As the 2010 is nearing its inevitable calendar demise, gold investors may be excused for looking back with a smirk of complacency. From the directional perspective, the market performed very well, even though it trailed the market darlings: cotton, coffee, sugar, silver, palladium, Peruvian or Sri Lankan stock exchanges. Yet it’s still somewhere up there, next to Matterhorn-solid Swiss Franc as the last sentinel of security. This party will end one day too, but the continued explosion of liquidity in China, interbank problems and persistent output gap in the developed economies may conspire in favor of gold-plated capital preservation a while longer.

So rather than focusing on self-congratulatory hindsight, let us have a peek into the other side of the gold market in 2010. What did it bring to volatility traders? Famously, gold is among the least volatile of commodities. Yet this statement alone does not reveal what an analysis of implied and historical volatility could provide. We are focusing here on the front contract, looking back all the way to January 2010.

The ranges, divergence or convergence between the volatility implied by the market price of the option contract and the annualized standard deviation of returns reveal as many as seven different stages throughout the past 12 months.

In February, implied volatility (IV) peaked for the year at above 28, pulling up in its wake the 30-day historical volatility. Naturally, this would have been a classic opportunity for delta-neutral long volatility traders and – as it later transpired – with few other such openings for the remainder of the year. As is the case in generic equity markets, the jump was associated with the fall in the gold price to the year low of $1058/oz.

In mid-March historical volatility retraced in synch with implied vol, which never again returned to the February levels. The gold price found a floor around $1100/oz, with at that time few signs of the European drama which was to befall us in the second quarter.

It’s the Greek troubles which seemed to be behind the implied and realized volatility gapping higher in May. This is, interestingly, exactly the same vol pattern that was revealed by the Irish conundrum in mid-October and November. But by late June historical volatility diverged from IV as if an imminent turn was in the offing. It was a safer period for a directional (and uniquely bearish, in the context of the entire year) strategy.

Accordingly, as July saw the gold prices fall back below $1200/oz, the implied volatility slid, while historical vol remained flat. From here to late December, you’d be on the right side staying short vol.

The next chapter opened in late August, with the seasonally stronger gold prices, steady IV and a historical volatility falling off the cliff to as low as 7 in early September. As a consequence, the strong Aug/Sep gold market consensus saw the biggest (13 point!) divergence between IV and historical vol.

The subsequent, steady gold price run until a new record in mid-October saw a strong recovery in 30-day volatility and occasional IV spikes – as mentioned above – a pattern reminiscent of the May chart.

It was only in mid-November that the chart reversed for the first time, with historical vol tracing a “mesa” above the implied volatility. This would normally indicate that the market unpredictability ebbed a bit around the time a new price record was established. The question remains why implied volatility was crushed, reaching eventually the year-low of 15.7, before recovering. Most likely, arbitrageurs forced the options prices lower to capture gamma and theta in the process. It must have been a tough moment for long-volatility market makers.

What an interesting year it was… Some regular seasonality, several short-termed yet strong USD/EUR correlation reversals, unusual volatility divergence… With 200t of open market IMF sales now depleted, I would be less bearish vol in 2011 and bullish on the direction.

Let’s revisit the chart in a year from now.

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Tags: divergence IV and historical vol, gold volatility trading, historical volatility and gold prices, implied vol

Ah, the 1990s… Rave parties, Cool Britannia, Clinton and Lewinsky, internet and incubators, Viagra and the unipolar world. Ah, and gold below $300/oz. Non-amnesiac market insiders still remember the bad old central bankers flooding the market with the barbaric relic and gold miners trying to protect their revenue by locking in the metal’s forward price. What worked for each company in isolation grew to a monumental fallacy of composition, accelerating gold’s supply to the market almost entirely dependent on jewelry.

Ah, the 1990s. Now, in the era of terrorism, nuclear proliferation, the rise of authoritarian “emerging markets”, the overleveraged US consumer and the tight-rope walking Eurozone, the idea that downside of gold-long holders should be protected seems a little far-fetched. And yet, several weeks ago, Graham Birch (formerly of ML Asset Mgmt) came out of his rural retirement to call for just that: a selective, opportunistic locking in of the upside.

Coming from Julian Baring’s school, Birch is an unlikely cheerleader for hedging. But if the circumstances change, it would be unwise not to change some of the convictions. And Birch advocates only a partial protection of the portfolio – something that any professional investor would do anyway.

But among fund managers there is a fear that a return to hedging could yet again damage the market. Already, they point to the underlying vulnerability of the market now that most of the large hedgebooks have been eliminated. Indeed, with the exception of Kinross, Pogo owner Sumitomo, St Barbara, Perseus and several smaller players, the hedging universe stood at some 200t in mid 2010 and consequently has now mostly run out of the potential to solidify the floor under the gold price.

Lack of de-hedging is a different issue from new hedges. Since the second quarter of 2001, hedging was, with two quarterly exceptions, firmly on the side of the demand of gold. Interestingly, the period of 2001-2002 coincides also with the flip in Comex, when long positions began to consistently outweigh shorts. But is lack of de-hedging a real threat to the market?

