Gold Inflation Disconnect / Commodities / Gold and Silver 2022

Gold should be soaringwith red-hot inflation raging, but instead it is breaking down.  This history-defying disconnect hasdevastated sentiment, leaving this leading traditional inflation hedgedespised.  Traders need to realize gold’sbizarre decoupling from all precedent is an extreme anomaly that will proveshort-lived.  It has been driven by aparabolic US-dollar surge fueling unsustainable heavy gold-futures selling.

As a professionalspeculator and financial-newsletter writer for the past 23 years, I’m deeplyimmersed in the markets.  I eat, breathe,and sleep trading, watching and analyzing market action all day every day.  In such a long span of time, I’ve seen plentyof irrational episodes where prices temporarily disconnect from reality.  But recent months’ serious gold weakness may takethe cake as the most absurd I’ve witnessed!

For millennia, gold hasproven the greatest investment in inflationary times of monetary debasement.  Its supply growth from mining is very-slow, constrainednaturally by the rarity of economic gold deposits and the decade-plus timelinesnecessary to bring them to production. So when governments irresponsibly expand their money supplies at excessiverates, gold prices surge to reflect those depreciating currencies.

Relatively-way-moremoney is suddenly available to compete for relatively-much-less gold, biddingup its price levels.  And the higher goldpowers, the more investors want to chase it accelerating its upside.  This logical gold-inflation dynamic hasfueled legendary gains during past inflation super-spikes.  The previous couple before today’s monster hitin the 1970s, and gold’s performances reflected how it should react.

From June 1972 toDecember 1974, headline year-over-year US Consumer Price Index inflation soaredfrom 2.7% to 12.3%.  During that 30-monthspan, conservative monthly-average gold prices blasted up an amazing 196.6%!  After that serious inflation wave passed, anotherone soon followed.  From November 1976 toMarch 1980, the YoY CPI prints skyrocketed from 4.9% to 14.8%.  Gold was a moonshot in that span.

Over that 40-monthinflation super-spike, gold shot parabolic with a stupendous 322.4% gain in monthly-average-price terms from trough to peak CPI!  As the world’s aboveground gold supply is waybigger now than during the 1970s, gold probably won’t nearly triple or morethan quadruple again in this first inflation super-spike since then.  But surely it ought to at least double withred-hot inflation raging out of control.

Today’s soaring generalprices are the result of the Federal Reserve flooding the world with a colossaldeluge of new US dollars in recent years. Between the end of February 2020 just before the pandemic-lockdown stockpanic and April 2022, the Fed mushroomed the US-dollar supply a ludicrousamount.  In just 25.5 months, the Fed’s balancesheet which is the US monetary base skyrocketed 115.6% or $4,807b!

By effectively morethan doubling the US money supply in just a couple years, the Fed conjuredup vastly more dollars to compete for and bid up the prices onfar-slower-growing goods and services. That’s why even headline CPI inflation, which is intentionally lowballedby the US government for political reasons, is soaring.  Just this week the latest June CPI print blastedup 9.1% YoY, its hottest since November 1981!

This chart superimposesgold prices over the headline YoY CPI over the last few years or so.  During the past 25 months, that leadinginflation gauge has skyrocketed from a pandemic-lockdown anomaly down at 0.1%in May 2020 to last month’s crazy 9.1%.  Butmonthly-average gold prices have only climbed a pathetic 6.9% in that span!  Clearly gold is not yet reflecting this firstinflation super-spike since the 1970s.

Fed money-supplychanges take time to work their way through the massive US economy, so headlineinflation lags them.  Fed officialsstarted panicking in mid-March 2020 after the flagship US S&P 500 stock indexcratered 33.9% in just over a month! They worried pandemic lockdowns would force a severe recession, whichcould snowball into a full-blown depression with the negative wealth effectfrom plunging stocks.

So they started redliningtheir proverbial monetary printing presses, flooding the world with epic amountsof US dollars newly conjured out of thin air. Headline CPI inflation remained low until spring 2021, when that dollardeluge finally filtered down to normal Americans.  In March, April, and May of that year, theYoY CPI surged to 2.6%, 4.2%, and 5.0%!  Money-supply-growth-drivenhigher prices have intensified since.

