Short Covering Propels Gold Rally: Will New Longs Follow?

Short Covering Propels Gold Rally: Will New Longs Follow?

At last, a short covering rally seems to have begun in gold. After a number of bear raids that failed to break the gold price below $1100, the shorts appear to be throwing in the towel, at least for now. Going into today, large speculators were sporting outsized short positions and small speculators, the proverbial contrary indicator, were likely holding a record net short position.

This is the way gold rallies start. But for the rally to be sustained, new money has to flow into newly-established long positions. Is this likely? We think it may be. Here’s why.

First, we believe the real driver of gold is risk aversion, which generally emerges first in credit markets. Below is a chart of the TED spread which represents the difference between US Treasury Bill rates and short term EuroDollar futures. Essentially, this spread measures the wholesale dollar market’s assessment of risk in such activities as interbank lending. This was an important indicator of risk aversion in 2008; it is rising now and becoming more volatile. Gold typically benefits from risk aversion while equities do not.

Another measure of risk aversion is the high yield debt market. When it underperforms, subprime interest rates rise and credit spreads widen. Gold tends to do better in this environment, as the one asset that does not have default risk. High yield debt is currently looking pretty weak.

Another measure to watch is the relative performance of bank stocks to the broader market. This ratio helps to signal increasing stress in the financial system. When bank stocks underperform the broader equity market, gold tends to attract a bid because banks are at the center of the financial system and gold is how some investors hedge their exposure to it.