The process of hedge book reduction can operate through the natural book decay or more spectacular (and headline-grabbing) buybacks. Commonly, the bulk of the book is in straight forwards, long puts and short calls (often through a near-zero cost risk reversal). It’s the forward market especially that has seen a radical reduction of some 93% in just five years.

More important than the remaining stock of the global book is the prospect for future flows. And the surprising news for those who fear the end of de-hedging is that… it does not seem to matter all that much in the market anymore. Looking at various quarterly correlations between the eliminated tonnage and the market response, we note that there is no consistent connection between the gold price performance and the tonnage of the hedge buyback/decay during the quarter of the treasury’s operation. There does seem, however, to be some impact during the subsequent quarter, but even this dissipates with years. In fact, the most significant correlation was between 2001-2004, when the tonnage flow/rate of price change correlation was is double digits. Interestingly, after the stabilization of US interest rates post-2004, the relationship completely disappears and the remaining 1400t of hedge reduction cannot be traced through the timing of the buybacks via impact on the gold price. The very small changes to the global hedgebook in the first half of 2010 would otherwise be incompatible with the nearly 14% increase in the gold price during the period.

With only around 15t per quarter expected to be delivered into the market in the next several years, there is now considerable anxiety that the hedging activity could flip more consistently onto the supply side of the global gold balance sheet. This will certainly happen if some of the producers manage to enter selective contracts – as suggested by Birch – without alienating their investor base. Looking at Perseus Mining’s experience after announcing the forward sale of 170’000oz fat $1240/oz (a price level broken by the spot barely 3 months later), the market may be now becoming a little more lenient…

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Tags: dehedging, gold hedging, hedging and gold price

President Obama has made an attempt to forge an agreement on the heavily charged issue of the extension of Bush tax cuts. This is an important step, heavy in consequences from both the ideological and budgetary perspective. The Republicans, many of whom act as they would not like the Federal Government to have any revenue, seem to be hopelessly wedded to the interests of 3% of the population and to the 1980-era Panglossian “solutions”. The budget hawks (many of them schizophrenically Republican) want to see speedy elimination of deficits. Some argue that a permanent maintenance of Bush era tax cuts would cost the Treasury some $3 to $4 trillion in revenue over 10 years. But polls seem to indicate that the majority of Americans are against these extensions and Obama’s proposal keeps the door open for only two years. Quite how the maintenance of the tax status quo is supposed to solve this economy’s manifold structural problems remains a mystery.

Several researchers have recently argued that the 2001 and 2003 bills were followed by the lowest rate of growth in US non-residential investment and that the benefits of the tax cuts leaked overseas. The combination of a weak dollar and tax cuts may have actually encouraged capital flight from America. Since 2004, coupled with the unprecedented shift by Chinese Communist Party to gear up fixed asset investment, the joint effect was the leakage of funds into emerging market equity and bond funds, commodities and gold – with lackluster performance of the US stock market as a corollary. Note that the emerging markets’ initial reaction to Obama’s proposal has been positive, despite the looming threat of Chinese interest rate rise.

Arguably, US stock markets also first responded positively. The expiration of the Bush taxes hung over the market like a gloomy nimbostratus. There is now a chance it will dispel. On the other hand, the bond market has seen a precipitous sell-off, although opinions are divided how much of the yield increase is attributable to the decision concerning the tax cuts. Higher yields are unequivocally a negative factor for gold. But what does the fiscal move mean for the gold market in the longer term?

Unless the bond market rout scuppers the accumulated gains, the result of the continued tax cuts is the same as for other non-yielding assets: there is no need to rush and realize the gains before the expiration of the decade-old bills. But for gold in particular, the longer-term answer lies in the currency market outcomes linked to the likely combination between US fiscal policy and its monetary activism.

For the most part of the previous decade, gold in US dollar terms benefited from a unique combination of a relatively loose fiscal policy and low interest rates. Such a combination leads to liquidity binge amplified further by low haircuts and high level of collateralization. The rest of the story we know – a boom in housing investment and fall in the nominal value of the currency. This was not the first such experiment in history. UK tried such a concoction in 1988 and the pound lost 20% within a year.

On the other side of the spectrum, we could imagine the policy combining fiscal curbs and a tight monetary policy. Income goes down, deflation ensues and growth is smothered. These days, one would have to seek out arsenic-fed economic systems on another planet to identify a good example. It is therefore more interesting to brood over the asymmetric combinations of fiscal and monetary policies.

A tight monetary policy, coupled with a loose fiscal policy initially triggers appreciation of the currency as higher rates invite capital inflows, promote high demand for money, an external deficit and eventually a fiscal deficit. How quickly the latter evolves will depend on the initial conditions, but the end-result is currency depreciation. Gold investors are wise to accumulate positions in the early stage of this scenario.

Conversely, a loose monetary policy, combined with higher taxes and/or lower government spending initially triggers currency depreciation. Yet even if the nominal interest rates fall, real interest rates go up favoring inflation. Interest-sensitive investment gains and bank reserves fall. This would be the scenario if the Bush tax cut were reversed. Naturally, the initial currency depreciation would be followed by an appreciation (real and then also nominal), pruning gains in speculative investments which would be negatively affected by a rise in real interest rates. Clinton-era US bathed in analogous context. Clinton? Now that was bad for gold!

