Gold on the Brink of a Breakout?

There is now a lot of data to suggest that the gold rally we have called for is now close at hand. The supporting data is of three kinds: the structure of the gold market; the reaction of markets to the Fed rate hike last week and the performance of the US economy.

First, the structure of the gold market now shows a record net short position by hedge funds. The so-called Managed Money category of traders on COMEX is now short 110,836 contracts (over 11 million ounces of gold) as of December 15, 2015. These traders do not own any physical gold to deliver into their short positions (they never do) and they are most assuredly on margin (they always are). They will need to buy back their shorts on COMEX. When? We don't know but we estimate that most of this shorting occurred under $1100 with an average price probably not much above $1080. So they do not have much of a margin to play with before they start showing losses. In our view, never have so many shorted so much for so little. If gold does not start a new leg down in price in the next few days, we think they will begin to cover, thereby initiating a short squeeze in gold.

Second, the reaction of the markets to the rate hike of last week must concern the Fed because it shows a significant lack of confidence in the economic projections the Fed used to justify its first hike and the four more it is predicting for 2016. The evidence is especially clear in credit markets where Treasuries of short and long durations are trading up in price and down in yield since the Fed decision. An economy strong enough to support interest rate normalization should result in higher rates across the term structure. The three month T-Bill today yields 0.16%, well below the newly raised Fed Funds Rate of 0.25%. The money markets seem to be betting that a rate cut could happen in the next three months, not a hike. If this occurs, we believe Fed credibility would be shredded and along with it the dollar and corporate credit markets. We cannot imagine a more bullish scenario for gold.

Third, the US economy is weakening according to the latest data releases. The inventory-to-sales ratio is in recession territory, industrial production is declining and retail sales are weak. There is very little factual support for the table-pounding assertions the Fed made last week about the strength of the US economy and the need to normalize interest rate policy. Here, again, Fed credibility is on the line. This point deserves its own more detailed analysis which will be posted in the next few days.

‍