Gold: It's Probably Not as Hopeless as It Looks

Gold: It's Probably Not as Hopeless as It Looks  

The US equity markets nearly broke hard to the downside yesterday but they were saved by another rumor of a deal to save Greece. The rumor will probably turn out to be false, like all the rest, and in any case there is a lot more going on than Greece. The point is that financial markets look increasingly unstable.

What about gold? Let's be clear that we don't know anything for sure...gold remains an opaque market. But our guess continues to be that special factors are at work that will soon shift in gold's favor.

There have been very large opening bids in the Treasuries the last few days and yields are plunging. A serious collateral shortage appears to be developing as derivative contracts and other hedged trades trigger margin calls. Gold is perfect collateral but when it is pledged it is immediately hedged in the forward or futures markets to protect the entities that accept the gold as collateral. So, this places pressure on gold in the short term, which should end abruptly as it did in 2008 (in that case, when the Fed changed the rules on what makes good collateral).

At the same time, commercial gold traders who have been very short gold have seen this collateral-induced order flow and they have taken the opportunity to push the market in the same direction. The aim of the commercials is to encourage technical traders to sell to them so they can cover their shorts profitably. The latest COT data shows they were doing this last week.

Why is there a collateral shortage? Increased volatility is one factor. Too much of the good stuff owned by the Fed thanks to QE is another. Dollar illiquidity and broader market illiquidity are also likely factors.

Big picture, we are now perhaps seeing the consequences of tapering. The Fed's QE ended last November. LIBOR immediately started upward as did some of the key credit spreads, indicating a process of tightening credit and dollar availability was underway. The dollar accelerated higher. We had the unprecedented October 15 event in which Treasuries soared and then fell, as well as the January 15 event when the Swiss suddenly abandoned their euro peg in order to trade with the dollar. Both of these extremely volatile events suggested growing illiquidity in key markets and a scramble for collateral and dollars. If this reasoning is accurate, we have not heard the last from gold. A change in Fed policy may also be close at hand.

High yield debt has once again begun to diverge from quality...evidence of growing risk aversion and liquidity contraction: