Gold Demand Looks Bullish As Dust Settles

The late November rally in gold prices wasn’t quite as spectacular as mid-September’s gain, but it was still impressive. There was good follow-through too, though the momentum softened as bulls knocked on resistance near $850.

The rally was a no-brainer. There is a strong line of support at $700, which was resistance during 2006 and the first half of 2007. Moreover, the market was, and is, oversold.

The catalyst was news that the U.S. government had to bail out Citigroup, the world’s largest bank by revenues. The event has given way to new concerns about the economy, which weighed on stocks and gold this week, or at least provided an excuse to take some profits in the latter.

The big question now is whether it was just a retracement rally that ultimately gives way to new lows or whether we have seen the bottom in gold, with this rally being only the first of many to come.

I don’t think the chart can answer that question alone. Technically, the structure of the market is healthy now, and as far as the fundamentals go, gold should not remain under $1,000 for very long.

Indeed, I sense the market is building up for a very bullish move.

Allow me to touch on some of the bullish factors coming into play.

“Notwithstanding the many developments on the bailout front during the past six weeks, The New York Times, like other media outlets, continues to quote Wall Street insiders who report” [that] “‘You have a market that is frozen.’ What planet do these guys live on? It certainly is not the same one to which the Federal Reserve’s data apply. I’ve been singing this song for many weeks, but I’m going to keep singing it until somebody in the news media wakes up and realizes that these ‘frozen credit market’ tales are pure hooey. Look at the data, for crissake.”

– Robert Higgs, author of Crisis and Leviathan, in a recent essay on the bailout programs

The fundamentals are significantly bullish for gold. I’d like to say they are bearish for the dollar, but in truth, they are increasingly bearish for all paper currencies. Outside of the Bank of Japan, everyone is inflating madly. In the G-7, narrow money (M1) is growing at 7-10% on a year-over-year basis in the U.S., Canada, the U.K. and Australia – more in developing countries like China. And this rate is picking up now.

October’s data are not in yet for the ECB. Its balance sheet increased by some 400 billion euros during the month, which is the first big change since the second quarter, and will probably reflect in M1. The Bank of Japan started inflating M1 again in September too, after holding it steady for most of the year.

The broader monetary aggregates (i.e., those determined by the banking system at large) are growing briskly everywhere but in the U.S. and Japan, though even the latter are still growing.

Broad money in the U.S. is growing between 5-10%, depending on whether you rely on TMS or MZM or higher, if you like M3 (I don’t).

The U.S. data are good through October. Up till the end of September, as far as we are updated, the year-over-year growth rate in broad money approached 20% in Australia, its highest rate in almost 20 years. In the U.K., the broader monetary aggregates are growing at close to 14% on a year-over-year basis, which is its highest growth in almost a decade.

These growth rates are almost as bad as China’s, which is approaching 20% year over year too, again. Given these numbers, it is no surprise to me whatsoever that the yen is the strongest currency, followed by the U.S. dollar, or that the Aussie and the pound are taking the greatest beatings, along with all the other riskier currencies.

The actions governments are taking now are bearish for stocks and bullish for inflation. But they are not just bullish for inflation – they are remarkably bullish.

I don’t mean to sound happy about it. It’s just an observation that the market has yet to come to terms with. Since September, the Fed has expanded its balance sheet a total of $1.3 trillion. Of that total, it has created about $600 billion in reserves out of thin air.

Most of that is not counted in money supply, because it excludes deposits held by depository institutions. Total money supply is about $6 trillion, if you rely on the Austrian School definition (I do). It has, nevertheless, translated into growth of about $100-200 billion in new money created by the banking system since September already. Deflation is a no-show so far, and I don’t think it will arrive at all. I think history will see this as just another scare.

The Federal Reserve just announced two new programs that commit it to another $800 billion, and that is even before President-elect Obama puts his stimulus package together.

Reuters cited Wachovia’s chief economist:

“Some, however, are worried the mounting costs of the measures, which have the potential to reach several trillion dollars, could eventually fuel a troubling inflation.

“‘It may mean (a) longer-run issue with inflation and inflation concerns,’ said John Silvia, chief economist at Wachovia Securities in Charlotte, N.C. ‘It may be too much of a good thing is a bad thing.'”

Ya think?

Even more inflationary, in my opinion, is the fact that the talking heads think the Fed’s latest facilities are simply not enough. They are complaining the programs do not include direct purchases of credit card debt and mortgages in the secondary market and that the Fed isn’t going to buy mortgages with maturities of more than one year. Not long ago, the Fed never bought anything but Treasury notes.

Gold bulls are going to attempt to raid Comex’s vaults by forcing delivery on their December futures contracts (Dec. 19). Who can tell how that will go? I can’t. But it’ll be interesting to watch.

