Fed Gooses Gold, Miners / Commodities / Gold and Silver 2018

The dovish FederalReserve lit a fire under gold and its miners’ stocks this week.  As universally expected the FOMC hiked ratesfor the 9th time in this cycle.  But it alsolowered its 2019 rate-hike outlook bowing to the stock-market selloff.  Traders dumped gold initially thinking thatwasn’t dovish enough.  But marketreactions to the FOMC form over a couple days, and gold surged overnight.  Its post-Fed rally has great potential.

Gold-futures speculatorsdominate gold’s short-term trading action. They punch way above their weight in capital terms thanks to the extremeleverage inherent in gold futures.  Thisweek, the minimum margin for trading each 100-ounce contract controlling$125,000 worth of gold at $1250 was just $3400! These traders can run crazy maximum leverage as high as 36.8x, compared to the stock markets’ legal limit of 2x.

At 10x, 20x, or 30xleverage, every dollar of capital deployed in gold futures has 10x, 20x, or 30xmore price impact on gold than a dollar invested outright.  Further compounding speculators’ hegemonyover gold prices, gold’s world reference price derives directly from USgold-futures trading.  Naturally extremeleverage means extreme risk.  At 37x a mere 2.7% gold move againstpositions wipes out 100% of capital risked!

In order to survive,gold-futures traders are forced to have an ultra-short-term focus.  Their time horizons are measured in hours,days, and maybe weeks instead of months and years.  And there is nothing that motivates them totrade aggressively like meetings of the Fed’s Federal Open Market Committee.  Gold volatility often surges in their wakes,as speculators watch the US dollar’s reaction and do the opposite in gold.

Gold-futures speculatorsare convinced Fed rate hikes are bearish for gold because they are bullish forthe US dollar.  They logically reason thatthe higher prevailing US interest rates, the more attractive the US dollarbecomes relative to other currencies. And a stronger dollar usually means weaker gold since they are competingcurrencies.  That all sounds rational,but the big problem is history doesn’t bear this out.

The FOMC started today’srate-hike cycle way back in mid-December 2015, raising the federal-funds ratefor the first time in 9.5 years.  Gold-futuresspeculators fled leading into that, ultimately crushing gold to a deep 6.1-yearsecular low of $1051 the day after.  But thatoversold extreme marked the birth of a new bull market that would catapult gold29.9% higher over the next 6.7 months! That same bull persists today.

In the 3.0 years sincewhich includes this week’s 9th Fed rate hike of this cycle, gold is still up18.1% and the US Dollar Index is down 2.1%. That’s no anomaly either.  This isactually the Fed’s 12th rate-hike cycle since the early 1970s.  During the exact spans of the prior 11, gold averaged strong gains of 26.9%!  That was an order of magnitude higher thanthe stock markets’ 2.8% average gains per the flagship S&P 500.

Gold-futuresspeculators either don’t know market history or their extreme leverage forcesthem to run as a herd no matter how irrational that stampede is.  They can’t afford to be wrong for long orrisk suffering catastrophic losses.  Thisweek they apparently expected the FOMC to prove even more dovish on future ratehikes than it was.  That led to volatilegold action surrounding this latest critical Fed decision on rates.

The FOMC meets 8 timesper year, about every 6 weeks.  But upuntil now, only every other meeting was accompanied by a Summary of EconomicProjections and followed by the Fed chairman holding a press conference.  That meant the Fed was only “live”, likely tohike rates, once a quarter at that every-other meeting.  Incidentally Jerome Powell will start holdingpress conferences after every meetingstarting in January.

That decision was madein mid-June, it had nothing to do with the recent stock-market volatility.  Since the Fed doesn’t want to spook tradersand ignite selloffs, rate hikes are well-telegraphed in advance.  3 weeks after each FOMC meeting, its fullminutes are released.  They are long anddetailed, offering all kinds of clues about whether top Fed officials arethinking about hiking rates at their next FOMC meeting.

Market-impliedFed-rate-hike odds are always available through federal-funds futurestrading.  The big wildcard at each liveFOMC meeting is a part of the SEP known as the “dot plot”.  It collates where each individual top Fed officialpersonally expects the federal funds rate to be in each of the next severalyears and beyond.  It’s literally a bunchof dots plotted on a table, hence the name. It can really move gold futures.

Though Powell and otherFOMC members stress the dot plot is not an official rate-hike forecast oroutlook by the Fed, traders universally use it as such.  A hawkish dot plot implies more future ratehikes than the previous one, and dovish less. Gold, currency, and stock-index futures speculators trade aggressivelybased on the quarterly changes in the dot plot. FOMC statements and press conferences also play roles.

