Gold Hit by USDX Squeeze / Commodities / Gold and Silver 2018

Gold was enjoying asolid spring rally until a couple weeks ago, nearing major upsidebreakouts.  But its nice advance hascrumbled since, really weighing on sentiment. Gold fell victim to a rare major short squeeze in US Dollar Indexfutures.  The surging USDX motivatedgold-futures speculators to flee rather aggressively.  But this will likely prove a short-livedanomaly, after which gold’s assault on highs will recommence.

Gold’sseasonally-atypical weakness over the past couple weeks is very important forspeculators and investors to understand. It had nothing at all to do with fundamentals, but was completely drivenby the hyper-leveraged gold-futures traders. These guys have long been fixated on the US dollar’s fortunes, lookingto its benchmark US Dollar Index for trading cues.  That can slave gold’s price to the dollar attimes.

6 weeks ago, goldslumped to a major seasonal low of $1310 the day before theuniversally-expected 6th Fed rate hike of this cycle.  The gold-futures traders fervently believeFed rate hikes are very bearish for gold, so they usually sell leading intoFOMC meetings with potential hikes.  Thishas happened before every Fed rate hike of this cycle.  The theory is higher US rates boost foreigninvestment demand for US dollars.

The ironic thing ismodern history proves the opposite! Fed-rate-hike cycles are bearish for the US dollar and bullish for gold.  The last cycle ranfrom June 2004 to June 2006, where the Fed hiked 17 times in a row for 425basis points.  Despite those aggressiveand relentless rate hikes, the USDX still slipped 3.8% lower over that exactspan while gold rocketed 49.6% higher!  Clearly futures specs’ theory is sorely lacking.

The Fed’s currentrate-hike cycle out of extreme zero-interest-rate-policy lows got launched inDecember 2015.  Gold was hammered to a6.1-year secular low leading into it, as futures specs were absolutely certainhigher 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 somemarket thesis fails to work over and over again for decades, traders would trysomething else.  But not futuresspeculators, they are a stubborn lot.  Soleading into every likely Fed rate hike, they bid up the USDX and dumpgold.  Then immediately after those ratehikes the dollar fails to surge and gold doesn’t plunge, so they reverse thoseexcessive trades driving the dollar down and gold up.

So like clockwork afterthe Fed’s latest rate hike in late March, gold started rallying as gold-futuresspecs 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 withinspitting distance of a majorbull-market breakout.  Gold regainedits $1365 bull-to-date high from July 2016 on an intraday basis on April 11th,but failed to push through.

Ironically futuresspeculators’ irrational obsession with the Fed was again to blame.  That day the FOMC released the minutes from itsMarch 21st rate-hiking meeting.  Tradersinterpreted them as hawkish, so the USDX was bought and gold was sold.  For 24 trading days in row between mid-March tomid-April, gold simply did the opposite of whatever the USDX did on every single day but one.  The dollar ruled gold.

Gold managed to hovernear $1350 multi-year-horizontal-resistance breakout territory for another weekafter those Fed minutes.  But thatstarted changing on April 19th.  That daythe USDX rallied 0.3%, which was actually its biggest up day in a coupleweeks.  USDX-futures speculators wereexcited because the yields on benchmark US 10-year Treasury notes crested2.9%.  Higher yields are great for thedollar, right?

For decades I’veclosely followed speculators’ collective gold-futures positions every week inthe famous Commitments of Traders reports published by the CFTC.  I discuss them and their implications forgold’s near-term price action in every weekly newsletter.  But I haven’t had the time to dig deeply intoUSDX futures.  The analysts who trafficin that realm said USDX short positions were the largest seen in several years.

The leverage inherentin currency speculation is extreme beyondbelief.  Since major currencies tendto move slowly, the margin requirements equate to maximum leverage of 50x,100x, or even 200x!  That compares to thedecades-old legal limit in the stock markets of 2x.  At 50x, 100x, or 200x, mere 2.0%, 1.0%, or0.5% currency moves against traders’ positions would wipe out 100% of theircapital risked.  It’s crazy!

So when currencyspeculators are wrong, they have to exitpositions fast or risk getting obliterated. The traders short USDX futures had no choice but to buy.  The more long USDX futures they bought tooffset and close their shorts, the faster the dollar rallied.  That forced still more traders to buy tocover even if they were running more-conservative leverage.  This self-reinforcing dynamic feeds onitself, fueling short squeezes.

As the USDX buyingmounted, the dollar’s rally accelerated in subsequent days.  Traders continued to use 10-year Treasuryyields as a fundamental excuse for their purely technical trading, as within aweek they crossed the psychologically-heavy 3% threshold to 3.03%.  That was the highest seen since the very endof 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 becomethe biggest dollar short squeeze since soon after Trump won the election in late 2016.  That heavy futures buying forced the USDX tosurge 1.5% in those first 3 trading days. Although that sounds trivial, at 50x, 100x, or 200x leverage it hammersspeculators to catastrophic 75%, 150%, or 300% losses!  I wonder how these guys can sleep at nightbearing such ridiculous and unforgiving levels of risk.

