Reprofiling Greek Debt Boosts Gold and Dollar

Trading the markets is sometimes like being a relationship counselor. There are times when it’s easy to see how one thing done or said affects the other’s actions. We use a fancy term for it, correlational analysis. When the correlation is positive, both things move in the same direction and when it’s negative, they move in opposite directions. Pretty straightforward stuff like when the Dollar falls, gold climbs. That’s a negative correlation based on inflation. Similarly, the stock market rises as interest rates decline because businesses find cheaper money for expansion and capital equipment acquisition. Unfortunately, every good therapist knows that relationships change over time. These markets, in particular, are not performing true to pattern.

Fortunately, in the financial world, we have tools that let us quantify these relationships. Now, it’s true that over the last year, gold has rallied and the Dollar has fallen. However, over the last couple of weeks, both the Dollar and gold have rallied. I think there is a significant change in the underlying nature of their relationship that could cause this to continue throughout the summer.

The primary reason for the Dollar’s strength has not been the domestic economy. The strength should be attributed to the global fear of a collapsing Euro, which attracts money to the U.S. as a flight to safety. We’ve talked at length about the troubles in Ireland and Greece. Well, Spain and Portugal are right behind them. The global credit markets are already pricing in the pending defaults. Greek 10 year bonds are yielding north of 16% and Ireland and Portugal are both above 9%. This compares to the U.K. Gilt 10 year yield of 3.3% and the U.S. 10 year Note’s yield of 3.1%. The European Union is caught between balancing what the Union’s lenders will accept as payment versus what rights of autonomy the borrowers will relinquish to remain in the Union itself.

The new catch phrase is a, “reprofiling” of debt. This word isn’t even in Microsoft’s spell check. However, this invention by the European Central Bank is really a synonym for, “default.” They want to extend the maturity dates of Greek debt. The Euro has fallen 7% as we’ve hunted through Webster’s Dictionary for, “reprofile.” The reprofiling or, restructuring of Greek debt would seriously devalue the 50 – 80 billion the ECB has already contributed monetarily and devastate the value of the European Union’s political solidarity.

The same fear of a Euro collapse has attracted money to the gold market. This week, gold hit an all time high priced in Euros. Investors are looking for a safer holding facility for their liquid cash than the Euro currency can provide them with. This move has been extended as the ECB has chosen to cancel its June meeting while reprofiling studies are being completed for their newly scheduled July meeting. Consequently, there have been four trading days in the last ten where both gold and the Dollar have rallied more than half of a percent. This compares to six days in the last twelve months when this has happened.

The rise in the Dollar has also coincided with a flood of money into U.S. Treasuries and a decline in the U.S. stock market. Commercial traders are aggressively rotating their positions from stocks to bonds as the Euro Zone drama is playing out. This is taking the classic low yield/high growth stock market relationship and turning it into a low yield/no growth scenario more consistent with times of fear. We’ve seen commercial money buying 10yr Notes in six of the last seven weeks and selling in the stock indexes in each of the last four weeks.

Reconciling relationships means being able to cope with change and allowing the relationship’s participants to grow in their own directions. Being able to recognize these changes in the marketplace as they are happening requires a sound combination of reading the back-stories and quantifying the participants’ actions.

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Cause of Commodity Volatility

Last week I suggested that the blame for the sell off in
silver was incorrectly placed on the small speculators’ direct participation in
the futures markets and further added that the volatility we’ve experienced is
going to be with us for quite some time to come. This week we’ll explain the
effect of Commodity Index Traders (CIT’s ) and Exchange Traded Funds (ETF’s) on
the commodity markets.

Commodity Index Traders are a relatively new phenomenon in
the futures markets. They began to gain notoriety as Exchange Traded Funds
based on commodities and started to make inroads with equity investors.
Commodity Index Traders have the same goal as mutual fund managers. They
attempt to mirror the index their fund is matched to. A mutual fund manager of
large cap stocks may try to match the S&P 500’s performance as their
benchmark. A Commodity Index Trader may try to mirror the Goldman Sachs
Commodity Index (GSCI) or, as it was known on the trading floor the, “Girl
Scout Cookie Index.”

The important similarity between these two types of
investment is that they are both, long only. People who invest in these funds
have bought the basket that the manager has acquired. This has, historically,
been a niche vehicle in the commodity markets and gone largely ignored until
the easy money policies following September 11th and the economic
crisis of ’08 devalued the dollar and sparked inflation in hard assets.

The oldest and largest commodity based ETF is GLD. As you
might have guessed, this is the gold ETF. It went public in 2004 and now holds $55
billion dollar’s worth of gold. Since the fund physically owns the gold, they
are responsible for holding more than 36 million ounces of gold at its current
price of $1,500 per ounce. This is the equivalent of more than 7,000 gold
futures contracts. They must adjust for their holdings as necessary to meet
investor redemptions as well as the demands of new subscriptions.

