Gold was enjoying a solid spring rally until a couple weeks ago, nearing major upside breakouts. But its nice advance has crumbled since, really weighing on sentiment. Gold fell victim to a rare major short squeeze in US Dollar Index futures. The surging USDX motivated gold-futures speculators to flee rather aggressively. But this will likely prove a short-lived anomaly, after which gold’s assault on highs will recommence.
Gold’s seasonally-atypical weakness over the past couple weeks is very important for speculators and investors to understand. It had nothing at all to do with fundamentals, but was completely driven by the hyper-leveraged gold-futures traders. These guys have long been fixated on the US dollar’s fortunes, looking to its benchmark US Dollar Index for trading cues. That can slave gold’s price to the dollar at times.
Six weeks ago, gold slumped to a major seasonal low of $1310 the day before the universally-expected 6th Fed rate hike of this cycle. The gold-futures traders fervently believe Fed rate hikes are very bearish for gold, so they usually sell leading into FOMC meetings with potential hikes. This has happened before every Fed rate hike of this cycle. The theory is higher US rates boost foreign investment demand for US dollars.
The ironic thing is modern history proves the opposite! Fed-rate-hike cycles are bearish for the US dollar and bullish for gold. The last cycle ran from June 2004 to June 2006, where the Fed hiked 17 times in a row for 425 basis points. Despite those aggressive and relentless rate hikes, the USDX still slipped 3.8% lower over that exact span while gold rocketed 49.6% higher! Clearly futures specs’ theory is sorely lacking.
The Fed’s current rate-hike cycle out of extreme zero-interest-rate-policy lows got launched in December 2015. Gold was hammered to a 6.1-year secular low leading into it, as futures specs were absolutely certain higher rates were bearish for gold and bullish for the USDX. Yet again they were proven dead wrong, wrong, wrong! As of the middle of this week, gold is up 23.0% since then while the USDX fell 5.5%.
You’d think after some market thesis fails to work over and over again for decades, traders would try something else. But not futures speculators, they are a stubborn lot. So leading into every likely Fed rate hike, they bid up the USDX and dump gold. Then immediately after those rate hikes the dollar fails to surge and gold doesn’t plunge, so they reverse those excessive trades driving the dollar down and gold up.
So like clockwork after the Fed’s latest rate hike in late March, gold started rallying as gold-futures specs bought back in. Gold enjoys a strong seasonal spring rally in April and May, which I discussed in depth last week. By mid-April, that propelled gold within spitting distance of a major bull-market breakout. Gold regained its $1365 bull-to-date high from July 2016 on an intraday basis on April 11th, but failed to push through.
Ironically futures speculators’ irrational obsession with the Fed was again to blame. That day the FOMC released the minutes from its March 21st rate-hiking meeting. Traders interpreted them as hawkish, so the USDX was bought and gold was sold. For 24 trading days in row between mid-March to mid-April, gold simply did the opposite of whatever the USDX did on every single day but one. The dollar ruled gold.
Gold managed to hover near $1350 multi-year-horizontal-resistance breakout territory for another week after those Fed minutes. But that started changing on April 19th. That day the USDX rallied 0.3%, which was actually its biggest up day in a couple weeks. USDX-futures speculators were excited because the yields on benchmark US 10-year Treasury notes crested 2.9%. Higher yields are great for the dollar, right?
For decades I’ve closely followed speculators’ collective gold-futures positions every week in the famous Commitments of Traders reports published by the CFTC. I discuss them and their implications for gold’s near-term price action in every weekly newsletter. But I haven’t had the time to dig deeply into USDX futures. The analysts who traffic in that realm said USDX short positions were the largest seen in several years.
The leverage inherent in currency speculation is extreme beyond belief. Since major currencies tend to move slowly, the margin requirements equate to maximum leverage of 50x, 100x, or even 200x! That compares to the decades-old legal limit in the stock markets of 2x. At 50x, 100x, or 200x, mere 2.0%, 1.0%, or 0.5% currency moves against traders’ positions would wipe out 100% of their capital risked. It’s crazy!
So when currency speculators are wrong, they have to exit positions fast or risk getting obliterated. The traders short USDX futures had no choice but to buy. The more long USDX futures they bought to offset and close their shorts, the faster the dollar rallied. That forced still more traders to buy to cover even if they were running more-conservative leverage. This self-reinforcing dynamic feeds on itself, fueling short squeezes.
As the USDX buying mounted, the dollar’s rally accelerated in subsequent days. Traders continued to use 10-year Treasury yields as a fundamental excuse for their purely technical trading, as within a week they crossed the psychologically-heavy 3% threshold to 3.03%. That was the highest seen since the very end of 2013! The USDX rallied 0.3%, 0.5%, and 0.7% in the initial few trading days of that buying to cover.
