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Posts Tagged ‘gold price volatility’

24
Nov

SHOULD GOLD BUGS CHEER KIM JONG-EUN?

   Posted by: Mr. Gold    in Uncategorized

Stupor, bewilderment, anxiety, shock and anger meet yet another provocation dished out by Pyongyang on its southern neighbor. These are the feelings expressed by those directly and indirectly affected, those still married to the post-war, UN-regulated order, the naïve bunch that has not quite grasped to what extent the rules of the game have shifted. Despite years of international sanctions, North Korea, an entity born out of sweat and blood of Mao Tse Tung’s troops, has now happily turned into a China’s bad boy testing ground. Assessing the patience of neighbors, fraying at the global resolve to cap the mercurial ambitions of the ruling family, helping Pyongyang to run its businesses and obtain more uranium for enrichment… The “global community”, if there was ever one, can’t stop it because Kim’s backers are today full of liquidity-oiled hubris and see no interest in hemming in the wayward behavior. Behavior that may well be channeled through the tensions with the immediate neighbor to the South, but ultimately is aimed at Beijing’s traditional enemies and rivals in the region – Japan and the US. After all, China invited Kim Jong-il when his navy killed 45 South Koreans in Cheonan incident last March. From Burma to North Korea, the neo-imperial Middle Kingdom revels in this sort of archaic clientelism. One just gets tired of the press mantra about Beijing’s concern about “refugees flooding into PRC”. China is managing the ‘refugee’ problem all right, stuffing stacks of banknotes into the pockets of every Manchurian who spots and denounces a non-fluent Chinese speaker in the backyard of the chilly Jilin Province. A police state does not need a private militia to protect its flank. Amnok River is no Rio Grande.

But there is a group of excited investors who, while may not exactly cheer Kim Jong Il’s (and now possibly Kim Jong-eun’s) aggressive antics, are anxious to see instability as a litmus test for further gains in the safe haven asset par excellence: gold, geum, huangjin – or whatever else it the 79th element on Mendeleev’s table could be called in that troubled region.

And the oxymoronically sobering news is – there is actually something to get excited about. In a simplistic, single-variable overview, gold’s usual response to Pyongyang’s ultimately unpredictable actions is positive and not necessarily short-lived.

We looked at 9 incidents caused by the North over the last 5 years, ranging from missile launches, to nuclear tests to warship clashes and bombing campaigns. We added to this any reports concerning dramatic changes at the top of the state’s structure (Kim family issues). We then compared the performance of the gold market in the ensuing period. It appears that gold in dollar terms is lifted by an average 0.09% in the day after an incident. In only two cases (reports on Kim Jong Il’s stroke in September 2008 and the second nuclear test in May 2009) did the gold price actually fall on the news. More surprising yet is the fact that in the week following the events, gold gains an average 2.31%, and a month later it is still higher by 5.36%, in dollar terms.

Of course, this is a single variable extracted from a wealth of other macro- and gold-specific influences. What is stunning is the regularity of the metal’s behavior, possibly coincidental and certainly orthogonal but regular nonetheless. Importantly however, in only one case (May 09) did the subsequent trading reverse the pre-existing trend. In all other instances, gold’s trajectory simply amplified or extended the trend. Remarkably, Korean incidents have a peculiar feature of not occurring during occasional gold market pullbacks.

One hypothesis could be that any posturing or outright aggression induces Asians to actually purchase more gold. This would require further research into historical demand data, but it is an intriguing thought. Just as most Westerners seem resigned to the swell of Asian juggernauts, locals may be a little more aware of the precarious state of liquidity-driven property boom, unresolved territorial disputes, ultra-nationalistic educational systems and the premature demographic peak. Contrary to Norman Angell’s hopeful students, there are reasons to believe a war in a region run by unreformed dictatorships is not becoming any less likely just because many of its inhabitants have now become wealthier.

