During this unprecedented month where the flagship S&P 500 has plummeted 23.0%, it isn't surprising this brutal stock-market selloff is monopolizing investors' attention. Thus gold's poor performance is largely flying under the radars. Month to date, this metal is down a massive 15.6%! This combined with the intense stock fears have led to an unthinkable 46.4% October decline in the HUI gold-stock index.
Shell-shocked gold and gold-stock investors are morosely trying to comprehend this incredible carnage. Traditionally a financial crisis of this magnitude would have led to a frenzy of gold buying, and we are indeed seeing this in the physical-gold world where bullion coin shortages remain acute. But despite the soaring physical demand, futures traders have sold gold aggressively driving down its price.
Many gold investors want to blame the usual gold villains, the central banks. I have no doubt they were selling, but this is nothing new. Since the Washington Agreement (now called CBGA) was signed in 1999, European CBs alone agreed to sell up to 400 tonnes of gold annually until 2004 and up to 500 tonnes a year since. Big CB gold sales are a constant, always there, and certainly weren't unique to October 2008.
After riding gold from the $250s to over $1000 between April 2001 and March 2008 despite heavy sustained CB selling over this period, it is very clear that CBs aren't running the gold market. They are a persistent headwind, but not a primary driver. Investors and speculators run this show. Though investment and speculation demand can fluctuate wildly, it is what has driven this secular gold bull. Just as gold couldn't have quadrupled without investors and speculators buying, it can't lose nearly a sixth of its value in three weeks without them selling.
So why were traders selling gold so aggressively in the face of the worst financial panic in decades? Forced selling is certainly a major factor. If you own gold and get a totally unrelated margin call from your broker or redemption request from your investors, you still have to sell whatever you can. And gold remains one of the most liquid assets in the world. Individuals and hedge funds getting into margin and leverage trouble were forced to unwind gold long positions (futures and ETFs) to raise cash fast.
But traders not in trouble were selling gold too, especially futures. This largely speculative selling is probably the single biggest reason for gold's extreme weakness of the past month. I suspect this selling was largely driven by the extraordinary surge in the US dollar. To most mainstream traders today, gold is still viewed as the anti-dollar rather than a unique asset with its own strong fundamental merits.
So when the dollar surges, especially if its move is a big, fast, high-profile one, gold futures are sold aggressively. I don't think this is rational anymore in Stage Two of this gold bull, but this Stage-One thinking is still pretty popular among futures traders. Regardless of futures traders' motivations to sell, logical or not, their sales still add supply which drives down prices over the near term.
And boy, if you think gold's whole story is merely that of a dollar-inverse proxy, there was no better time to sell it than the last few months. The US dollar, as measured by the venerable US Dollar Index (USDX), rocketed higher in one of its biggest bear-market rallies in history. The sheer ferocity of the dollar's run since mid-July defies belief. The USDX is rendered in blue on these charts with gold drawn in red.
If you are a student of the currency markets or a currency trader, you know that major currencies usually move with all the sound and fury of a glacier. The currency markets are the world's largest, they are hugely important and affect everything else, but they just don't move very rapidly most of the time. So the massive and fast spike in the USDX seen here is extraordinarily rare, maybe even totally unprecedented.
While I suspect it is unprecedented, I haven't carefully looked at every 3-month period in the USDX's long history since its early-1970s origin. But as the next chart will show, this massive USDX surge was easily the biggest and fastest of this entire dollar secular bear that stealthily began in the summer of 2001. To see this world reserve currency rocket 19.2% higher between July 15th and today is mind-boggling!
Not only does this massive USDX bear rally look impressive on this chart, a nearly vertical surge, but it is impressive mathematically too. If you divide the dollar's huge total-rally gains by this rally's short duration, the USDX has been climbing 0.274% per day on average since mid-July. Such a sustained rate of ascent defies belief, it is unheard of in the major currencies. Only an extreme crisis could drive such intense dollar demand.