Gold-futuresspeculators run extreme leverage too, but much less than currency traders.  This week a single gold-futures contractcontrolling 100 troy ounces of gold worth $130,500 only required speculators tokeep $3100 cash margins in their accounts. That equates to 42.1x maximumleverage!  For traders running at theedge, every 1% adverse move in gold would wipe out an insane 42% of theircapital risked.

So these guys nervouslywatch gold on a minute-by-minute basis. And in a fascinating confirmation that gold is indeed a currency, theylook to the US dollar for their trading cues. They started selling their gold-futures positions as the dollar startedrallying.  That drove gold 0.2%, 0.7%,and 0.9% lower in the first 3 trading days of that USDX short squeeze thatignited on April 19th, forcing gold down 1.9% overall to $1324.

Our lone chart thisweek looks at gold during this current Fed-rate-hike cycle superimposed on the long and short positions large and small speculators holdin gold futures.  Again these are publishedonce a week in those Commitments of Traders reports.  All 6 Fed rate hikes of this cycle are alsohighlighted, to show how gold is bludgeoned lower leading into them which spawnsstrong rebound buying in their wakes.

While the weekly CoTs are current to eachTuesday, they are released late Friday afternoons.  Thus the newest-available CoT when this essaywas published covers the week ending April 24th.  That includes those initial few trading daysof that USDX-futures short squeeze.  Andit’s very illuminating, showing why gold was pummeled back down frommajor-breakout levels and its strong spring rally was short-circuited.

For pre-dollar-rally baselines, on TuesdayApril 17th speculators held 284.2k long and 98.9k short gold-futurescontracts.  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 about3/4ths and 6/7ths of their near-term long buying and short selling.  Of course buying gold-futures longs isbullish for gold, while shorting is bearish.

When gold-futures shorts are low, there’salways the risk speculators will aggressively sell on the right catalyst comingalong.  That forces gold’s pricelower.  And this unlikely dollar shortsqueeze erupting out of the blue proved that triggering event.  On seeingthe USDX surge, the gold-futures specs were quick to start jettisoning longsand ramping shorts.  Thus gold fell 1.2%on the 1.4% USDX rally over that CoT week.

The magnitude of this initial gold-futuresselling became evident in the next CoT report current to April 24th.  During that CoT week, specs sold 7.9kgold-futures long contracts while adding another 15.6k on the short side.  That made for big total CoT-week sellingequivalent to 73.0 metric tons of gold.  That is simply far too much for normal buyingto absorb.  Thus the only possibleoutcome was a lower gold price.

Just this week, the World Gold Councilreleased its latest Gold Demand Trends report for Q1’18.  That’s the definitive source for world gold fundamentalsupply-and-demand data.  In Q1, globalgold investment demand averaged 22.1t per week. So heavy gold-futures selling easilyoverwhelms that.  Gold always fallswhen the futures specs get on a selling kick. They flood the market with too much short-term supply.

That dollar-short-squeeze reaction leftspecs’ collective long and short gold-futures positions running up 22% and 30%into their past-year trading ranges.  Sothese traders still had room to do about 4/5ths of their likely near-term longbuying, but expended a significant chunk of their shorting firepower.  That left total spec shorts at a 12-CoT-weekhigh of 114.5k contracts.  The higherspec shorts, the more bullish gold gets.

Short positions in futures are bullishbecause they necessitate proportional near-term buying.  In selling short, speculators essentiallyborrow futures from other traders to sell. The specs are legally obligated to buy back those contracts relativelysoon 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.  Thenewest CoT data current to this Tuesday May 1st won’t come out until lateFriday 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 continuedwhich drove more spec gold-futuresselling.

The dollar rally actually accelerated inthis newest CoT week ending Tuesday, as shown by the sharp 1.9% rally in the USDX.  Thus gold’s CoT-week selloff also grew to2.0%.  That was 2/3rds larger than theprior CoT week’s 1.2%.  So odds are thegold-futures selling balloonedsignificantly in this latest CoT week. That implies another 35k to 40k gold-futures contracts were dumped, withthe majority likely on the short side.

Assuming the prior week’s spec gold-futures-sellingmix of 1/3rd long and 2/3rds short holds, total spec longs could’ve droppedanother 12.9k contracts while shorts could’ve soared 25.8k.  If that proves true, total spec longs andshorts could have been running near 14% and 54% up into their past-year tradingranges as of this Tuesday.  That wouldmean the majority of the likely gold-futures shorting is already done!