At the FOMC’s previousmeeting accompanied by a dot plot in late September, those forecasts impliedtop Fed officials expected this week’s rate hike, another 3 in 2019, and 1final one in 2020.  But market conditionswere way different then.  That decisioncame just 4 trading days after all-time record highs in the lofty euphoria-drenchedUS stock markets.  Top Fed officials are boldlyhawkish when stocks look awesome.

In early October Powelldoubled down on this hawkishness, saying in an evening speech that thefederal-funds rate was “a long way from neutral at this point, probably” and that“We may go past neutral.”  The very nextday the stock markets started sliding and haven’t looked back since.  By this Monday that selloff had gradually mushroomedinto a moderate 13.1% correction in the S&P 500.  Many blame it on Fed hawkishness.

Facing witheringcriticism led by president Trump himself, Powell tried to walk back his ownmany-more-rate-hikes-to-come outlook in late November after the S&P 500 hadpassed the 10% correction threshold. Powell said “Interest rates are still low by historical standards, andthey remain just below the broad range of estimates of the level that would beneutral for the economy...”  Stockselling was softening the Fed.

While traders fullyexpected the 9th rate hike of this cycle Wednesday, they were sure the dot-plotoutlook of future rate hikes would be far more dovish than late September’s 5including this week’s.  Gold ralliednicely in anticipation, climbing from $1214 before Powell’s second speech to$1249 the day before this latest FOMC meeting. In the hours before this new dot plot’s release, gold was bid to a newupleg high of $1261.

Market expectations werefor just 1 rate hike in 2019 compared to the previous 3 implied, followed by anactual rate cut in 2020!  That seemed excessive,so I figured top Fed officials would kill one of the hikes next year leaving 2in 2019 and remove 2020’s lone hike as well. While this latest dot plot was indeed dovish as expected, it wasn’t dovish enough.  2019’s outlook shrunk to 2 more hikes, and2020’s kept that final one.

So instead of going from4 future hikes down to 1 or 2 as hoped, the dot plot only retreated from 4 to3.  Both dollar-futures and gold-futuresspeculators expected more dovishness, leading to moderate gold selling after thedot plot.  Gold fell from $1251 justbefore its release to $1242 a couple hours later, and closed 0.6% lower on theday.  Stock markets fared worse, theS&P 500 falling 1.5% to a new correction low!

But the impact of FOMCdecisions usually takes a day or two to settle out.  They are released at 2pm New York time whenAsian and European markets are closed. So until foreign traders get their chances to react to the Fed, the marketoutcome isn’t known.  Even Americantraders have to get past their initial kneejerk reactions, so the next trading day following the FOMCis crucial as actual implications sink in.

Gold was slowly bid headinginto Thursday in Asian markets, heading back up near $1248 by the time Europewas opening.  And then gold quicklysurged to $1256, a new closing upleg high. In US afternoon trading the day after this FOMC decision, gold surged ashigh as $1266!  Top Fed officials’ futurerate-hike outlook falling from 4 to 3 might not have been dovish enough, but itwas still certainly dovish absolutely.

Seeing the Fed waver on future rate hikes in response tothe mounting stock-market selloff this quarter is super-bullish for gold andits miners’ stocks going forward.  Bothgold-futures speculators and normal investors remain way under-deployed ingold, with vast room to buy.  Odds arethis week’s dovish FOMC will accelerate major gold and gold-stock uplegs.  That’s happened after past Fed rate hikes inthis cycle too.

This first chartsuperimposes gold prices over the total gold-futures long and short contracts speculatorshold, which are rendered in green and red respectively.  All 9 Fed rate hikes of this cycle are highlightedin blue.  Gold has often surged stronglyon gold-futures buying in recent years following FOMC rate-hiking decisions, ormore precisely dot-plot changes in the future-rate-hike outlook.  Gold is set up to surge again.

Again this entire goldbull was born the day after the Fed’s first rate hike of this cycle, resultingin that big initial 29.9% gold upleg over 6.7 months in essentially H1’16.  That left gold overbought so it started tocorrect like normal.  But that wasgreatly exacerbated by Trump’s surprise election victory which ignited amonster stock-market rally on hopes for big tax cuts soon.  Investors aggressively fled gold to chase stocks.

But gold bottomed inmid-December 2016 the day after this cycle’s second rate hike, and soon startedsurging sharply higher.  Yet gold-futuresspeculators didn’t learn their lesson, and continued to dump gold heading into FOMCdecisions with expected rate hikes.  Goldrallied strongly immediately out of the 3rd, 5th, and 6th hikes of this cycle,and soon after the 4th and 8th.  Ratehikes have definitely proven bullish forgold!

The 7th rate hike inmid-June 2018 was a major exception. Gold fell sharply in subsequent days as gold-futures speculators lapsedinto a stunning extreme recordorgy of short selling.  Initiallysparked by a US dollar rally, that epic gold-futures shorting soon took on alife of its own driving total short contracts to their highest levels ever by far! That ultimately blasted gold to a deep and unsustainable 19.3-month lowin mid-August.