In the 27 months sincethe Fed’s fateful March-2020 decision to hyper-inflate the US dollar, the YoYCPI has averaged 4.2%.  That is skewed downby really-low reads during and after the lockdowns in 2020, but still doublethe 2.1% average CPI in the 27 months before that pandemic-lockdown stock panic.  During the 17 full months Joe Biden has beenpresident, the headline YoY CPI has been far worse averaging 6.2%.

This current raginginflation is literally unlike anything witnessed since the 1970s.  And it sure should be after such radically-unprecedentedmoney-supply growth by this profligate Fed. Yet gold is acting like the Fed never doubled the US dollars in circulation,like this latest inflation super-spike doesn’t even exist!  That’s exceedingly-frustrating for contrarianspeculators and investors, as well as students of market history.

Gold’s vexingdisconnect from this red-hot inflation is fairly-new though, mostly emergingover just the last several months. During the initial year between March 2021 when the headline CPI firstsurged over the Fed’s 2% inflation target to March 2022, gold powered 22.0%higher.  That way-more-normal behavior formounting inflationary pressures was a good start.  Gold marched higher like it should have in asolid uptrend.

Gold would’ve fared betterin that span, but the US dollar was also strengthening.  During that first real year of this inflationsuper-spike, the leading benchmark US Dollar Index climbed 7.2%.  That is counter-intuitive, as inflationarydebasement of currencies eroding their purchasing power eventually forcesthem lower.  But the US dollar wasbid higher on an increasingly-likely new Fed-rate-hike cycle to fight raginginflation.

Since currenciesusually meander glacially, incredible leverage is available for currency tradersas high as 50x to 100x!  At those extremes,a mere 2% or 1% US-dollar move can double or wipe out traders’ capital bet.  That forces them into a super-myopic ultra-short-termperspective.  Currency traders often focuson yield differentials, shifting capital from countries with lower interestrates to others with higher ones coming.

The Fed launched itslatest rate-hike cycle in mid-March 2022, ending its zero-interest-rate policyin place since March 2020’s pandemic-lockdown stock panic.  Those rate hikes have really accelerated inthe last three Federal Open Market Committee meetings, running 25 basis points,50bp, and then 75bp in mid-June.  The lattertwo hikes proved the biggest the Fed had dared since May 2000 and November 1994!

And the panicking Fedofficials weren’t only jacking rates sharply higher, in early May they detailedhow they would start unwinding that epic money-supply growth.  The Fed would begin selling $47.5b of bondseach month in June, doubling to a terminal $95b-per-month pace in September.  That dwarfed the Fed’s first quantitative-tighteningcampaign, which slowly ramped up to $50b monthly over an entire year intoQ4’18.

Together that ultra-aggressiverate-hike cycle and big QT made for the most-hawkish Fed pivot by far inits entire century-plus history!  Socurrency traders stampeded into the US dollar, further motivated by the weakereuro.  Europe’s common currency dominatesthe USDX at 57.6% of its weighting, and the European Central Bank was draggingits feet in even starting to hike rates out of its own negative-interest-ratepolicy.

Crazy-leveragedcurrency traders love chasing momentum, so they increasingly piled into the soaringUS dollar while dumping the cratering euro.  That dynamic triggered gold’s inflation disconnect, which merelystarted three months ago in mid-April. Gold was still trading way up at $1,977 before the USDX rocketed parabolicand the euro collapsed.  Their huge movessince then have been extraordinary and unsustainable.

As of this Monday the USDXhad skyrocketed 8.3% in just 2.9 months, an exceedingly-extreme move for theworld’s reserve currency.  Epic Fedhawkishness fueled that, while helping the competing euro crater a brutal 7.7%in that same span.  By major-currencystandards, the dollar’s massive rally compressed into such a short timeframe wasparabolic.  It catapulted the USDX wayup to an incredible 19.7-year secular high!

Such an anomalous surgeattracted huge capital inflows, leaving the US dollar extremely-overboughtand wildly-overcrowded.  It also generatedmania-like universal bullishness, leaving herd psychology for the USDX overwhelmingly-greedy.  It was that euphoric dollar that slammedgold, as I analyzed in depth in last week’s essay.  Gold’s apparent inflation disconnect resultedfrom an exceedingly-extreme dollar rally.

