Is gold still a safe haven?

David Franklin : 

With the deadline for a US default looming this Thursday night, hopes were high Monday evening that the legislative impasse could be breached. What is more puzzling than elected officials ‘playing with fire’ over a potential US debt default is the performance of gold during the recent period of uncertainty. This would seem to be a crisis custom made for gold, but the price action of late is telling a different story – since the government shutdown on October 1st, the gold spot price has fallen $50. So while the US government has closed down and the potential for a historic default exists, gold has delivered a negative return to investors. Owning an asset that is no-one’s obligation and has no ties to the financial system would seem to be prudent at a time like this, so why hasn’t gold performed better?

For all of the dysfunction in Washington, the market is signaling that the US Government will get a deal done before Thursday’s deadline. With the volatility index (VIX) trading at depressed levels, and the US equity markets close to all-time highs, the markets are clearly expecting that the US Government won’t skip its interest payments. While credit default swaps on US government securities have jumped recently, they are nowhere close to the stress levels seen in 2011. In fact, according to Bloomberg, as of yesterday the market was pricing in a mere 4% chance that the US Government will actually default on its debt obligations. In the words of Congressman Jim Himes, in an interview on Bloomberg TV, the markets have been trained to expect, “that we can pull a rabbit out of a hat… and resolve this problem at the last minute.” If a deal is not reached in the next couple of days, the Thursday deadline could still come and go without a debt ceiling increase, triggering what’s known as a technical default. However, a true default, which would involve the Government not servicing its outstanding debts, could take several more weeks. But the damage of even a technical default is impossible to predict. While everyone seems to expect a solution to be reached, no one knows exactly what it will look like. This makes the steep drop in the price of gold on Friday that much more puzzling.

Shortly after the opening of trade on the Comex market in New York on Friday, the gold price plunged more than $30 an ounce to an almost three-month low of $1,259.60 an ounce. Chicago’s CME Group said at around 8:42 am Eastern Time a 10-second stoppage occurred after a volatility safety mechanism was triggered, apparently after a 2 million ounce order was executed. The trading desks that we speak to regularly estimate that a large sell order in the order of 800,000 oz of paper gold hit the electronic market at that time, sending gold from $1,285 to under $1,260 in mere seconds. These same traders noted that this large sale was in contrast to a very docile PM gold fixing in London with 68,000 oz of physical gold offered against 88,000 oz of physical gold wanted. This is a prime example of the paper market in gold pushing around the price of the physical metal. It is confounding to us why a rational trader would dump almost $1 billion dollars of notional gold value on the paper market in seconds. The event was classified as a Stop Logic event which detects potential market movements caused by the triggering and trading of stop orders where the resulting price move would extend beyond an exchange specified threshold.1The triggering of stop orders can potentially exaggerate price movements in temporarily illiquid markets. This activity suggests a forced liquidation or a trader spying a technically vulnerable market that was light on liquidity and launching a program to push the paper price of gold lower.

It is true that long-term trend following funds, which typically use futures contracts to establish trading positions, are headed for a third straight year of losses and may be liquidating positions due to redemptions. While this might add selling pressure to the gold market, and partially explain such a large sale, it doesn’t do much to explain the sloppy trading of such a significant position.

After the debt ceiling debates in 2011, there was irreparable damage done to investors’ long-term faith in the body politic of the United States and these worries have been reignited during the current impasse. A commentary published in a Chinese state-run newspaper went so far as to suggest the need for a de-Americanized world. Further suggesting that, “What may also be included as a key part of an effective reform is the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar.”2

What this man-made crisis in Washington does is highlight all the reasons why an investor should hold a portion of their portfolio in gold in the first place. The key drivers of the gold price remain firmly in place: an accommodative monetary policy from the Federal Reserve, continuing physical demand from Asia and governments around the globe looking for alternatives to the US dollar. When you consider even the remote chance that the world’s largest counterparty might fail on its debt obligations, what would stop lesser governments from doing the same?

Under these conditions, it seems that owning gold at these prices as a hedge against the risk of default and continued currency turmoil would be a prudent (and contrarian) course of action. And in the unlikely case that the world experiences a default by the US, you will be happy that you did.

Previous Post Next Post