Most of that shortingspree has been covered since, fueling most of gold’s young upleg since.  But the long-side gold-futures speculatorswho control much more capital than short-side guys have barely started to buy.  Shortcovering is legally mandated to repay the debts incurred by borrowing to shortsell.  But long buying is totallyvoluntary, speculators have to believe gold is heading higher to make leveragedbets on it.

At the end of Novemberthe day before Powell’s about-face on how far rates were from neutral, thetotal gold-futures longs held by speculators had crumbled to just 204.9k contracts.  That was a serious 2.9-year low, levels lastseen in late January 2016 just as this gold bull was starting to march higher. So gold-futures speculators are nearly as under-deployed in gold as theywere near the end of its last secular bear!

That leaves vast roomfor them to buy to reestablish normal positions.  Back in essentially the first half of 2016,speculators added 249.2k longs while covering 82.8k shorts to help catapultgold 30% higher.  It’s amazing to seesimilar long-buying potential today, with speculators’ total longs running just7% up into their past year’s trading range. We’re nearing the tipping point where short covering ignites far-biggerlong buying.

Gold bull uplegs have 3 distinct stages that triggerand unfold in telescoping fashion.  Theyall start out of major lows with that mandatory gold-futures short covering, thefirst stage.  That eventually pushes goldhigh enough for long enough to entice long-side gold-futures speculators toreturn, the second stage.  I suspect thisweek’s dovish FOMC meeting could prove the catalyst that ignites big stage-twogold buying.

This latest dot plot maynot have been dovish enough for traders, but Fed dovishness will snowball withstock-market weakness.  The lower thestock markets slide, whether or not Fed hawkishness is really to blame, themore pressure on the FOMC to slow or even stop its future-rate-hike tempo.  Gold-futures speculators will crowd into goldto chase its upside momentum with their feared rate-hike boogeyman fading.

But all the stage-oneand stage-two gold-futures buying that fuels young gold uplegs is just the preludeto far-larger stage-three investmentbuying.  After gold’s upleg growslarge enough and lasts long enough to spawn investor interest, their capital inflowssoon dwarf anything the gold-futures speculators could ever manage.  There’s also precedent in this cycle for Fedrate hikes soon leading to surging gold investment demand.

A great high-resolutionproxy for gold investment-demand trends is the amount of physical gold bullion heldin trust by the dominant GLD SPDR Gold Shares gold ETF.  It effectively acts as a conduit for the vast pools of American stock-market capitalto slosh into and out of gold.  Just acouple weeks ago I wrote an essay on how GLD works and why it is criticallyimportant to gold prices, especially during stock selloffs.

This next chart looksat GLD’s holdings superimposed over the gold price, with all 9 Fed rate hikesof this cycle highlighted.  Whilegold-futures trading usually dominates gold prices, it is still easily overpoweredby material flows of American stock-market capital into or out of gold via GLD.  Investors have started to return to gold again on the stock-market selloff, andthis prudent reallocation should accelerate on Fed dovishness.

The last time Americanstock investors were worried enough about stock-market selloffs to redeployinto gold for refuge was that first half of 2016.  Since gold is a rare counter-moving assetthat tends to rally as stock markets weaken, investment demand soars when theS&P 500 slides long enough to ignite serious concerns.  We’re certainly getting to that point again,as worries are mounting about this latest major selloff.

Gold went from beingleft for dead in mid-December 2015 to surging 29.9% higher in just 6.7 months solelyon American stock investors returning!  This is no generalization, the hard numbersprove it without a doubt.  The world’sbest gold fundamental supply-and-demand data comes from the venerable World GoldCouncil.  It releases fantastic quarterlyreports detailing the global buying and selling happening in gold.

Gold blasted higher on stockweakness in Q1’16 and Q2’16.  Accordingto the latest data from the WGC, totalworld gold demand climbed 188.1 and 123.5 metric tons year-over-year inthose key quarters.  That was up 17.1% and13.2% YoY respectively!  But the realstunner is exactly where those major demand boosts came from.  It wasn’t from jewelry buying, central-bankbuying, or even physical bar-and-coin investment.

In Q1’16 and Q2’16, GLD’sholdings alone soared 176.9t and 130.8t higher on American stock investorsredeploying into gold after back-to-back S&P 500 corrections.  Incredibly this one leading gold ETF accountedfor a staggering 94% of overall global gold demand growth in Q1’16 and 106% inQ2’16!  So there’s no doubt withoutAmerican stock investors fleeing into gold via GLD this gold bull never would’ve been born.

Gold was holding thosesharp gains throughout 2016 until Trump’s surprise presidential victory unleasheda monster stock-market run on hopes for big tax cuts soon.  Gold was pummeled in Q4’16 as American stockinvestors pulled capital back out to chase the newly-soaring S&P 500.  That quarter total global gold demand per theWGC fell 103.4t YoY or 9.0%.  GLD’s 125.8tQ4’16 holdings draw accounted for 122% of that!