Mutual fund, ETF and CIT managers all have a tough time
beating their benchmarks. They are all bound to act on behalf of the public and
therefore, are subjected to the same shortcomings as the individual
participants’ human psyches.  In
practical terms this means that people, the individual investors, are most
anxious to buy at the top and sell at the bottom. When management fees are
factored in, it’s no wonder that gold futures have out performed the GLD since
its inception by more than 5% in price alone.

Furthermore, because an ETF’s trading strategy must be made
public in its prospectus, the managers’ trades are subject to market
manipulation by traders who know what action GLD must take in the markets and
when. The potential for manipulation is directly addressed in their prospectus.
“Other market participants may
attempt to benefit from an increase in the market price of gold that may result
from increased purchasing activity of gold connected with the issuance of
Baskets. Consequently, the market price of gold may decline immediately after
Baskets are created.”

Commodity based ETF’s have exploded in popularity over the
last few years. There are now more than 100 publicly available funds with a
combined net asset value of more than $110 billion dollars invested.
Furthermore, at the market highs in 2008, Commodity Index Traders held more
than 40% of the total commodity futures markets’ open interest, which was worth
an additional $60 billion. This is the money that has created the current price
floors that we are all calibrating ourselves to as the new normal.

The new money added to the commodity markets has roughly
doubled the size of the commodity markets’ capital base and indirectly, brought
untold numbers of new investors to commodity futures products. Considering that
this money is almost exclusively individual investors on the buy side, it’s
easy to see how general human psychology will exacerbate the highs and lows of
each rally and decline. The new normal will be higher volatility on the greedy
path to new highs as people climb on board followed by higher volatility on the
down side as individuals abandon ship.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Small Speculators Not Responsible for Silver’s Fall

 

Financial writers and TV reporters require an authoritative
presence to capture their audience. Sometimes, in the pursuit of sounding
important, they borrow facts from one story to make the case for another. This
was the case last week when it was commonly reported that the commodity
exchanges were raising margins to shake out the speculators. Many reports stated
that higher margin requirements were forcing small speculative traders out of
the silver market and this was the cause of the rapidly falling prices. I say
the commonly reported cause did not create the end effect.

First of all, a quick understanding of margin is necessary.
Margin in the futures market is not like margin in the stock market. Margin in
the stock market is money the clearing firm lends, with interest, to someone
who wants to purchase more assets than they have cash in the account to do. This
makes the borrower responsible for the extra positions purchased with the
margin money as well as the interest charged to them for the money they’ve
borrowed to create them.

Futures margin is a performance bond placed with the
exchange by both the buyer and the seller of a commodity contract. This money
is an equal amount supplied by both parties and is held by the exchange to
guarantee the obligation of both parties. No interest is charged to or by, any
of the parties involved. Think of it as the exchange holding funds in escrow
until the trade is offset and settled. The amount of money required for margin
is based on a mathematical equation developed by the exchange. It is designed
to protect and insure the exchange’s solvency by knowing that the buyer and
seller can both meet their obligation. The amount fluctuates according to how
much and how quickly a market is moving.

Since there is no, “charging,” of margin, raising margin
requirements applies equally to both the buyers and sellers. Therefore, it
cannot have an unequal impact on the market’s participants. Mathematical
equations are not emotional.

The second flaw in the reported cause of silver’s decline is
that forcing out the speculators will drive down the price. The Commodity
Futures Trading Commission has a weekly report that tabulates the number of
positions held by various trader groups. These groups include, small traders,
managed money, commercial producers and users as well as large traders and
spread traders. Small traders show up in the, “non-reportable,” column of the
report. Their individual positions aren’t large enough to meet the market’s
reporting level.

Silver at $40 per ounce has a cash value of $200,000 per
exchange-traded contract. Every small trader in the report has at least one
contract. How many small traders do you know who own $200,000 worth of silver?
The record net long position for small traders in the silver market was 35,847
contracts. That was set in April of 2004 when silver was trading at $6 per
ounce – a cash value of $30,000. Currently, small traders hold just under 20,000
total contracts. This represents approximately 15% of the total open interest
in the silver futures market.

Silver prices fell more than 30% last week. Would this be
physically possible by wiping out the entire small trader population, which
holds 15% of the market’s open interest? Once again, unbiased math makes it a
physical impossibility. Next week, we’ll start with a discussion of who the
real players are in the market and their effects on market tops, bottoms and
news events. We’ll discuss the true cause and effect of the enormous swings in
commodity markets and why they’re here to stay. You might be surprised.

 

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Commodity Bubble Targets

The commodity bubble of 2008 was a textbook bubble. Multiple
markets participated and supply and demand had nothing to do with value.
Commercial traders were losers when the prices traded did not reflect their
view of market fundamentals. When oil reached its high of $147 per barrel,
there were tankers circling the delivery ports, killing time as prices rose,
waiting for instructions to enter and unload. Many commodities were witnessing
a flood of new capital in the form of Exchange Traded Funds. The oldest pure commodity
ETF, the SPDR Gold Trust, started trading in 2004. Since that time, more than
$1 trillion dollars has flowed into commodity based ETF’s. A recent calculation
suggests that energy ETF’s control the equivalent of 1.6 million futures contracts,
which is equal to the total futures market open interest.