While the USDXskyrocketed 8.3% since mid-April, gold plunged 12.3% from that $1,977 to just$1,733 this Monday.  Since I write theseweekly web essays on Thursdays, their data cutoff is Wednesdays.  As I’m penning this essay, gold has been hammeredeven lower near $1,700 as the USDX soars to new secular highs around 109.3!  But this unsustainable USDX parabolic rallyis doomed to reverse hard soon.

Exceptionally-big-and-fastsurges to lofty heights inevitably generate overwhelming herd greed.  Traders rush to chase the upside momentum,which temporarily becomes self-feeding. But that soon sucks in all-available near-term buyers, leavingonly sellers.  So vertical rallies soonpeak with sentiment growing universally-bullish, then quickly fail in symmetricalplunges.  Selling begets selling, acceleratingthe downside.

Any day now, theradically-overbought US dollar and equally-oversold euro are going to start violentlymean reverting in the opposite directions. The catalyst could prove unexpected economic data out of the US orEurope which is less-hawkish for the Fed or more-hawkish for the ECB.  Or it might be central-bank officials changingtheir jawboning, implying slower tightening in the US or faster tightening overin Europe.

Regardless of newsflows, vertical parabolic rallies resulting in mania-like exuberance never lastlong.  The universal bullishness forthe US dollar on extreme Fed tightening reminds me of herd psychology forbitcoin back in early November.  Traders collectivelyexpected it to keep soaring indefinitely, with endless arguments to rationalizethat sentiment.  But since that extremegreed bitcoin has collapsed 71.9% at worst!

The mighty dollar won’tshare that ugly fate, but its blistering 8.3% parabolic spike since mid-April shouldbe symmetrically unwound over a few months. That would work wonders for gold, as that extraordinary dollar surge isthe sole reason gold plunged since mid-April. That’s because the gold-futures speculators who dominate gold’sshort-term price action watch the US dollar’s fortunes for their primarytrading cues.

While the leverageinherent in gold futures doesn’t rival that in currencies, it is stillextreme running near 25x in recent months. At those levels, a mere 4% gold move against speculators’ bets wouldwipe out 100% of their capital risked!  Thatforces them into myopic short-term focuses as well, with time horizons in days toweeks on the outside.  They aren’t eventhinking about inflation, all they care about is the US dollar.

So specs aggressivelydumped both long and short contracts since mid-April as the USDX skyrocketed.  This chart reveals that heavy selling, which isreported weekly in the famous Commitments of Traders reports showing specs’overall gold-futures positioning.  Currentto Tuesday closes, these weekly CoTs aren’t released until late Fridayafternoons.  So the latest-available datafor this essay was only July 5th’s.

Despite traders’ swellingparanoia that gold is somehow no longer the ultimate inflation hedge, the dominantreason it collapsed 15.9% between early March to this Tuesday is heavygold-futures selling.  From thenearest CoT Tuesday closes matching that span, speculators dumped a huge 108.8kgold-futures long contracts while ramping their shorts by 32.5k!  That 141.4k total contracts jettisoned is alot of selling.

That’s equivalent to439.7 metric tons of gold cast into global markets, with nearly 7/8ths floodingin during that mid-April to early-July timeframe where the USDX shot parabolic!  Heedless of way-more-important broader trendslike raging inflation, the myopic gold-futures specs have long been the villainsof the gold world.  Their frenetic leveragedtrading bullying around gold prices also affects investors’ psychology.

The longer heavy gold-futuresselling slams the metal lower, the more investors assume that gold must havesome real fundamental problem justifying lower prices.  So they join in the selling, amplifying downside.  Between mid-April to early July, the besthigh-resolution proxy for global gold investment demand saw another 98.9t ofselling.  That’s the combined holdings ofthe huge dominant GLD and IAU gold ETFs.

So in just the lastthree months, gold suffered about 480 metric tons of identifiable selling!  Fully 4/5ths of that was on the gold-futuresside, in response to that parabolic US Dollar Index.  But just as the dollar’s blistering rally is unsustainable,so is that heavy gold-futures selling.  Whilespecs wield outsized influence on gold prices due to their extreme leverage,their capital firepower is very finite. They can only sell so much.

