Gold has been battered lower in recent months as gold-futures speculators fled in dread of the Fed-rate-hike boogeyman. As universally expected, the Fed’s 5th rate hike of this cycle indeed came to pass this week. When gold didn’t collapse as irrationally feared, the cowering futures traders were quick to start returning. Past Fed rate hikes have actually proven very bullish for gold, and this latest one will be no exception.
Back in early September, gold was sitting pretty near $1348. It had rallied dramatically out of its usual summer-doldrums low in its typical major autumn rally, blasting 11.2% higher in just 2.0 months. But even way back then, Fed-rate-hike fears for the FOMC’s December 13th meeting started creeping in. When gold peaked on September 7th, federal-funds futures implied December rate-hike odds running just 32%.
Over the next 8 trading days leading into the September 20th FOMC meeting where the Fed birthed its unprecedented quantitative-tightening campaign, those rate-hike odds climbed as high as 62%. That day’s FOMC statement and subsequent Janet Yellen press conference blasted the December rate-hike odds even higher to 73%. So gold slumped back down to $1300 as futures speculators sold in trepidation.
By early October as these futures-implied rate-hike odds hit 93%, gold fell as low as $1268. Over the mere one-month span where December rate-hike odds nearly tripled from 32% to 93%, gold dropped 5.9% on heavy spec gold-futures selling. That erased nearly 6/10ths of its autumn rally, which really weighed on sentiment. Gold still managed to stabilize around the $1280s in late October and November.
Starting early last month, federal-funds futures traders became so totally convinced the Fed would hike this week that their implied odds hit 100%. They stayed pegged at total certainty for 27 trading days in a row. Gold was able to stage a minor rally to $1294 surrounding Thanksgiving, but speculators resumed dumping gold futures in early December. Thus gold fell as low as $1242 leading into this week’s FOMC decision.
Gold-futures speculators have always deeply feared Fed rate hikes. Their rationale is simple and sounds logical. Since gold pays no interest or dividends, it will struggle to compete with bonds and stocks in a higher-yielding world following Fed rate hikes. Therefore gold investment demand will wane, leading to lower gold prices. Speculators always attempt to front run their forgone conclusion by selling gold futures.
This scenario has played out for three Decembers in a row now. The Fed kicked off this rate-hike cycle back in mid-December 2015 with its first rate hike in 9.5 years. A year ago in mid-December 2016 the FOMC made its second rate hike. And following two more hikes earlier this year, the Fed’s newest mid-December hike this week was the 5th of its current cycle. Gold-futures speculators sold aggressively into all.
So gold’s slump into this week on more Fed-rate-hike fears is certainly nothing new. The lead in to this December FOMC meeting is starting to feel like that old Bill Murray movie Groundhog Day. So the key question gold investors need to ask today is how did speculators’ excessively-bearish gold-futures bets play out after the prior couple Decembers’ rate hikes? Did gold crumble in the face of higher rates as feared?
This first chart superimposes gold during this current Fed-rate-hike cycle over speculators’ collective long and short positions in gold futures. Gold is rendered in blue, and speculators’ total number of upside and downside contracts in green and red respectively. This gold-futures data comes from the CTFC’s weekly Commitments of Traders reports, which are published every Friday afternoon current to the preceding Tuesday.
Gold-futures speculators have long been utterly convinced gold’s mortal nemesis is Fed rate hikes and the resulting higher prevailing interest rates. They fervently believe a sterile asset like gold simply can’t compete in a rising-rate environment. And to their credit, these elite traders sure aren’t afraid to put their money where their mouths are. Their trading surrounding past December hikes illuminates gold’s path today.
Way back in December 2008, the Federal Reserve panicked and slashed interest rates to zero for the first time in its history. For years after that, top Fed officials talked about normalizing rates but never had the courage to start. But finally in late October 2015, the FOMC started getting serious about ending its ridiculous ZIRP anomaly. The Fed warned it might “be appropriate to raise the target range at its next meeting”.
That would be December 16th, 2015. Since there hadn’t been a Fed rate hike in nearly a decade, the gold-futures speculators freaked out. Extreme selling erupted as they rushed to dump gold-futures long contracts while catapulting their short positions higher. So between mid-October and early December that year, gold plunged 11.4% to a major new secular low. Surely rate hikes doomed zero-yielding gold!
