Positioning, sentiment and market structure favor a powerful rally in
gold. The COTs released by the CME on September 7, 2018, show the gross
speculative short position grew 1.3% to 213,259 contracts, just shy of the
all-time record set two weeks ago. On a net basis, speculators are short
13,500 contracts, the largest short position since December, 2001.
The commercial net short position collapsed into negative territory for the first
time since December, 2001 at -6,525 contracts. In other words, commercials
are now net LONG, a very rare occurrence historically seen only at major
turning points.
Nonetheless, gold continues to look weak, largely the result of a stronger
dollar and market expectations of further dollar strength, which is putting
pressure on gold, commodities and emerging markets currencies. Not
surprisingly, speculators have been crowding into the dollar.
There are four main reasons why the dollar looks to go higher despite U.S.
political uncertainty, growing deficit spending and a worsening trade
balance. Each of those reasons may prove to be short-lived.
First, U.S. dollar-denominated debt offers higher interest rates than the
debt of other developed economies, especially euro debt, which has attracted
funds into the dollar. The key comparison here is the yield on the German
10-year note compared to its U.S. counterpart.
Over the past year, the yield gap has widened in favor of the dollar until
June when the trend has stalled, reflecting a 50% cut in bond purchases by
the European Central Bank and an expectation that ECB buying will come to an
end this December. If true, EU debt will fall (yields will rise) as the
biggest and least price-sensitive purchaser stops bidding. We expect the
yield gap will likely close.
The second main support for the dollar is the market's perception of the
U.S.-China trade war. In a nutshell, the market sees China and the Chinese
economy as the losers while Trump and the U.S. economy are perceived to be
winners before any serious damage is done to the U.S. economy and corporate
earnings. Every time Trump implements a new set of trade sanctions, the
dollar rises while the yuan, commodities and gold fall. This pro-dollar trade
will unwind when markets begin to conclude there is no easy, early victory.
We think this may be imminent. America's largest companies are now warning
that Trump's trade policies are beginning to cut into their business prospects
and many are reporting serious upward pressures in pricing due to the tariffs
and their disruption to established supply lines.
Third, the U.S. has had the best performing stock market on the planet for
the past two years, which has attracted global capital to the dollar. U.S.
corporate earnings are up strongly, in part because of the magic of share
buy-backs but also because of the pro-business policies of the Trump
Administration. Regulations have been reduced and taxes have been cut. We
think the tax cut has produced a "sugar high" but its effect is
already wearing off. Meanwhile, mid-term elections are fast approaching and
there is a real possibility that Republicans will lose control of the House
to increasingly "progressive" Democrats, effectively ending the
Trump effect. U.S. political uncertainty, growing deficit spending and a
worsening trade balance may then begin to matter, all to the detriment of the
dollar.
Fourth, in our view, the dollar still depends primarily upon one thing…the
perception of Fed policy. The Fed is tightening, steadily raising short-term
rates and selling assets into the market for dollars it then extinguishes.
The latter initiative will shortly reach its objective of removing $50
billion per month, a level the Fed has said it will maintain for years to
come.
The key question for the dollar is whether the Fed stays the course. The
market assumes it will. We are less certain. We believe that Fed tightening
will break the stock market and cause a reversal in Fed policy, which will
have a dramatic impact on the dollar and gold.
Even now, while the stock market remains strong, the Fed is laying down
markers that support the end of tightening. First, Fed Chairman Powell says
he is not concerned about imminent inflation. The latest Fed statement noted
that "market-based measures of inflation compensation have increased in
recent months but remain low; survey-based measures of longer-term inflation
expectations are little changed, on balance." Second, the Fed has stated
that it is watching to see if there is a negative economic impact from
Trump's trade policy and the stronger dollar. Third, the yield curve is only
one 25 basis point increase away from inverting, a fact noted in the latest
Fed minutes where some governors expressed concern that an inverted curve has
reliably signalled oncoming recessions in the past.
But especially, watch the Emerging Market currency implosions that now
threaten more than 20 countries ranging from Turkey, Argentina and South
Africa to Poland and Brazil. This growing crisis is directly attributable to
Fed tightening thanks to the fact that Emerging Markets have incurred more
than US$3.7 trillion in dollar-denominated debt. None of these economies may
be big enough to matter in a global context but their impact on the global
banking system may be another matter.
Gold is sold out and should begin to rally. The obstacle is the dollar,
but perhaps not for much longer.
This article is the collaboration of Rudi Fronk and Jim Anthony, cofounders of Seabridge Gold,
and reflects the thinking that has helped make them successful gold
investors. Rudi is the current Chairman and CEO of Seabridge and Jim is one
of its largest shareholders. Disclaimer: The authors are not registered or
accredited as investment advisors. Information contained herein has been
obtained from sources believed reliable but is not necessarily complete and
accuracy is not guaranteed. Any securities mentioned on this site are not to
be construed as investment or trading recommendations specifically for you.
You must consult your own advisor for investment or trading advice. This
article is for informational purposes only.
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