All this means that in the current monetary context, the continued maintenance of the loose fiscal policy in the United States, however disastrous in the longer term for the sustainability of the country’s public finances, is “good” news for those who hold part of their portfolio in gold. This bond market’s knee-jerk reaction this week and the subsequent dollar strengthening may therefore be short-term phenomena – offering yet another opportunity to late comers.

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Tags: Bush tax cuts and gold, combination of monetary and fiscal policy, fiscal policy and gold

As a currency, gold is known to be difficult to adulterate as its supply is fairly price-inelastic. But as a commodity, gold is plentiful – even though many stocks cannot be easily mobilized into flows. This huge, quasi-available inventory means that the price of the metal is as dependent on physical flows as it is on the sentiment surrounding the sustainability of these flows in near future.

The driver of the gold price has for many years been set by Comex futures trading – easily swayed by the perception of changes to the interest rate environment, liquidity conditions and currency swings. The currency myopia of many observers leads to underestimation of the impact that FX market has on the level of gold prices on a given day.

But any significant movement on the futures market is ultimately not sustainable without the robust physical flow underneath. It is here – in the markets of India, Europe, Middle East, US and East Asia that the rules of supply and demand reappear – regardless whether gold is purchased and sold for investment or adornment purposes.

What is unique in the current environment is that many of the short-term and mid-term determinants of both the paper and physical market point north. We are seeing as many as eight factors impacting on the gold price over the next 2 months.

First, let us look at the drivers of the gold price. Currently the attention of this fast-paced market is focused on the troubles of European banking system. Yesterday’s successful bond auction in Portugal may have stemmed somewhat the hemorrhage and Euro has stopped sliding. But much depends on the ECB’s next move. The immediate reaction to the delay in the withdrawal of emergency liquidity has been bearish Euro and positive for gold, accentuating further the periodic breakdown of the negative USD/gold correlation.

Secondly, we have the stellar manufacturing data. From Sweden and Switzerland to US and China – the data are nothing short of impressive, coming against the backdrop of positive surprises in economies as different as UK and India. This generates positive momentum in global stock markets and broader commodity markets. Yet for as long as the extraordinary monetary policies remain in place, any such data flow also raises a specter of inflation. And when the economy reflates, no asset rises faster from the starting block than gold. Except that this might have already taken place.

Third, there is the sentiment surrounding the ‘wall of demand’ for gold ETFs coming out of China. Although the first approval for a Chinese fund to invest in gold ETFs overseas is constrained by the tethers of the QDII system, which limits PRC investors’ rights to deploy capital overseas, the news conjure the image of millions of greedy buyers in search of golden security, wherever it is available. As usual, the actual impact will be mitigated, but it is the sentiment that counts.

And finally, we have the WikiLeaks with all the manipulatory, slanderous, self-serving nonsense which delights journalists the world over. Any sophisticated observer of the world’s affairs knows of South Korean disdain for the Chinese “negotiators”, Saudi fears of Iran or mafia’s power in Russia. But because we are touching upon overblown egos, nuclear non-proliferation and major geopolitical faultlines, the barrage of news does contribute to the level of overall market uncertainty.

Then we have the physical market which provides the floor under the gold prices. It currently tells us that any pullbacks in gold against a basket of currencies will be limited. First we have the central bank and IMF sales. The World Gold Council has just announced that the new selling quota since September has been largely used up by the well-documented IMF sales. As of end of October, IMF had 32.7t left to sell and is probably now finalizing the program. This is very constructive for the physical gold market.

Secondly, we have the import tariff jumping phenomenon in India. In the last 3 years, New Delhi’s budget steadily increased the tax imposed on gold imports. Rumors that another increase is in the offing for next February may have contributed to the unusual pace of purchases in the country. In fact, the budgetary round may further exacerbate the seasonal patterns of demand on the Subcontinent – an issue discussed on these pages previously.

The third physical issue is the investment demand inside China. Unlike the expectations of ETF purchase overseas, the current gold flows reflect something of an inflation panic. China’s official banking system has found it difficult to stick to the RMB 7.4 trillion lending quota this year and the tolerated, though largely unregulated minjian jeidai lending system may have increased the money supply by another RMB 4 trillion. As a result, food prices run in double digits and gold imports have increased fivefold.

And finally, we have the miners’ hedging issue. Although the hedges left AngloGold’s balance sheet a while ago, it is interesting to note how well supported the prices were in the subsequent weeks. A similar phenomenon took place after Barrick’s announcement in 2009.

On balance, the comparison of the factors that dominate the macroeconomic newsflow with the gold-specific flow determinants yields a picture in which further price gains may lose some of the recent momentum, but in which pullbacks will be very shallow. Barring a sudden deflationary shock, such as caused by a major default, this scenario is bound to stay with us for several weeks. Anyone hoping for a significant correction any time soon will be disappointed.

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Tags: China gold imports, China inflation, Chinese ETF demand, ECB liquidity measures, gold euro correlation, gold price floor, India import tax, minjian jeidai, WikiLeaks and gold