After years of broken promises to end ZIRP, the Fed indeed hiked for the first time in 9.5 years in mid-December 2015. Gold rallied 1.1% that day, but plunged 2.1% the next to edge down to a brutal 6.1-year secular low of $1051. With relatively-low longs and extreme record short positions, speculators had heavily bet that was just the beginning of gold’s woes. Their positions were exceedingly bearish into that hike.
But gold didn’t collapse as they expected, it stabilized. Speculators had sold such huge amounts of gold-futures contracts that their selling was exhausted. Thus they had no choice but to start unwinding their own hyper-leveraged bearish bets. So after that initial Fed rate hike of this cycle, speculators first bought to cover their extreme shorts and then aggressively bought long contracts. This is readily evident in this chart.
So instead of cratering on the brand-new Fed-rate-hike campaign, gold skyrocketed on massive gold-futures buying by the very speculators convinced rate hikes would slaughter it. Over the next 6.7 months gold blasted 29.9% higher into its first new bull market since 2011! One of its primary drivers was these speculators adding 249.2k gold-futures long contracts while cutting 82.8k short ones over that gold-surge span.
Unfortunately gold-futures speculators command a super-disproportional wildly-outsized impact on gold price levels because of these contracts’ extreme inherent leverage. Each contract controls 100 troy ounces of gold, which is worth $125k this week. Yet speculators are now only required to maintain $4450 margin in their accounts for each contract held, which equates to incredible maximum leverage to gold of 28.1x!
That means any amount of capital deployed in gold futures by speculators can have up to 28x the price impact on gold as investors buying it outright. 28x is exceedingly dangerous though, as a mere 3.6% adverse move in gold prices would wipe out 100% of the capital bet by futures speculators. This forces them to have an ultra-short-term focus in order to survive. They can’t afford to be wrong for very long.
While their collective conviction that Fed rate hikes are like Kryptonite for zero-yielding gold might sound logical, history proves just the opposite! Back before that initial Fed rate hike of this cycle, I undertook a comprehensive study of how gold reacted in every Fed-rate-hike cycle in modern history. If speculators were right about Fed rate hikes’ bearish impact on gold, it would be fully confirmed in past Fed-rate-hike cycles.
The history was stunning, as you can read about in an update on this groundbreaking work we published in March 2017. Prior to today’s rate-hike cycle, the Fed had executed fully 11 between 1971 and 2015. They are defined as 3 or more consecutive federal-funds-rate increases with no interrupting decreases. During the exact spans of all 11, gold averaged a strong 26.9% rally! Fed rate hikes are actually bullish for gold.
Breaking down this critical historical precedent further, gold rallied big in 6 of these cycles while slumping in the other 5. It averaged huge gains of 61.0% in the majority in which it powered higher! Generally the lower gold was relative to recent years when entering a new rate-hike cycle, and the more gradual those Fed rate hikes were, the better its upside performance. Both conditions describe today’s 12th cycle perfectly.
And in the other 5 where gold suffered losses, they averaged an asymmetrically-small 13.9% retreat. The futures speculators’ cherished notion that Fed rate hikes crush gold is totally false, an irrational myth they deluded themselves into believing. You’d think with tens of billions of dollars of capital at stake with extreme leverage these elite traders could take the time to study historical precedent on gold and rate hikes.
While gathering and crunching all this data since 1971 certainly isn’t trivial, why not simply look to the last Fed-rate-hike cycle for some guidance? Between June 2004 to June 2006, the FOMC hiked the FFR at every meeting for 17 consecutive hikes. Those totaled 425 basis points, more than quintupling the federal-funds rate to 5.25%. If higher rates and yield differentials slay gold, it should’ve plummeted at 5%+.
Yet during that exact span, gold powered 49.6% higher! There’s literally zero chance today’s hyper-easy Fed will dare hike rates 17 times or get anywhere near 5%. The new Fed chairman Jerome Powell that Trump nominated to replace Janet Yellen in early February is widely viewed as a Republican clone of the Democratic Yellen. Powell will stay Yellen’s course, gradually hiking to new norms way below past FFR levels.