Nor should the conclusion be any different if you are a South Korean resident and most your wealth is Won-denominated. Not only have you suffered from your central bank’s ongoing intervention to keep the currency competitive against the undervalued Renminbi, but now the Kims up north are doing this job just as efficiently. You may have little choice but to hold gold as an insurance against sudden falls in the value of your currency. On the basis of the 9 peninsular incidents, it turns out that your wallet’s one-day gold price sensitivity is seven (!) times higher than for dollar-denominated gold investors.

For all other gold investors the solution lies elsewhere. For as long as the North Korean forays remain low frequency events (on average every 7 months over the last 5 years, but with significant variance), the option market may not adequately price in the probability of such idiosyncratic shocks. When things quiet down a bit, the lingering uncertainty left by the 60-year long positioning in the region may in fact give the advantage to investors paying for long vol on a regular basis. To all those who retort that this could sound like a bet against traditional Korean concept of kibun (interpersonal harmony), here’s a quick refresher. Although peace and security are the objectives of kibun, flare-ups and hostility occur if it is not observed. The frustrated, exaggerated reactions to the perceived lack of harmony can be observed anywhere in this cultural context – from violent students’ demonstrations to fistfights by upset clients on Korean Air flights. Betting against kibun with option volatility assumptions slightly above the ‘implied’ number on the screen could yet be one way to derive value from the fat boy’s ascendancy into a Beijing-backed loose cannon.

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17
Sep

‘TIS THE SEASON TO BE PATIENT

   Posted by: Mr. Gold    in Uncategorized

As the record-setting gold market (and the very sympathetic gold equity market) are reminding us, we have now entered the seasonally friendly environment for the investors who patiently tread through two and half months of relatively uneventful lull.

The seasonal theme inevitably brings us back to the question of demand and Indian demand in particular. After all, late August to mid-September period is known to have brought positive returns in every year except the sadly memorable 2008. We have previously devoted these pages to the misunderstandings surrounding the changing nature of Indian demand seasonality. In light of the summertime reports heralding the alleged “end” to Indian infatuation with gold, it is worth reviewing the recent ebbs and flows in the context of the changing Rupee price of gold.

We have looked at the last three years, using the western (Gregorian) calendar. We do realize that many (though by no means all) of the gold purchasing patterns in India are related to the lunar calendar, but we have elected to reflect the fluctuating nature of Indian demand with respect to Western investors’ seasonal perceptions.

We delved into the demand patterns both from the perspective of the jewelry and investment market in India. We cross-checked these data with average intra-period Rupee price levels, price volatility and volume changes. The investment demand, dominated by retail bars, medallions and recently also small 24-carat coins (worth around $20 each) represents between 20% and 30% of the overall demand. The investment component peaked in 2007 – 2008 and has yet to recover to the levels prior to the massive dishoarding that occurred in early 2009. The circumstances of the first quarter of 2009 went well beyond the traditional “seasonality” and were associated with drop of incomes, mainly due to the sudden fall in exports and remittances.

Overall, as could be expected, Indian investment flows are inversely correlated to the Rupee prices of gold. No such inverse relationship can be detected in the case of the jewelry demand. Although the correlation is not statistically significant (0.16), it is nonetheless positive. The functional characteristics of the Indian demand ensures that the jewelry flows slow down, but do not reverse during the periods of high prices. Interestingly, this caps the potential for further increase in scrap supply. Again, the first quarter of 2009, which was marked by massive re-melting and volume-neutral jewelry exchanges, constitutes an outlier.

The old adage goes that in India it is the volatility of gold prices that counts, rather than the level of the gold prices itself. Even a cursory overview of the last 12 quarters bears out this popular thesis. Jewelry volumes have a negative -0.25 correlation to price swings in Rupee terms. Investment volumes seem to be less sensitive. The picture is again reversed if we compare the price volatility with inter-quarter changes in volumes. High volatility appears to have a strong negative correlation to changes in jewelry purchases (-0.5) and an even stronger negative relationship to the rate of change in investment flows (-0.62).