Facts: The open interest in futures contracts on the Comex has fallen to its lowest level since summer 2005, breaking a general uptrend in place since 2001. From a contrarian standpoint, the short-term bottoms in these data tend to favor the buyers over the sellers. However, the statistic went into orbit during the last half of 2007 – it broke away from the upper channel on the charts, creating a bubble in appearance. The current extremity could simply be a symmetrical reaction to that extreme.

Nevertheless, this is a bearish fact, technically speaking, if it represents a lasting new trend.

It is tempting to suggest that the threat of a raid in futures contracts is causing a short squeeze.

It is true that the commercials are liquidating their short positions promptly. But the funds are increasing their short bets, and the liquidation of longs is such that the net short ratio has hardly budged off its mid-September low – which, incidentally, is a level that has coincided with strategic buying points at seven other junctures since the bull cycle began in 2001.

However, the record of this statistic in gold is unique in that during bear markets, the commercials tend to be net long (wrong) most of the time.

So the fact that they are covering their short interests on net does not necessarily presage a rally if a bear market has set in. A bear market would mean that gold prices could fall as far back as US$500.

Fundamentally, the conditions just don’t look ripe for a bear.

I don’t believe the COTs (Commitment of Traders report published by CFTC) have any real predictive value. They tell us only whether the market is too much extended one way or another; they don’t tell us how long those conditions will last. Right now, the structure of the market is healthy. The commercials are covering their shorts, the funds are getting short and the numbers basically favor the bulls. The contraction in open interest worries me a little, but it could be explained in terms of a collapse in spread trades linked to various index products.

In its most recent report on gold demand, the World Gold Council said as much in trying to explain the drop in the gold price in the context of soaring physical demand. In its third-quarter report on gold demand, the WGC noted growth in both jewelry and investment demand across the spectrum relative to both the last quarter and the year-ago quarter. I don’t want to go into a critique of the method here, except to point out that it chronically understates investment demand and overstates jewelry demand.

The inclusion of ETFs all but proves the point.

In just one year, investment demand has grown in importance from under 15% to over 30% of total gold demand, causing the deficit (supply shortfall) to grow nearly tenfold. The WGC interprets this deficit as supply coming from speculative sources, like futures trading or changes in inventories at the various exchanges – like at Comex. Thus, it calls it “inferred investment.” Formerly, it called this the “balance.” But as it grew, the WGC decided it meant something. What is causing it to grow, aside from growing demand in general, is that while the WGC is “identifying” new kinds of demand, it has not kept up with the various sources of supply. Gold bugs have argued for years that the supply of gold is not limited to mine production, officialdom or scrap…that it is not like other consumable commodities.

It is more useful to assume that most of the gold ever produced is held as a reserve, or store, aboveground. And if this is true, then investment demand must be much larger than the WGC calculates, or the price would, frankly, never go up. If the WGC is smart enough to include producer hedging (or dehedging) in the equation, it should also include a measure of demand that expresses itself through all the exchanges and bring itself up to speed on all the sources that supply the market. It assumes that jewelry demand dominates the market, which is incorrect, but even if it were, it still has the wrong idea.

Jewelry demand may be price sensitive in the short term, yet it has grown every year, at successively higher prices, since the bull market began. Despite my objections, however, I am in total agreement with the council’s explanation why gold prices have fallen despite the evidence of soaring gold demand:

“Notably, the selling captured by the [inferred] investment category was mainly by investors with a short-term focus. It largely reflects the fact that gold was caught in the downdraft of other commodities and other assets – it does not reflect a questioning of gold’s value or role as a safe haven. The strong buying in the ETF and bar and coin markets during the quarter, which reflects investors with largely a longer-term focus, suggests that investor belief in gold’s role as a safe haven and store of value is stronger than ever.”

No wonder the commercials are covering. The establishment is getting hot for gold.

JP Morgan’s gold analysts “urged” investors to stock up on gold this month, citing counterparty risk and tight supplies.

Citigroup’s foreign exchange group also put out a bullish tout.

Well, that’s an understatement, actually. “[Gold] continues to look like a bull market to us. We continue to believe that a move of similar percentage to that seen in the 1976-1980 bull market can be seen, which would suggest a price north of $2,000,” Citigroup’s FX group said last week.

What I found particularly intriguing, besides the timing of these calls, was that they both discounted the dollar. That is, they noted, as I have in the past, that the foreign exchange value of the dollar may not be important at this stage. Morgan said, “It is not an absolute given that a rally in gold means a falling U.S. dollar,” while Citigroup pointed out, as I also have, examples of just such a situation during the 1970s.

Anyway, it’s not a sure thing yet, and it all makes great fodder for the bull market in gold.

Good Trading,

Ed Bugos
for Markets and Money

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