As late as July 15th, the USDX was grinding along near all-time lows. It bottomed in mid-April about 7 months after sliding decisively below 80 for the first time in its entire 37-year history. The last chart in US Dollar Bear 5 shows this entire history if you want some valuable long-term perspective. By mid-July the dollar was still bottom feeding just 0.5% above its all-time closing low. Global demand for dollars was weak as foreign investors continued to diversify out of their dollar-heavy holdings.
During normal times, the USDX probably would have continued grinding sideways or maybe rallied modestly to its 200-day moving average (black above) simply due to being technically oversold. But around this mid-July time frame as the GSEs' (Fannie and Freddie) stocks plummeted, fears for the whole global mortgage-backed bond trade really intensified. Flight capital began to pour into the very highest-quality bonds.
Globally, short-term US Treasury bonds are considered the safest debt investment. The US has long had the largest, strongest economy in the world. And because Washington can use the Fed to create endless US dollars out of thin air, the US Treasury can never default (unless Washington is overthrown in rebellion or conquered in an invasion, neither likely). Sure, bondholders will get paid back in dollars worth less, but over the short term (a few months) this inflationary impact to investors is trivial.
Since the US is a single sovereign nation, as opposed to the often-fragile federation of competing sovereignties that is the European Union, foreign investors still have more confidence in US Treasuries than other government bonds. So as toxic US mortgage debt started to bludgeon European banks and markets, European bond investors rushed to exit this hazardous realm. They parked their capital in short-term US Treasury bills.
This surge in T-bill demand was so immense it forced T-bill yields to unprecedented lows. The higher a bond's price is bid up, the lower its effective yield for a new purchaser becomes since its coupon payment is fixed on issuance. At one point a month ago, T-bill prices were driven so high that yields actually briefly went negative! Investors were effectively paying the US Treasury for the privilege of lending to it!
The more intense the financial panic grew, the greater the deluge of flight capital desperately seeking the safety of short-term US Treasuries. For American investors, this was easy. But foreign investors selling their local bonds for local currencies couldn't buy T-bills directly. After selling their bonds, they first had to convert the proceeds into US dollars to enter the Treasury market. This drove the unbelievable US dollar demand responsible for its huge spike.
The US Dollar Index is traders' favorite proxy for the US dollar's relative price among major world currencies. And it is dominated by Europe. The euro alone accounts for 57.6% of this index's total weight, and the UK, Sweden, and Switzerland add another 19.7% on top of this. So a whopping 77.3% of the dollar's behavior, as reckoned by the USDX, is driven by Europe.
European financial stocks, and hence stock markets, were hit hard in recent months by the growing problems with mortgage-backed debt. Many analysts believe that European banks' exposure to bad mortgage debt (both US and European) is much worse systemically than US banks' exposure, which is rather ironic since the sub-prime mess originated in the States. So European investors aggressively liquidated European bonds and stocks and sought a temporary safe haven to weather this storm.
That safe haven was US Treasury bills. Before buying them, most European investors converted their local currencies into US dollars. Thus this financial panic drove incredible levels of euro selling, so the euro-heavy USDX soared. This giant flight-capital trade out of euros (and pounds, kronor, and francs) led to incredibly intense dollar demand. And the result of this unprecedented event is evident in this chart.
On July 15th just before this dollar rally ignited, gold was trading at $976 an ounce, not far from its bull high of $1005 from mid-March. And gold in euros was running near €614. While disappointing to contrarians expecting some flight capital to seek gold's unparalleled safety, perhaps we shouldn't be surprised that such a violently fast 19.2% USDX rally would drive futures traders to sell gold aggressively.
Over this same span of time, gold was down 25.4% in US dollar terms. Such a fast gold decline, coupled with indiscriminate panic selling across all stock-market sectors, drove the horrific losses in gold stocks. Like many prices we've seen in recent weeks, I certainly believe gold and gold stocks were driven to absolutely unsustainable levels and will quickly surge once rationality starts returning to the markets.
