Gold’s bullish outlook left unscathed by recent weakness

Instead the market has been focusing on the continued rally in global stocks and continued easing of lockdowns around the world. These developments have, despite improved but still dismal economic data, raised hopes that a V-shaped recovery may occur over the coming months. This is optimism we unfortunately do not share - with millions of workers unlikely to return to work, company earnings are likely to disappoint. Adding to this the unfortunate risk of the virus re-emerging as some economies attempt to open-up too soon.

On a product specific note the market has become somewhat uncomfortable about the continued decline in open interest and speculative longs held by funds in the CME gold futures contract traded in New York. Both have dropped to 12-month lows and while it may signal fading interest in gold, developments elsewhere are pointing to a product specific challenge and not the underlying itself.

The transatlantic disconnect that occurred between gold futures traded in New York and spot gold traded in London back in March, left many market makers with heavy losses. The link between the two markets is called the ETP (Exchange for physical). Once the spread between spot and futures diverge too much from fair value market makers step in to take the other side of the trade. EFP trading however depends on the ability to freely move gold from London to New York in order to arbitrage these spreads.

The pandemic temporarily shut transport routes and refining activity and it let to the blow out in spreads. A development which ended up costing market makers hundreds of millions of dollars in unrealized and eventually realized losses. As a consequence several market makers have closed down while others have had their trading limits cut. The risk of repeat has led to many investors and traders instead focusing on bullion-backed ETFs.

Total holdings in bullion-backed ETF’s now exceeds 100 million ounces with continued growth seen during the past couple of years. The two biggest ETF’s hold 50% of these investment with 36.4 million in the SPDR Gold Shares (GLD) and 14.2 million in the Ishares Gold holdings (IAU).

The above mentioned developments contrast with hedge funds who have cut their net-long in half since February. We suspect some of that reduced exposure has been transferred to ETF’s as per the above.

One tailwind that gold did experience up until this week was the continued recovery in silver. The 35% collapse in the silver price between February and March drove the gold – silver ratio (ticker: XAUXAG) to a record above 125 (ounces of silver to one ounce of gold). Well above its five-year average closer to 80. From that very weak level silver has now recovered and based on the technical picture it may struggle to outperform gold further, at least in the short term as per the XAUXAG ratio chart below.

We maintain our bullish outlook for both metals, not least gold now that its premium to silver has narrowed. The main reasons why we cannot rule out reaching a fresh record high over the coming years are:

• Gold acts as a hedge against Central Bank monetization of the financial markets
• Unprecedented government stimulus and political need for higher inflation to support debt levels
• The inevitable introduction of yield controls in the US forcing real yields lower
• A rising global savings glut at a time of negative real interest rates and unsustainably high stock market valuation
• Raised geo-political tensions as the Covid-19 blame game begins
• Rising inflation and a weaker US dollar