Ready for the next leg of the bull market?

It would appear that the effect of the margin increase has now largely worked itself through the system, both in the US and in Japan, where open interest in gold futures also reached record levels during the run up to 8 – the owners of long positions then got hammered by the sell-off, apart from the direct effect on their cash flow of the increase in margin on Comex..

We saw that for some time the gold price did poorly in both Asian and US trade; buyers knew exactly what was happening and were calmly waiting for panicking sellers to offer at lower prices before they stepped in to the market – with the futures leading spot lower all the time. The gold price dipped below 0 for a few days, but then recovered again. The reason is simple – holders of long positions were under pressure to reduce exposure because margin calls proliferated as a consequence of the falling gold price; however, at the same time there are a large number of holders of short positions who want to take profit where they think the bottom of the market will be.

These shorts know how volatile the gold market can be and they do not want to chase a steeply rising gold price. Further, we know that not only are there also large short positions in bullion itself, but demand also exceeds supply for the past two years. Buyers of bullion in Asia, the Mid-east and elsewhere are also looking for bargains – yet they all know they have to compete against each other and that they ought to start accumulating while it is still a buyers’ market with many eager sellers.

As gold fell below the psychological 0 level, this enticed prospective buyers into the market – probably first into the relatively thin bullion market. Once the gold price itself started to show some resilience at this level, there was no long longer an opportunity for arbitrage players who had been forcing the bullion price lower in reaction to fierce selling on the futures markets. This in turn meant that the futures market was no longer the tail that wagged the dog – the latter being bullion itself.

As the futures market started to react to a more stable bullion price, selling became less intense and this brought in short covering as profitable short positions were being closed in greater quantity.

A first bottom was reached at 3 on Monday 17th February; the gold price then rebounded to 7 where it remained for two days – long enough to create doubts about its recovery among those who were still long of gold and who feared a further decline in the price. Renewed selling took the price down to 2 this time, but again there was a quick reversal on increased buying interest. After reaching 4 on Thursday, the price dipped again during US trade on Friday to end the week just above 0.

In trying to anticipate what will happen, we have to consider three groups:

  • Gold Bulls who had to close out when the margin was increased and who got hurt during the subsequent steep fall in the gold price – how soon will they come back into the market in numbers, or will they write off the gold market as too volatile and look for some other investment opportunity? Or will enough of them turn buyers now that a new week is starting to make a difference to the trend?
  • Gold Bulls who still have open futures positions – will they begin another selling spree now that gold pulled back to the 0 level? Or will they hang in there to see whether the gold price can rebound off that level?
  • The Professional Shorts who still sit with large short positions in both the physical and the futures markets – will they view this as a good opportunity to induce more panic by pounding the futures market and hoping that bullion will follow suit?

One factor against the Gold Bulls is that India – a major buyer of physical during recent months – have been shifted to the sidelines by a rumour that the /oz levy on gold imports might be reduced or removed altogether this coming Friday when the Indian budget is to be presented. As a result, imports have dwindled; buyers wait to see whether the rumour will prove true. This gives a window of opportunity of one week for the Big Shorts to push gold down before the pent-up demand out of India re-enters the market, irrespective of what happens to the levy, but likely to result in much increased demand if the levy is lowered or removed.

This coming week could present a stiff tussle for direction, but for now the odds probably favour the Gold Bears – yet next week could well be another matter.