But gold-futures speculators didn’t learn their lesson after getting massively burned by their excessively-bearish bets leading into this 12th modern Fed-rate-hike cycle’s opening increase. They did the same thing again a year later leading into the Fed’s heavily-telegraphed second hike in mid-December 2016. They aggressively dumped gold-futures longs, and ramped shorts, leading into the FOMC’s year-ago decision.
While irrational rate-hike fears remained a prime motivator to sell gold futures, those decisions certainly were aided by the stock markets. After Trump’s surprise election win in early November last year, the stock markets rocketed higher in Trumphoria on hopes for big tax cuts soon. Gold investment demand really wanes when record-high stock markets generate much euphoria, killing demand for alternatives led by gold.
So just like a year earlier, following last December’s second Fed rate hike of this cycle gold dropped to a major low of $1128 the very next day. In 5.3 months gold had plunged 17.3% partially thanks to gold-futures speculators dumping 164.5k long contracts while adding 25.8k short ones. But yet again just as their collective bets hit peak bearishness on another Fed rate hike, gold was ready to reverse sharply higher.
The reason is excessive gold-futures selling by speculators is self-limiting. Despite the market power their extreme leverage grants them, their capital is finite. They only have so many long contracts they are willing and able to sell, and only so much capital available to short sell gold futures. So once they near those limits, a reversal is inevitable. They soon have to resume buying longs again while covering shorts.
So for the second year in a row, gold blasted higher out of its major lows immediately after a December Fed rate hike. Over the next 8.7 months leading into early September, gold powered 19.5% higher with speculators adding 111.0k long contracts. They were starting to learn their lesson on shorting a young bull market though, as their total shorts fell just 1.0k contracts over that span. This 2017 gold upleg was impressive.
Gold not only rallied on balance through the 3rd and 4th Fed rate hikes of this cycle in mid-March and mid-June, but climbed despite this year’s extreme stock-market euphoria generated by the endless new record highs. Speculators temporarily shorted gold-futures to near-record levels leading into gold’s usual summer doldrums, but that artificial low soon gave way to a powerful autumn rally. Gold has held strong.
Despite surging Fed-rate-hike odds leading into this week’s universally-expected 5th hike of this cycle, gold was even able to stabilize from early October to early December. But as the third Fed rate hike in as many Decembers loomed closer, gold-futures speculators again lost their nerve in recent weeks. That’s readily evident in the newest CoT report before this essay was published, current to Tuesday December 5th.
As another December rate hike looked certain, gold-futures speculators jettisoned 39.2k long contracts and short sold another 17.4k more in a single CoT week! That total selling of 56.7k contracts was the equivalent of a staggering 176.2 metric tons of gold. That ranked as the third-largest CoT week of spec gold-futures selling out of the 988 since early 1999. These goofy traders were freaking out again over a rate hike.
The Fed indeed hiked for the 5th time in this 12th modern cycle as widely forecast, taking the FFR up to a range between 1.25% to 1.50%. I suspect gold-futures speculators expected top Fed officials’ outlook for 2018 rate hikes to rise from the prior dot plot’s three published a quarter earlier. But 2018 rate-hike projections didn’t budge, holding at exactly the same average in this week’s newest mostly-neutral dot plot.
So speculators resumed buying gold futures right as the FOMC released its decision and rate-hike projections at 2pm this past Wednesday. Gold surged 1.0% higher that day, paralleling its 1.1% rate-hike-day gains two years earlier that was about to kick off a major new bull market. Gold remained up 18.3% in the Fed’s current rate-hike cycle to date, solid gains considering futures speculators’ erroneous beliefs.
Odds are their excessively-bearish bets battering gold in recent months will prove every bit as wrong this December as they did in the last couple years’ Decembers! Gold will likely again stage a powerful rebound rally into 2018 as these hyper-leveraged traders reestablish long positions. They don’t have many short contracts to cover, continuing last year’s trend. Leveraged shorting of a healthy bull market is suicidal.
