metals assets are at an all time low and commentary in the financial press is almost universally bearish.

In fact, we had to laugh when coming across the following sentence that concluded a report on the record high speculative gross short position in gold futures. A commodities strategist for Saxo bank remarked:
“As long as prices continue to fall, investors will keep piling into the shorts,” he said. “We need a counter reaction and I just don’t think there is anything out there that will do it.”
When experts are telling you that there is absolutely nothing that can possibly induce a market to rally, especially one in which bearish sentiment is vastly out of proportion with the actual price action, it is probably a good time to consider these allegedly non-existent possibilities.

Admittedly, gold’s price chart in USD terms still isn’t much to write home about, and there are several technical “attractor” levels below current prices. There is certainly no evidence of a trend reversal just yet. However, we have seen such extremes in bearish sentiment every time the gold price has approached the support level near $1,140 and so far, it has been an indicator of an imminent short term trend reversal every time.

Rydex precious metals assets have just declined to a new all time low.

Gold stocks have acted very badly, and often this is an indication that even lower gold prices should be expected. However, keep in mind that this principle does not hold near major lows. For instance, in the final stages of the previous gold bear market in the year 2000, gold stocks lost roughly half of their value relative to gold in the final phase of the bear market – however, gold did not break down further, and gold stocks eventually rose by nearly 200% in six months in the initial rally leg, while gold itself actually didn’t do all that much.

 EF premium/discount to NAV vs. the gold price

Furthermore, we have recently observed that gold stocks tend to follow industrial metal mining stocks rather than the gold price. We believe that this is due to the vast increase in indexation and ETF trading. Since gold mining stocks tend to be included in broad-based resource portfolios and ETFs, redemptions in these funds will put pressure on the sector even if gold is merely going sideways, resp. is trading just slightly weaker. Below is a “QED” chart of the XME and the HUI-gold ratio demonstrating this phenomenon:

The S&P metals and mining ETF XME and the HUI-gold ratio

To this it should be noted that this correlation is not set in stone. Historically it tends to end long before most industrial commodities actually bottom out. The lead times are vary, with historical precedents suggesting they can last up to two years.


There are actually good reasons why gold didn’t rally in light of the growing “Grexit” threat. Technically, gold continues to look weak in USD terms and reasonably strong in terms of most other currencies. Sentiment is completely in the gutter again, as it always is at such junctures.

While sentiment to a large degree simply mirrors price action, it is worth taking it into account when it reaches extremes. We once again seem to have reached such a point. Lastly, if the idea that central banks are actually paper tigers instead of nigh omnipotent entities begins to take hold in the “market mind”, then gold will be set to rise regardless of prevailing technical conditions.

The Gold Optimism Index is at a mere 15 points – very close to previous lows. This index combines the results of major sentiment surveys and positioning data.

Charts by: investing.com, StockCharts, SentimenTrader

Courtesy Pater Tenebrarum at Acting-man.com 

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle

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