Fast-forward to summer2018, and investors again started shifting out of gold to chase euphoric USstock markets nearing new record highs.  Thatforced GLD’s holdings to a deep 2.6-year low, investors hadn’t been so underinvested in gold since early inthis bull market when they started flooding back in helping to catapult goldsharply higher.  That gives them massiveroom to buy back in since their allocations are so low.

This mass exodus of Americanstock-market capital out of gold via GLD ended in mid-October the exact day the S&P 500 startedplunging in what’s grown into this newest correction-grade selloff!  Ever since GLD’s holdings have continuedrecovering on more capital inflows, helping to drive gold higher.  This trend should only accelerate as stage-twogold-futures long buying on Fed dovishness further lifts gold prices.

Investors are often asmomentum-driven as futures speculators, but over much-longer time horizons.  So as this young gold upleg grows, gold isgoing to look much more attractive to them. Their desire to chase its upside performance is really intensified bymaterial stock-market weakness.  That makesgold stand out as not just a safe-haven capital-preservation hedge, but a wayto grow wealth while everything else burns.

And as goes gold, so gothe stocks of its miners.  Last week I wrotea whole essay detailing the imminent major upside triple breakout in gold stocks likely to be triggered by a dovish FOMC.  That indeed started to happen this week before the Fed, as this updated GDX chartshows!  The GDX VanEck Vectors GoldMiners ETF is the leading gold-stock investment vehicle and benchmark, andremains poised for massive gains.

Three major resistancezones have converged at GDX $21.  Theyinclude its 200-day moving average, past-year descending-triangle overheadresistance, and the old consolidation basing trend’s support.  In anticipation of a gold rally on a dovish Fed,GDX closed above $21 on Tuesday.  And inthe hours before that FOMC decision Wednesday, it hit $21.47 intraday which wasvery-bullish decisive-breakout territory.

But when futuresspeculators bid the US dollar higher and pushed gold lower on this latest dot-plotrate-hike outlook not being dovish enough, the gold stocks reversed hard.  GDX plummeted a staggering 7.3% intradayacross that FOMC decision!  It closed 5.4%lower, making for absurd 9.0x downside leverage to gold’s small 0.6% Fed Dayloss.  That was a wildly-irrational downsideanomaly that never should’ve happened.

In trying to figure outwhy after Wednesday’s close, I waded through dozens of gold stocks to see if therewas some adverse news besides a not-dovish-enough FOMC.  There was nothing.  But provocatively in after-hours trading soonafter the US stock-market close, many if not most of the gold stocks had alreadyregained 2/3rds to 3/4ths of that day’scrazy losses!  So traders realized thatkneejerk selloff wasn’t righteous.

Indeed right out of thegates Thursday GDX surged 4.1% higher erasing over 7/10ths of the extreme FedDay losses.  Remember market reactions toFOMC decisions usually aren’t fully apparent until the entire next trading day,after the implications have sunk in and overseas traders have reacted.  Gold stocks’ major-upside-breakout thesis portendinga powerful new upleg remains intact,the Fed likely accelerated it.

The beaten-down goldminers’ stocks remain the lastcheap sector in the entire stock markets, a coiled spring ready to soar asgold returns to favor.  The more shortscovered and longs bought by gold-futures speculators, and the more capital investorsallocate back into gold, the greater the upside the gold miners’ stocks have asgold powers higher.  Their potentialgains are enormous, dwarfing anything else in 2019.

Again the last time majorstock-market weakness rekindled gold investment demand was essentially thefirst half of 2016, when gold powered 29.9% higher.  That drove a parallel monster 151.2% gold-stock upleg per GDX, makingfor huge 5.1x upside leverage.  The gainsin major gold stocks generally amplify gold upside by 2x to 3x, and smallermid-tier miners with superior fundamentals tend to do much better than that.

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The bottom line is thisweek’s FOMC decision is very bullish for gold and its miners’ stocks going forward.  While only seeing 1 of 3 projected 2019 ratehikes axed wasn’t considered dovish enough, it still showed the Fed’s hawkishresolve is cracking.  That dovishness willmount the longer stock markets remain weak, further shortening and shrinkingthis rate-hike cycle.  That green lightscapital returning to gold in a big way.

There is massive roomto buy back in, with both speculators’ gold-futures longs and stock investors’gold held via GLD just modestly above major multi-year lows.  Dovish Fedspeak, weaker stock markets, andhigher gold prices will really motivate them to reestablish normal goldpositions and portfolio allocations.  Thegold miners’ stocks will be the major beneficiaries of higher gold prices, nicelyleveraging gold’s gains.

Adam Hamilton, CPA

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