There are two easy money policy events that spurred this on.
The first was September 11th. In the face of tragedy and
uncertainty, the government and the Federal Reserve Board instituted an easy
money policy to prop up demand in a shell-shocked population. This, in turn,
fueled the housing boom and the cash out mortgage refinancing boom. Excess cash
found its way into all investment vehicles until it all unraveled in the
economic collapse of late 2008. The institutions’ response was the second event
that brings us to where we are – easier money, QE1 and QE2.

The result of easy money is cheaper dollar based commodities
in the face of growing global demand. We can see the devalued Dollars’ effect
on commodity prices in the face of the economic collapse of ’08. Commodity
prices put in a higher floor than they had from September 11th
through the bubble top in ’08. The ’08 bottoms in the commodity markets have
simply served as a new, higher floor price. The market has since traded higher
on growing global demand, ETF investment and a falling Dollar. Therefore, the
recent rallies are not bubbles, and that is the scary part.

I’d like to point out that my preference is for sound
economic policy and rational investment strategies. These would include curbing
U.S. spending, allowing China’s currency to freely float and opening up foreign
commodity exchanges to cross hedging. However, given the current architecture
and political leanings we will trade as if we’ve witnessed a two- year basing
and consolidation pattern with the major rally yet to come. This is where
things get stupid.

When measuring things we can’t get our heads around it helps
to use analogs. This is when we compare something we’ve already experienced and
know to something we’re presently trying to understand. You’ll hear this in the
markets as, “This wheat market is trading like the Australian drought of ’07.”
Or, when the market collapsed in ’08, people were comparing it to the crash of
1929 and the depression was to follow. Traders also use this to compare charts.
We disregard the scale numbers on the charts and simply try to find similar
patterns. Comparing patterns allows us to measure amplitude, the size of the
moves and the rhythms of the markets.

Using analogs, chart pattern recognition and a little
quantitative analysis, we come up with bubble targets we can’t quite get our
heads around. Here are some examples: Corn – $11 per bushel, Wheat – $22 per
bushel, Cattle – $1.50 per pound, Sugar – 47 cents per pound, Crude Oil – $250
per barrel. Some markets have already hit their targets like gold, silver,
coffee and cotton. Therefore, the end prices of these markets will end with the
old adage, “The only cure for high prices is, high prices.” How high will just
have to be seen to be believed.

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Commodity Market Bubbles

Defining a market bubble has become a bit like the moral right’s hunt for pornography. They can’t quite quantify it but they’re sure it’s evil, it must not be tolerated and they’ll know it when they see it. Of these four qualifications, twenty years of chart study at least allows me to agree with the last statement. I’ve studied market bubbles from Belgian tulips to the Hunt brother’s cornering of the silver market and actively traded the tech bubble on the way up AND down. We traded the economic collapse of ’08, an inward bubble, as well as the commodity bubble that immediately preceded it. We’ve analyzed them mathematically through standard deviations and statistical analysis. We’ve read university studies, which focus on the psychological aspects of the markets’ participants and we’ve watched politicians blame it all on the speculators. Out of all of this, there are a few things that help us understand where we are now, and that is the key to investing.

There is a difference between an individual market bubble and a rising tide floating all ships. A summer drought or a winter freeze may push grains or orange juice into bubble mode through crop damage. However, those are individual market issues. An economic policy that devalues the Dollar in the face of growing global demand is the tide that floats all ships. The U.S. commodity markets remain the global commodity pricing mechanism. Therefore, all commodities priced in Dollars will continue to climb as long as our economy flounders, regardless of speculative trader participation.

Quantitatively, the only current market that may be headed towards the psychological bubble area is, silver. A recent survey of commodity bubbles, both up and down does provide us with some clues towards the identification of a bubble. Typically, we see moves in excess of 100% in less than six months. The primary focus is rate of change. Bubble markets have large moves over a very short timeframe.

The psychological aspect is the history of human nature. Trading bubbles have been reproduced over and over in academic labs. According to a study done at the University of Zurich, human beings do tend to learn from their mistakes. They found that subjects burnt by a bubble are two thirds less likely to be burnt by the second one. Unfortunately, several other studies on the human decision making process have concluded that once people have acquired enough information to make an informed decision, more information only increases their level of conviction – not their accuracy. We are just beginning to see an entirely new wave of market participants. Therefore, psychological aspects of trading will have to be learned again and again.

The growing global demand is just in its initial stages. We have seen the first leg of the new global commodity price norms. Old world Europe is struggling and China and India are both reining in inflation as best they can. A near term slow down will prove to be a huge buying opportunity in the commodity markets by new participants in Asia and India who have seen their incomes grow three fold over the last ten years and have money that must be invested to keep pace with their domestic inflation. They are already pushing the trading volume of overseas commodity markets to new volume records. Much of this has to do with the typically small contract sizes they trade, which broadens their appeal. Their volume is further enhanced by political systems that won’t allow their people to invest outside of their country. This eliminates cross hedging, which does minimize price fluctuations relative to value. Thus, a whole new population is beginning to fuel the bubble and subsequent burst cycle of their markets and financial education.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.