While this gold plunge feels terrible, American gold investors need to understand that our perception of what happened in gold in recent months was really distorted by the panic flight into dollars to buy US Treasuries. Over this same span of time where USD gold fell 25.4%, euro gold only fell 7.8%. In fact, in early October euro gold carved new all-time highs near €673 that were actually 3.9% above its previous March highs!
So independent of the crazy dollar surge, gold actually did pretty well around the world. Some of the flight capital out of international stocks and bonds indeed fled into gold, as expected. And if gold was easier to trade, I suspect many times more capital than entered gold would have joined in. Even you or me, in a similar dire situation as these big money managers, would probably also have chosen US Treasuries over gold in the heat of the moment. Here's why.
Imagine you are running billions of dollars of Other People's Money in your fund, and you are taking a big hit like everyone else on the planet. You love gold personally, but you have to get your clients' capital out of harm's way fast. You can sell your stocks and bonds and get cash as fast as you want, so liquidating is easy. But how do you put billions of dollars into gold fast?
Physical gold would be best, but it would take weeks to arrange such a big buy, not even considering taking delivery and securing your gold bullion. And the coin market is far too small for big funds to enter without a radical price impact. And if you aren't a futures trading house, you can't buy futures since you have no infrastructure in place to do it. And even if you think ETFs are fine in normal times, they are ultimately just paper gold so you are probably wondering what will happen to gold ETFs if their issuing entities succumb to the growing financial panic.
So sadly, even if you want to buy gold in a financial panic, it isn't easy for a big fund manager. But in the time it takes for you to read this sentence, you could deploy billions into US Treasuries. They sure aren't gold, but they aren't going to lose value like everything else and there is a near-zero chance that Washington will fall before these 3-month instruments are redeemed. So despite loving gold myself, I don't fault big fund managers for choosing the ease of T-bills over gold during such a time-sensitive panic.
Now realize I am not arguing that Treasury debt is better than gold, far from it. Gold has preserved wealth for millennia before Washington and will keep preserving wealth long after Washington fades. But I can still understand why fund managers can't easily move billions into gold as fast as they can into effectively safe short-term Treasuries. I don't like it either, but the flight out of the world stock and bond markets and into US dollars and T-bills in the face of unprecedented levels of fear and uncertainty is definitely logical.
The resulting hyper-fast and massive rally in the USDX was amazing, and I wanted to understand it within the context of the US dollar's secular bear. This next chart shows all the major bear rallies witnessed in the USDX since its bear began in July 2001. Our current is actually the 10th, and technically it started in mid-April 2008 at the USDX all-time low although the dollar was still effectively flat until mid-July.
For each USDX bear rally, the top blue number describing it is its absolute percentage gain. The next white number is its duration in months. The second blue number below that is its average gain per day, a measure of velocity and intensity. Finally the red number is what happened to the US dollar price of gold over an identical span of time. As you can see, today's dollar rally has been unbelievably big and fast.
At 19.9% in 6.3 months, nothing else even comes close to our current massive USDX bear rally. The next biggest dollar bear rally is the 6th above, ending in November 2005. Yet it was only 14.6% absolute and it occurred over a much longer 10.6 months. This translates into a velocity of just 0.066% per day compared to our current specimen's crazy 0.151% per day. And if you reckon our current rally starting 0.5% higher at July 15th instead, its velocity was an amazing 0.274% per day. This is mind-blowing for a major currency!
There are a few other dollar bear rallies with higher velocities above, but they were all extremely short-lived and only lasted a matter of weeks. To see the USDX power higher so aggressively for a matter of months is absolutely unprecedented in this bear. And considering how extreme this USDX rally was, gold really did do a decent job of holding its own. The gold carnage certainly could have been worse.
Over this 10th rally's total span since mid-April, gold fell 23.0% while the USDX rallied 19.9%. As a ratio this 1.16x inverse relationship isn't bad compared to bear precedent. For example in the dollar's 3rd major bear rally the gold price fell 8.1% on a 4.3% dollar rally, a 1.88x inverse. During the 7th dollar bear rally in mid-2006, gold plunged 19.4% while the USDX only rallied 3.8%. Of course that particular episode, like today, was after a very sharp gold upleg so gold had technical reasons of its own to correct.
