Volatility – a sign of increasing stress?

There was a time not so long ago when the gold price showed relatively little variation from day to day and even week to week. It was almost easy to predict where the price would be – steady to lower, with the emphasis on the latter trend. There would be the occasional spike, such as when the European central banks announced in 1999 that they will limit their participation in the selling of gold reserves and even cap the leasing of their gold, or when Placer Dome said in early 2000 that they would reduce their forward book, partly by buy backs and partly by ending the practice of forward selling.

These spikes lasted only for a matter of days to a week or two, then the price subsided again and resumed its overall downward trend. Over the past 18 months or so the trend has change from down to up, still with the occasional steep spike of brief duration. During May there was a quite steep and sustained rising trend – as opposed to a sudden steep spike – and from early June, when gold peaked just short of $330, the whole tenor of the gold price has changed from its previous pattern of the past 5-6 years.

We now have substantial volatility – sudden steep rises followed by steep corrections all within a matter of days, if not just one or two days. Technically, the recent pattern is a megaphone, a widening formation, made up of a series of steeply descending yet very volatile waves, similar to an Elliot 5-wave pattern. More recently, since early August, the overall trend has reversed, with the gold price rising steeply, again with a volatile wave pattern of which it seems wave 4 might have been completed last week.

Previously, if gold got hammered during Comex trading hours by massive injections of futures, the price remained down for some length of time. Buyers of physical gold took to the woods when they saw large lots on offer on Comex, as they knew this would bring out arbitrage selling of bullion and load them with gold at a price that was no longer attractive. And they stayed away until they thought the coats was clear again.

It has been mentioned before that this was a most effective means to place a lid on the gold price, because the gold futures market is many times larger and more liquid than the bullion market. The only real counter attack to negate that strategy would be if there were large demand for bullion itself – large enough to absorb all of the physical gold that flows onto the market in the wake of the futures attack and ask for more. In that case, as the physical market failed to react to what the futures are doing, the short sellers on the futures would suddenly have to start covering before they leave themselves open to the prospect that buyers of their recent sales of futures might find it profitable to ask for physical delivery against their contracts.

With news from GATA that there may well have been two large buyers in the market for some time now, it seems plausible that this is what has been happening. Heavy selling of futures send the futures price lower, and as usual enough physical gold comes onto the market in response to this to satisfy whatever demand remained after the buyers fled the scene. Then, quite rapidly, strong demand returns and takes out all the sellers of bullion, pushing the spot price higher – with the futures sellers then being compelled to cover before they start running unacceptable risks in a tight physical market.

Now this deduction, if correct, does not imply a steep rise in the gold price is imminent. A sustained buyer of gold would much rather buy the metal at below $320 than above $330, with the risk that if the price is pushed that high it could explode. A clever large scale buyer would much rather play the short sellers as they have for so long toyed with the buyers of physical gold. This time around, the large buyers might push the price to where the short sellers feel the pressure and launch a futures raid on gold – buyers would then sit back and wait for arbitrage sellers to take positions after which they would rapidly take them all out, picking up a quantity of gold at a good price.

The next day, after the gold price had risen in reaction to their activity, another raid on the futures market would provide them with another opportunity to milk the physical market – still at a good price. This may well continue for some time either until the short sellers throw in the towel and start to cover their longer term positions, or until the supply of physical gold dries up and the competing buyers realise that now it is time to get far more aggressive than they have been before.

The former is unlikely to happen as doing so would undoubtedly spell the end for some of the players with very large short positions in gold itself, which implies that the buyers should have rather deep pockets in order to deplete the potential supply of gold from probably some of the central banks still able to lease gold into the market.

However, the recent strange volatility does warn that this point might not be too distant in time. One would almost guess that with some luck gold could take off for perhaps the second reason mentioned above well before the end of 2002.