Fed Gooses Gold, Miners

Friday, December 21, 2018
By Paul Martin

By: Adam Hamilton, CPA
Friday, 21 December 2018

The dovish Federal Reserve lit a fire under gold and its miners’ stocks this week. As universally expected the FOMC hiked rates for the 9th time in this cycle. But it also lowered its 2019 rate-hike outlook bowing to the stock-market selloff. Traders dumped gold initially thinking that wasn’t dovish enough. But market reactions to the FOMC form over a couple days, and gold surged overnight. Its post-Fed rally has great potential.

Gold-futures speculators dominate gold’s short-term trading action. They punch way above their weight in capital terms thanks to the extreme leverage inherent in gold futures. This week, the minimum margin for trading each 100-ounce contract controlling $125,000 worth of gold at $1250 was just $3400! These traders can run crazy maximum leverage as high as 36.8x, compared to the stock markets’ legal limit of 2x.

At 10x, 20x, or 30x leverage, every dollar of capital deployed in gold futures has 10x, 20x, or 30x more price impact on gold than a dollar invested outright. Further compounding speculators’ hegemony over gold prices, gold’s world reference price derives directly from US gold-futures trading. Naturally extreme leverage means extreme risk. At 37x a mere 2.7% gold move against positions wipes out 100% of capital risked!

In order to survive, gold-futures traders are forced to have an ultra-short-term focus. Their time horizons are measured in hours, days, and maybe weeks instead of months and years. And there is nothing that motivates them to trade aggressively like meetings of the Fed’s Federal Open Market Committee. Gold volatility often surges in their wakes, as speculators watch the US dollar’s reaction and do the opposite in gold.

Gold-futures speculators are convinced Fed rate hikes are bearish for gold because they are bullish for the US dollar. They logically reason that the higher prevailing US interest rates, the more attractive the US dollar becomes relative to other currencies. And a stronger dollar usually means weaker gold since they are competing currencies. That all sounds rational, but the big problem is history doesn’t bear this out.

The FOMC started today’s rate-hike cycle way back in mid-December 2015, raising the federal-funds rate for the first time in 9.5 years. Gold-futures speculators fled leading into that, ultimately crushing gold to a deep 6.1-year secular low of $1051 the day after. But that oversold extreme marked the birth of a new bull market that would catapult gold 29.9% higher over the next 6.7 months! That same bull persists today.

In the 3.0 years since which includes this week’s 9th Fed rate hike of this cycle, gold is still up 18.1% and the US Dollar Index is down 2.1%. That’s no anomaly either. This is actually the Fed’s 12th rate-hike cycle since the early 1970s. During the exact spans of the prior 11, gold averaged strong gains of 26.9%! That was an order of magnitude higher than the stock markets’ 2.8% average gains per the flagship S&P 500.

Gold-futures speculators either don’t know market history or their extreme leverage forces them to run as a herd no matter how irrational that stampede is. They can’t afford to be wrong for long or risk suffering catastrophic losses. This week they apparently expected the FOMC to prove even more dovish on future rate hikes than it was. That led to volatile gold action surrounding this latest critical Fed decision on rates.

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