It had already become the biggest dollar short squeeze since soon after Trump won the election in late 2016. That heavy futures buying forced the USDX to surge 1.5% in those first 3 trading days. Although that sounds trivial, at 50x, 100x, or 200x leverage it hammers speculators to catastrophic 75%, 150%, or 300% losses! I wonder how these guys can sleep at night bearing such ridiculous and unforgiving levels of risk.
Gold-futures speculators run extreme leverage too, but much less than currency traders. This week a single gold-futures contract controlling 100 troy ounces of gold worth $130,500 only required speculators to keep $3100 cash margins in their accounts. That equates to 42.1x maximum leverage! For traders running at the edge, every 1% adverse move in gold would wipe out an insane 42% of their capital risked.
So these guys nervously watch gold on a minute-by-minute basis. And in a fascinating confirmation that gold is indeed a currency, they look to the US dollar for their trading cues. They started selling their gold-futures positions as the dollar started rallying. That drove gold 0.2%, 0.7%, and 0.9% lower in the first 3 trading days of that USDX short squeeze that ignited on April 19th, forcing gold down 1.9% overall to $1324.
Our lone chart this week looks at gold during this current Fed-rate-hike cycle superimposed on the long and short positions large and small speculators hold in gold futures. Again these are published once a week in those Commitments of Traders reports. All 6 Fed rate hikes of this cycle are also highlighted, to show how gold is bludgeoned lower leading into them which spawns strong rebound buying in their wakes.
While the weekly CoTs are current to each Tuesday, they are released late Friday afternoons. Thus the newest-available CoT when this essay was published covers the week ending April 24th. That includes those initial few trading days of that USDX-futures short squeeze. And it’s very illuminating, showing why gold was pummeled back down from major-breakout levels and its strong spring rally was short-circuited.
For pre-dollar-rally baselines, on Tuesday April 17th speculators held 284.2k long and 98.9k short gold-futures contracts. These were running 27% and 15% up into their own past-year trading ranges. Thus these traders had the capital firepower and room to still do about 3/4ths and 6/7ths of their near-term long buying and short selling. Of course buying gold-futures longs is bullish for gold, while shorting is bearish.
When gold-futures shorts are low, there’s always the risk speculators will aggressively sell on the right catalyst coming along. That forces gold’s price lower. And this unlikely dollar short squeeze erupting out of the blue proved that triggering event. On seeing the USDX surge, the gold-futures specs were quick to start jettisoning longs and ramping shorts. Thus gold fell 1.2% on the 1.4% USDX rally over that CoT week.
The magnitude of this initial gold-futures selling became evident in the next CoT report current to April 24th. During that CoT week, specs sold 7.9k gold-futures long contracts while adding another 15.6k on the short side. That made for big total CoT-week selling equivalent to 73.0 metric tons of gold. That is simply far too much for normal buying to absorb. Thus the only possible outcome was a lower gold price.
Just this week, the World Gold Council released its latest Gold Demand Trends report for Q1’18. That’s the definitive source for world gold fundamental supply-and-demand data. In Q1, global gold investment demand averaged 22.1t per week. So heavy gold-futures selling easily overwhelms that. Gold always falls when the futures specs get on a selling kick. They flood the market with too much short-term supply.
That dollar-short-squeeze reaction left specs’ collective long and short gold-futures positions running up 22% and 30% into their past-year trading ranges. So these traders still had room to do about 4/5ths of their likely near-term long buying, but expended a significant chunk of their shorting firepower. That left total spec shorts at a 12-CoT-week high of 114.5k contracts. The higher spec shorts, the more bullish gold gets.
Short positions in futures are bullish because they necessitate proportional near-term buying. In selling short, speculators essentially borrow futures from other traders to sell. The specs are legally obligated to buy back those contracts relatively soon to close out those trades and repay those effective debts. So futures shorts are guaranteed near-future buying, whether they are in the USDX, gold, or anything else.
This essay was penned and proofed Thursday, and then published Friday morning. The newest CoT data current to this Tuesday May 1st won’t come out until late Friday afternoon about 4 hours after this essay went live. So while I can’t wait to see the latest CoT, I can only speculate about it at this point. During this latest CoT week, the USDX-futures short squeeze continued which drove more spec gold-futures selling.
