Some commentators have been anticipating a “commercial signal failure” in
the gold market for more than 15 years. Moreover, whenever the gold price
experiences a large rally the same commentators routinely cite the potential
for a commercial signal failure (CSF) as a reason to maintain a full
position, the argument being that the coming CSF is bound to result in
massive additional price gains. The reality, however, is that whereas a CSF
is an extremely unlikely event in any commodity market, in the gold market it
is an impossibility.
A CSF theoretically becomes possible in a commodity market after the price
has been trending upward for some time, and speculators, as a group, have
built-up an unusually-large net-long position in the commodity futures.
Naturally, if speculators have a large net-long position then “commercials” have
an equivalently-large net-short position, since one is a mathematical offset
of the other.
Commercials are generally hedging or spread-trading, so once they have
established a position they will usually be indifferent with regard to future
price direction. Whatever they lose on the futures they will make in the
physical, and vice versa. However, in some commodity markets it is possible
for the supply or demand in the physical market to undergo such a sudden and
dramatic change that exploding margin requirements on the futures side of a
commercial-trader’s hedge or spread-trade could force the commercial to exit
(buy back) the short futures position, even though the short position in the
futures is ‘covered’ by a long position in the physical. For example, take
the case of a wheat farmer who has locked in the price of his
yet-to-be-harvested crop by selling wheat futures. If extreme and unexpected
weather suddenly causes a moon-shot in the wheat price then the farmer might
— depending on how his price hedging has been structured — be faced with a
huge margin call on his futures position and forced to exit his hedge, even
if his own crop is unaffected by the extreme weather. Exiting the hedge would
involve buying wheat futures into a sharply rising market, which would only
exacerbate the price rise.
If it happens on a market-wide scale, the hypothetical case of the wheat
farmer described above could be part of what’s called a “commercial signal
failure”. The so-called signal failure involves commercial traders being
forced, en masse, to cover their short futures positions at large losses
despite the short futures positions being offset by long positions in the
physical commodity. By definition, it can only happen when speculators have
built up a large net-long position in the futures market (meaning, when
commercial traders have built up a large net-short position in the futures,
thus generating the bearish warning signal), a situation that will usually
only arise after the price has been in a strong upward trend for several
months. Due to the CSF, speculators on the long side make more money more
quickly than they were expecting.
However, even in a market where a CSF is technically possible, a prudent
speculator would never bet on it. The reasons are that 1) a CSF requires a
sudden and totally UNPREDICTABLE change in either supply or demand, and 2)
CSF’s almost never happen. In the rare cases when a CSF happens it tends to
be the result of an unexpected supply disruption. In agricultural
commodities, the most likely cause is an unforeseeable bout of extreme
weather.
Major supply disruptions are possible in the markets for all agricultural
and industrial commodities, but they are not possible in the gold market.
This is primarily because almost all the gold ever mined still forms part of
the supply side of the equation, which means that shifts in the current
year’s mine production will always be trivial relative to total supply. In
other words, in the gold market there is no chance that a CSF could be caused
by a major supply disruption.
Although a major supply disruption is not possible in the gold market,
there could at some point be a large and unanticipated demand disruption
(note that the bulk of the world’s gold is demanded (held) for investment,
store-of-value, speculative or monetary purposes). However, such a disruption
would not cause a “commercial signal failure”; it would be the EFFECT of a
total monetary-system failure.
A “commercial signal failure” is, by definition, an event that results in
bullish futures speculators making large and rapid gains, but bullish
speculators in gold futures could not profit from a total monetary-system
failure. In fact, they would be big losers because the futures market would
shut down in such an outcome.
The bottom line is that it is not a good idea to bet of a “commercial
signal failure” in any market, because the probability of it happening is
extremely low. It is, however, a particularly bad idea to make such a bet in
the gold market because in the gold market the event has a probability of
zero.