While I don’t have the USDX-futures dataand background to analyze in depth, odds are the USDX is in a similar oppositeplace.  I suspect the majority of thedollar short covering has already run its course.  That paves the way for this sharp dollarrally to at least peter out and probably reverse.  Trade-warfears are going to flare again soon as the distraction of stocks’ Q1earnings season passes, which is bearish for the dollar.

If you look at the chart above, the greenline 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 floodinto gold on the long side when the USDX inevitably stalls or reverses.  They likely now have the capital firepower todo about 6/7ths of their potential near-term buying!  That portends big gold upside in comingweeks.

While gold’s strong seasonal spring rally was interrupted by this surprise USDX-futures short squeeze, I doubt it waskilled.  Gold was driven to a newseasonal low of $1304 this week, under its previous $1310 of mid-March.  Thus all the usual spring-rally buying inApril and May will likely be compressed intothis month alone!  That means goldcould enjoy a major mean-reversion bounce rally in the coming weeks.

During the 10 trading days as of the middleof this week since the dollar’s sharp rally started, gold has moved inversely proportionally to the USDX onevery trading day but one.  8 of thesetrading days of the past couple weeks saw the dollar rally, and gold’s biggestlosses of 0.9% both occurred on the dollar’s best up days of 0.7%.  Gold’s down days were all about the same sizeas the dollar’s up days, mirror images.

But in the 2 trading days of the pastcouple weeks when the USDX retreated modestly, gold surged way out ofproportion to the dollar’s weakness.  Thesetrivial 0.2% and 0.1% USDX slides allowed gold to rally a relatively-outsized0.6% and 0.5%!  Gold wants to rally, and will likely quickly surge back up near major-breakoutlevels soon after this dollar-rally pressure abates.  And that’s likely going to prove very soon.

The mounting US/China trade war has beenpushed out of the financial-media spotlight by Q1 corporate earnings, whichhave soared on the big corporate tax cut. But earnings season is winding down just as major trade-war deadlines arelooming for the US to implement recent tariff announcements.  The dollar looks far less attractive toforeign investors if tariff threats become reality, their capital will seekrefuge elsewhere.

And though the extreme leverage inherent ingold futures enables their speculators to wield outsized influence onshort-term price action, investors’ capital massively dwarfs thespeculators’.  So when investors’ vast fundsstart bidding on gold again, likely on the next major stock-market selloffdriving demand for prudent portfolio diversification, gold-futures specs’ influencewill 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 verybullish, as they will rush to buy back in to ride any upside momentum ingold.  Speculators’ mounting gold-futuresshorts are increasingly bullish, as these will have to be covered and closed bybuying offsetting longs.  And investors’ super-low gold allocations are wildly-bullish.

So odds are gold’s atypicalcounter-seasonal drop in the last couple weeks driven by the surprise USDXshort squeeze will soon reverse hard.  It won’t take much buying to drive gold back upnear those major bull breakout levels around $1365.  And gold powering higher again will quicklyturn sentiment around, with buying begetting more buying.  The dollar depressing gold prices leaves thismetal more bullish, not less so.

While investors can ride gold’s comingmean-reversion rebound in physical bullion itself or shares in the leading GLDSPDR Gold Shares gold ETF, far-better gains will be won in the stocks of itsleading miners.  They are already radically undervalued attoday’s prevailing gold prices, and their profits tend to amplify underlying gold gains by 2x to 3x.  Thissmall contrarian sector’s upside is vast, dwarfing everything else.

With gold still so near a major bull-marketbreakout, it’s ironic gold stocks remain so deeply out of favor.  Between our weekly and monthly newsletters, we have30 open gold-stock and silver-stock trades added in the past year.  As of this week near gold’s lows, fully 25 had average unrealized gains of18%.  One gold miner added in lateNovember is already up 95%!  The 5 othertrades had average unrealized losses of just 5%.

When gold inevitably rebounds, theseunrealized gains are going to explodehigher.  Buying low first isnecessary before selling high later to multiply wealth.  That means adding gold stocks when you leastwant to, when they’re hated.  That’s whatwe do at Zeal.  We spend all our timerelentlessly studying the markets so you don’t have to, and share our acclaimedresearch through our popular financial newsletters.

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The bottom line is gold’s recent weaknessis the result of a rare major short squeeze in US Dollar Index futures.  The resulting dollar rally spookedgold-futures speculators, who rushed to sell to avoid getting slaughtered bytheir extreme leverage.  While thatshort-circuited gold’s spring rally, this anomaly won’t last.  Gold-futures speculators and gold investorsare far too bearish and under-allocated, with big room to buy.

The USDX short covering is likely runningout of steam, which will clear the way for gold’s big seasonal spring rally toresume.  All that delayed buying willlikely be compressed into May, and drive gold back up near recentmajor-bull-breakout levels.  Anydollar/gold reversals will force gold-futures specs to quickly buy to covertheir ballooning shorts.  The resultingrally will entice in long-side traders, then gold is off to the races.

Adam Hamilton, CPA

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