Just like following the prior couple Decembers’ Fed rate hikes, gold investment buying will likely resume as well. Through speculators’ collective trading’s adverse impact on gold leading into hikes, investors too get worried about gold in higher-rate environments. But once another Fed rate hike passes and gold doesn’t collapse on cue as expected, investors resume buying. Their inflows are the most important of all.
While gold investment is usually done outright with no leverage, investors’ vast pools of capital dwarf the gold-futures speculators’ limited firepower. So gold investment trumps gold-futures speculation. This final chart looks at the best daily approximation of investment available, the holdings of the leading GLD SPDR Gold Shares gold ETF. When its holdings are rising, American stock-market capital is returning to gold.
When investors aren’t interested in gold, their lack of buying allows gold-futures speculators to dominate short-term price action. But once investors buy or sell gold en masse, that easily overpowers whatever the futures traders are up to. The main reason gold exploded into a new bull market after that initial rate hike in December 2015 was massive differential GLD-share buying by American stock investors in early 2016.
During that same 6.7-month span where gold rocketed 29.9% higher in a new bull, GLD’s physical gold bullion held in trust for shareholders soared 55.7% or 351.1t! Gold then collapsed after Trump’s election win as GLD’s holdings shrunk 14.2% or 138.9t in 5.3 months leading into last December. While GLD’s holdings kept slumping after the December 2016 hike, they soon climbed modestly and stabilized in 2017.
Early 2018 is likely to see big gold investment buying much closer to early 2016’s than early 2017’s, which will help catapult gold dramatically higher again. The extreme record stock-market rally of 2017 that generated such epic euphoria isn’t likely to persist into 2018. As stock markets finally roll over into a long overdue major correction or more likely new bear market, investment capital will flood back into gold again.
Though few investors realize it yet, 2018 is going to look radically different from 2017. The major central banks that have injected trillions of dollars of capital since 2008’s stock panic that levitated stock markets are slamming on the brakes. The Fed is ramping its new quantitative-tightening campaign that destroys the QE money created out of nothing to a $50b-per-month pace by Q4’18, something never before witnessed.
At the same time the European Central Bank is slashing its own quantitative-easing campaign from this year’s €60b-per-month pace to just €30b monthly starting in January. Together Fed QT and ECB QE tapering will drive $950b of central-bank tightening in 2018 and then another $1450b in 2019 compared to this year! I explained all this in depth in late October in a critical essay for all investors to fully digest.
As the Fed and ECB reverse sharply from their unprecedented easing of recent years to unprecedented tightening in the coming years, these record-high, euphoric, bubble-valued stock markets are in serious trouble. As they roll over and sell off, investors will rush to prudently diversify their stock-heavy portfolios with counter-moving gold. There’s nothing more bullish for gold investment demand than weakening stocks.
So contrary to recent weeks’ and months’ erroneous view that Fed rate hikes are bearish for gold, history proves just the opposite is true. Gold has thrived in the 11 modern Fed-rate-hike cycles before today’s, and it has powered higher on balance in this 12th one. While you wouldn’t know it after this past year’s extreme Trumphoria rally, Fed rate hikes are actually bearish for stocks and thus quite bullish for gold.
The last time investors flooded into gold in early 2016 after that initial December rate hike, gold powered 29.9% higher in 6.7 months. The beaten-down gold miners’ stocks greatly amplified those gains, with the leading HUI gold-stock index soaring 182.2% higher over roughly that same span! Gold stocks are again deeply undervalued relative to gold, a coiled spring ready to explode higher in this gold bull’s next major upleg.
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The bottom line is Fed rate hikes are bullish for gold, and this week’s is no exception. Gold has not only powered higher on average in past Fed-rate-hike cycles, but has rallied strongly in the current one. After each past December rate hike which gold-futures speculators sold aggressively into, gold dramatically surged in the subsequent months. These guys always buy after getting excessively bearish, forcing gold higher.
Gold’s next upleg following the Fed’s 5th rate hike since late 2015 is likely to get a massive boost from weaker stock markets. The same thing happened a couple years ago during the last US stock-market correction. As the Fed and ECB drastically reverse and slash their liquidity injections in 2018, these wild central-bank-inflated stock markets are in serious trouble. Gold investment demand surges when stocks weaken.
Adam Hamilton, CPA
December 15, 2017
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