Gold's absolute levels compared to the dollar's in this rally's aftermath are also interesting. The USDX rocketed up to November 2006 levels, gaining back two years' worth of losses. Meanwhile gold only retreated to September 2007 levels, temporarily erasing one year's worth of gains. This might not be much consolation when considering the impact of today's irrational gold price on your portfolio, but gold really did weather this extreme dollar rally fairly well.
Since panic drove this sharp dollar surge, what happens when this panic abates? I bet the dollar collapses almost as fast as it rose. Of course gold would probably soar in such a scenario. This case can be made in both sentiment and fundamental terms, and both are very compelling. Market anomalies driven by extreme emotions typically unwind once the driving emotions finally peter out.
All over the world, money managers are hunkered down in short-term Treasuries. Yet T-bill yields are now running around 1%. This is pathetic. How many money managers are going to be comfortable reporting to their clients that they are only earning 1% before fees? So the moment the markets turn in the inevitable V-bounce, money managers are going to want out of Treasuries and back into assets that are either rallying or actually yielding something.
These money managers will sell Treasuries, sell dollars (if they are foreign), buy their local currencies, and start aggressively redeploying capital. 2008 has been a bad year in the markets for everyone, yet professionals still fear nothing more than underperforming their peers. So if they perceive rallies anywhere in stocks or bonds, they are going to dump Treasuries fast and rush to participate to mitigate some of their 2008 losses before year-end results are reported to their clients.
There are also fundamental reasons to unwind this anomalous dollar-long surge. Over the long term, relative yields drive currencies. While target rates are running 1.5% in the States, over in Europe the ECB's benchmark rate is still 3.75%. Why would European bond investors want to hang out one day longer than necessary in terribly-yielding US Treasuries when they could buy high-quality bonds in their own countries yielding 2x to 3x as much? European yields are very favorable for euro currency buying.
In addition, real rates of return (inflation-adjusted bond returns) are now massively negative in the US. The low-balled CPI has surged by an absolute 4.9% in the past year yet 1-year Treasuries are now only yielding 1.7%. Thus investors in short-term Treasuries are effectively guaranteed a 3.2% loss in real purchasing power annually by owning them thanks to the Fed. So while short-term Treasuries are attractive in a panic, the moment fear fades they return to being terrible investments.
For these reasons among many, I maintain the contrarian stance that this sharp dollar surge will rapidly unwind as soon as the intense systemic fear passes and money managers get comfortable enough to return to their usual stock and bond markets. The USDX spike is not the beginning of a new bull, as new bulls are driven by positive fundamentals that definitely don't exist for the dollar. Instead this was just an emotional anomaly that drove a spectacular bear rally that simply isn't sustainable.
And when this dollar panic buying reverses itself, so will the gold panic selling. The metal is just way too cheap today relative to its bullish fundamentals and the incessant fiat-currency growth all over the world. This anomaly is a heck of an opportunity for new long-side capital to deploy into gold and gold stocks. Virtually everything gold-related is available at such a discount today that it may be the best buying-op of this bull.
I am going to discuss all this, including specific trading strategies and trades, in our upcoming Zeal Intelligence monthly newsletter. October 2008 was very frightening and painful, but it has led to some of the most amazing prices we will ever see in awesome investments and speculations. Buying into this fear is tough, but fortunes will be made when the recovery arrives. Join us today and don't squander this once-in-a-generation opportunity!
The bottom line is extreme circumstances, a rare global financial panic, drove the sharp rally in the US dollar. And this massive and fast dollar rally hammered gold. But once the panic abates and money managers all over the world start chasing good returns again, the dollar-long T-bill buying frenzy will reverse hard. And as the USDX sinks again to reflect its dismal fundamentals, gold will really shine.
Adam Hamilton, CPA
October 24, 2008
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