Those limits are beingreached, which is super-bullish for battered gold!  In that latest-reported CoT week before this essaywas published current to July 5th, total spec longs and shorts ran 311.7k and146.2k contracts.  And given gold’s weakprice action since then on the USDX soaring ever-higher on early-quartermomentum buying, speculators’ longs are almost certainly even lower and shorts evenhigher this week.

Both are already nearextremes as this chart reveals.  Speclongs are right at major multi-year support, from which gold has surged dramaticallyhigher on mean-reversion buying.  So thesetraders likely have little additional room to keep selling, but massive room tobuy back longs to normalize specs’ excessively-bearish bets.  Since longs outnumber shorts by 2.1x, theyare proportionally more important for gold’s direction.

Adding to evidence speclong selling is mostly-exhausted, longs have stabilized around that 312k supportline for six CoT weeks in a row since late May despite much-lower goldprices.  Most of gold’s weakness sincethen has been fueled by surging short selling. While total spec longs only fell a small 4.4k contracts since late May,spec shorts have surged 30.1k!  That propelledthem up near unsustainable multi-year highs.

Total spec shorts areabove their uptrend resistance, nearing the same extreme levels that birthedgold’s last upleg in late September 2021. Gold was trading way down near $1,725 then, driven by gold-futuresselling on a stronger US dollar fueled by hawkish-Fed expectations.  But despite gold being universally despisedthen much like today, it powered 18.9% higher over the next 5.3 months on big gold-futuresbuying!

Since speculators’ hyper-leveragedgold-futures trading dominates gold prices when investment capital inflowswane, I always analyze the latest CoTs in our weekly and monthly newsletters.  I like to recast total spec longs and shortsas percentages of their past-year trading ranges.  As of that latest July 5th CoT, spec longs andshorts were running 0% and 96% up into those ranges.  This is great news for gold.

That’s right at themost-bullish-possible near-term setup for gold of 0% longs and 100% shorts!  That reveals spec selling on both sides ofthe trade is effectively spent, leaving room for nothing but bigmean-reversion buying.  So despite gold’sugly selloff in recent months and technical breakdown in early July, its outlookremains incredibly-bullish.  Gold has notdisconnected from inflation, this is a temporary anomaly.

Fortunes are won in themarkets by buying low then selling high. The former requires betting on sectors when they are deeply-out-of-favor,like gold and its miners’ stocks today.  Itis never easy maintaining a contrarian worldview and fighting the herd, whichis always wrong at price extremes.  But markethistory has long proven that’s the best way to generate life-changingwealth.  This anomalous gold selloff is agift.

The radically-overboughteuphoric US dollar is soon going to roll over hard, as the wildly-oversold eurorebounds.  That dollar weakness willdrive gold higher, forcing gold-futures specs to quickly buy to cover their shortsor face catastrophic leveraged losses. That will accelerate gold’s gains, attracting back long-side gold-futuresbuyers then later investors with their vastly-larger pools of capital.  Gold will soar on all that!

The biggest beneficiariesof higher gold prices are goldminers’ stocks, which are far-more-oversold than their metal.  The larger gold stocks of GDX tend to amplifygold upleg gains by 2x to 3x, while the smaller fundamentally-superior mid-tiers and juniors welloutperform even that!  Before this inflationsuper-spike runs its course and gold fully reconnects, the better smaller goldstocks should see order-of-magnitude gains.

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The bottom line is today’sapparent gold-inflation disconnect is a temporary unsustainable anomaly.  Gold powered higher on balance like normalduring the first year of this inflation super-spike.  But a few months ago, the US dollar startedshooting parabolic on incredible Fed hawkishness.  That spawned heavy gold-futures selling, hammeringgold into a serious technical breakdown. But both extremes are exhausting.

Theextraordinarily-overbought, euphoric, and wildly-overcrowded long-dollar trade isoverdue to reverse sharply.  And speculators’capital firepower to sell gold futures is largely tapped-out based onmulti-year trends.  So when the USDX inevitablyrolls over on a less-hawkish Fed or more-hawkish ECB, gold will soar on massivemean-reversion gold-futures buying.  Thatwill attract back investors, accelerating the upside.

Adam Hamilton, CPA

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