The dollar rally actually accelerated in this newest CoT week ending Tuesday, as shown by the sharp 1.9% rally in the USDX. Thus gold’s CoT-week selloff also grew to 2.0%. That was 2/3rds larger than the prior CoT week’s 1.2%. So odds are the gold-futures selling ballooned significantly in this latest CoT week. That implies another 35k to 40k gold-futures contracts were dumped, with the majority likely on the short side.
Assuming the prior week’s spec gold-futures-selling mix of 1/3rd long and 2/3rds short holds, total spec longs could’ve dropped another 12.9k contracts while shorts could’ve soared 25.8k. If that proves true, total spec longs and shorts could have been running near 14% and 54% up into their past-year trading ranges as of this Tuesday. That would mean the majority of the likely gold-futures shorting is already done!
While I don’t have the USDX-futures data and background to analyze in depth, odds are the USDX is in a similar opposite place. I suspect the majority of the dollar short covering has already run its course. That paves the way for this sharp dollar rally to at least peter out and probably reverse. Trade-war fears are going to flare again soon as the distraction of stocks’ Q1 earnings season passes, which is bearish for the dollar.
If you look at the chart above, the green line shows specs’ total gold-futures long contracts. Note even a CoT week ago that was trading below bull-market support. There is big room for these traders to flood into gold on the long side when the USDX inevitably stalls or reverses. They likely now have the capital firepower to do about 6/7ths of their potential near-term buying! That portends big gold upside in coming weeks.
While gold’s strong seasonal spring rally was interrupted by this surprise USDX-futures short squeeze, I doubt it was killed. Gold was driven to a new seasonal low of $1304 this week, under its previous $1310 of mid-March. Thus all the usual spring-rally buying in April and May will likely be compressed into this month alone! That means gold could enjoy a major mean-reversion bounce rally in the coming weeks.
During the 10 trading days as of the middle of this week since the dollar’s sharp rally started, gold has moved inversely proportionally to the USDX on every trading day but one. 8 of these trading days of the past couple weeks saw the dollar rally, and gold’s biggest losses of 0.9% both occurred on the dollar’s best up days of 0.7%. Gold’s down days were all about the same size as the dollar’s up days, mirror images.
But in the 2 trading days of the past couple weeks when the USDX retreated modestly, gold surged way out of proportion to the dollar’s weakness. These trivial 0.2% and 0.1% USDX slides allowed gold to rally a relatively-outsized 0.6% and 0.5%! Gold wants to rally, and will likely quickly surge back up near major-breakout levels soon after this dollar-rally pressure abates. And that’s likely going to prove very soon.
The mounting US/China trade war has been pushed out of the financial-media spotlight by Q1 corporate earnings, which have soared on the big corporate tax cut. But earnings season is winding down just as major trade-war deadlines are looming for the US to implement recent tariff announcements. The dollar looks far less attractive to foreign investors if tariff threats become reality, their capital will seek refuge elsewhere.
And though the extreme leverage inherent in gold futures enables their speculators to wield outsized influence on short-term price action, investors’ capital massively dwarfs the speculators’. So when investors’ vast funds start bidding on gold again, likely on the next major stock-market selloff driving demand for prudent portfolio diversification, gold-futures specs’ influence will be overwhelmed and drowned out.
Add in strong spring seasonals to all this, and gold has a fantastic foundation for a strong rebound rally. Speculators’ low gold-futures longs are very bullish, as they will rush to buy back in to ride any upside momentum in gold. Speculators’ mounting gold-futures shorts are increasingly bullish, as these will have to be covered and closed by buying offsetting longs. And investors’ super-low gold allocations are wildly-bullish.
So odds are gold’s atypical counter-seasonal drop in the last couple weeks driven by the surprise USDX short squeeze will soon reverse hard. It won’t take much buying to drive gold back up near those major bull breakout levels around $1365. And gold powering higher again will quickly turn sentiment around, with buying begetting more buying. The dollar depressing gold prices leaves this metal more bullish, not less so.
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The bottom line is gold’s recent weakness is the result of a rare major short squeeze in US Dollar Index futures. The resulting dollar rally spooked gold-futures speculators, who rushed to sell to avoid getting slaughtered by their extreme leverage. While that short-circuited gold’s spring rally, this anomaly won’t last. Gold-futures speculators and gold investors are far too bearish and under-allocated, with big room to buy.
The USDX short covering is likely running out of steam, which will clear the way for gold’s big seasonal spring rally to resume. All that delayed buying will likely be compressed into May, and drive gold back up near recent major-bull-breakout levels. Any dollar/gold reversals will force gold-futures specs to quickly buy to cover their ballooning shorts. The resulting rally will entice in long-side traders, then gold is off to the races.
Adam Hamilton, CPA
May 4, 2018
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