Hedge funds and large speculative investors are currently more bullish on gold than at any time in the past quarter-century and, contrary to the conventional view, a bet on gold is a bet on deflation – with help from global capital flows – not inflation.
The Washington-based Commodity Futures Trading Commission releases a report each Friday showing aggregate futures positioning, long and short, in all major commodities and asset classes. The data are divided into two sections. Commercial positions show futures exposure for companies involved with the commodity itself – the oil hedge books for crude producers is a good example. The non-commercial section of the report is widely viewed as a proxy for hedge-fund trades.
As the first chart shows, the most recent report shows the largest net long position – record bullishness – among non-commercial investors since this data compilation began in 1993.
Gold's traditional role for investors is as the "anti-dollar," protecting wealth when inflation erodes the spending power of the U.S. dollar and other developed-market currencies. But the current rally in gold is occurring when central banks have tried, and largely failed, to raise inflation to target levels.
The next chart compares the gold price with the yield on the U.S. 10-year Treasury Inflation Protected Securities note, which tracks the inflation adjusted (real) yield on 10-year bonds. The trend has been for gold to move in the exact opposite direction of yields, benefiting from deflationary, not inflationary pressures. Most recently, the gold price jumped 21 per cent from Dec. 15 while real 10-year yields fell from 77 basis points to 15 basis points.
One technical reason for gold to rise in a declining rate environment is "opportunity cost." Low bond yields mean investors are giving up less in terms of risk-free return, the coupon payments on government bonds, when buying gold.
For some investors, the value of gold as insurance against widespread financial calamity is a strong reason to buy the precious metal. They worry that the large expansion in central bank balance sheets will cause extensive currency devaluations and boost the bullion price.
In my opinion, cross-border investment flows are a vastly underrated factor behind gold's rise. Because of gold's function as the "anti-dollar," it moves in accordance with the outlook for U.S. investment assets, particularly equities. When U.S. economic and market optimism rises, this attracts foreign investment into the S&P 500 and creates demand for U.S. dollars in currency markets and boosts the greenback's value. When the U.S. dollar rises, bullion prices – valued in U.S. currency – inevitably decline.
We've seen the reverse case in recent weeks. The S&P 500 is in the midst of a dismal earnings reporting season and U.S. economic data have disappointed to the point where the consensus view among economists is now that interest rate hikes will be delayed. The greenback has declined and gold investors have reaped the benefits of higher bullion prices.
Stanley Druckenmiller, the famed hedge-fund manager (and former protégé of George Soros), supported the thesis of U.S. pessimism driving gold higher during the recent Ira Sohn conference in New York. Mr. Druckenmiller said, "higher valuations, three more years of unproductive corporate behaviour, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself … Some regard [gold] as a metal, we regard it as a currency and it remains our largest currency allocation."
Follow Scott Barlow on Twitter @SBarlow_ROB.