Can gold recover?

The precipitate increase in Comex margin for gold futures last week has taken its toll on the gold markets. The Big Question now is whether there is sufficient resilience for gold to stage a come-back effort and perhaps to challenge its recent high just short of 0/oz. Today we take a look at some factors that could influence the answer to the question.

Firstly, the financial – and mental! – state of the market players. The open position of the gold futures at the time of the margin increase, with virtually no warning before it took effect, was about 230 000 contracts; the highest since 1981, when the gold price was reaching over 0/oz. The increase in margin was all of 50%, from 00 to 00 for members and hedgers and rising from 50 to 25 for speculators, or individuals.

Just prior to this increase, the gold price had gone to 6 in Japan, where the TOCOM futures market also saw a surge in open interest on high turnover. Which meant that Japan too would be vulnerable – also financially and psychologically – to any decline in the gold price, something that was on the cards from the moment the margin increase was announced.

One can make some thumb-suck estimates of the effect of the margin increase. As a first order estimate, one could assume that the short side of the futures contracts was for all practical purposes held by bullion banks and large hedgers who have been trying to stem the rising gold tide and, like old king Canute before them, were slowly sinking beneath the ever surging waves. Similarly, one might assume that the long positions were held in mostly speculative plays by individuals and smaller non-hedged producers – all of whom had to match the 5 increase in margin per contract, or close their positions.

At 230 000 contracts, the speculative players had to find more than 5 million within a day if they had wanted to keep their positions open. And that is a good deal of money to scrape together at short notice. Granted, many of the speculators would have reserves from which the increase in margin could be paid; however, in view of the fact that the week prior to the margin increase had seen gold rise from below 0 to over 0 and also since the open interest was at record level, it seems likely that a good proportion, if not the majority, of speculators were geared to the absolute maximum in anticipation of a challenge to the 0 level.

Just hanging in there, like ripe fruit ready to be picked by the powers that be!

And, of course, as the selling started and the gold price fell, additional margin calls were issued to the speculating community to cover losses being suffered on the futures, thereby accelerating the liquidity squeeze. At the same time, the Commercials and hedgers, who had faced a proportionately smaller demand for cash on their own margin increases, were quite happily reaping the rewards of the sell-off as their positions increased in value.

With gold down by more than from its high of 6, one could easily have expected that the double whammy – of increased basic margin as well as the margin needed to compensate for the steep decline in the gold price – suffered by the longs would result in perhaps as much as half the speculative positions being closed out, to bring the open interest down to more normal levels. This to be followed by a long time of recovery and healing before these players would be prepared to enter the market again. It is therefore very surprising that the open interest by Thursday had remained above 208 000 contracts, for a net reduction in open interest of only 23 000 contracts.

There are two possible explanations for this, probably acting in combination. Existing longs have sold only as much as what they were required to do in order to keep their remaining positions open; in other words, there was little wholesale liquidation by longs who were fed up with the gold market. Secondly, as the declining price of gold reached more attractive areas near 0, fresh players stepped up to the plate to take up the slack of any selling and thereby bolstered the market.

These two conclusions, if they are correct, imply a very strong positive for gold; it means the gold bulls are there for the long haul and are not put off by near term volatility.

Secondly, lets take a look at the supply-demand relationship. Another plus for the timing of the margin increase was that it took place at a time when India was preparing for a religious holiday during which interest in gold would be at a low. As we know, India and Japan have been the major markets for gold and with India on the side-lines, odds were in favour of a steep drop in the gold price. That gold has so far kept to the psychological support of 0, is also a major plus – even more so if it can recover from that level over the US long weekend, Comex being closed on Monday for Presidents’ Day.

With gold shares holding up well, apparently because recent short sellers have started to take profit – and probably with more short-covering to come – all the factors appear to be in place to make this decline to 0 quite short lived, a fact that in due course may well hasten the gold bull into an even steeper rising trend.