What does all this mean for the gold market in the near term? As we get closer to Pitru Paksha period, when many Hindus give Shraddh offerings to honor ancestors, the demand is bound to slacken a bit, as this two week period (starting late September) is considered inauspicious. This means that even lower levels of price volatility could dampen demand, especially in the South and West of the country. The “modernization” of India notwithstanding, it is prudent not to underestimate the traditional drivers of (and brakes on) the gold demand. For example, the second quarter this year saw a slight drop in both jewelry and investment purchases even despite the marketing efforts surrounding Akshiya Tritya festival. This slowdown could be associated with the addition of the extra month in the lunar calendar (Adhik Vaishak Maas), which is not considered auspicious for gold purchase (sweets are more commonly offered). Luckily for gold investors, Adhik Maas is added to the calendar only once every three years.

Beyond mid-October, as move towards the second wedding season, things will clear up again. This year in particular, the demand should be robust, thanks to plentiful monsoon. 70% of Indian gold demand is still rural-based and the growth of rural incomes in excess of local gold prices is critical for further demand. Only very high volatility of Rupee gold prices could snuff out this opportunity. Let us hope the gold prices do not accelerate too fast before Diwali on November 5.

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15
Apr

GOLD VOLATILITY AND ITS MANY MEANINGS

   Posted by: Mr. Gold    in Uncategorized

Last week something interesting happened to gold options. The short trading week saw the return of strong investor interest to the gold market, with net long positions on Comex increasing by 4.5 moz. This constitutes the most significant weekly inflow since the 6.4 moz rise during the first week of September, which at that time helped gold break the $1000/oz barrier. Yet, unlike in September, 1 month contracts initially did not experience a pick-up in volatility that usually accompanies decisive shifts in the spot market. In order to understand what this means, it is worth stepping back to consider some unique characteristics of gold’s historical – and implied volatility.

In theory, gold should not be volatile at all. Inventories and storage capacities are a non-issue for this “commodity”. Unlike other commodities, gold volatilities cannot be easily dissected into structural (long-dated prices) and cyclical (forward curve structure) components, as the metal is not mean-reverting and its global inventory is always plentiful. Unlike platinum, or oil, gold is geologically abundant in almost all major regions of the world. And, unlike silver, gold is usually produced and accounted for predominantly as the main output of mining operation. Consequently, it does not suffer from low elasticity of supply.

Secondly, for the purposes of the investment and jewelry markets as we know them today, the supply from mines, scrap and, if need be, central banks is sufficient to satisfy demand. Finally, gold storage is not a big deal. Ultimately, people carry this stuff on their bodies. This is probably why gold is notorious for being the least volatile of all commodities, bar livestock. Indeed, long-term comparisons show that commodities difficult to store – such as power – are the most volatile. The long-term annualized daily return volatility of power rates (say, US PJM West Hub) is over ten times gold’s.

But there is another unique characteristic of gold’s volatility. During bouts of strong momentum buying, as during the last quarter of 2009, gold’s volatility surges. And while, at that time, implied volatilities of the VIX index continued to fall in the broader market – almost in synch with the bullish sentiment in equities, gold’s volatility increased in line with spot price gains. It eventually peaked some two weeks after the metal notched its all-time high level in dollar terms.

According to World Gold Council, over the last 20 years, standard deviation of positive returns for gold is above 3% (compared to 2.3% for S&P500). Typically, in the broader equity market, negative returns are associated with higher volatility, yet gold’s standard deviation for negative returns is actually lower, 2.5%.

How does volatility correlate with gold prices? The last three years provide an interesting lesson. During the year separating the “subprime” fallout in Sep 2007 and the Lehman debacle in Sep 2008, the correlation was positive and high (0.8). It dropped precipitously, as gold prices reacted negatively to the potentially deflationary shock of the banking collapse. Gold volatilities shot up, in synch with other asset classes, and the correlation between gold prices and gold volatilities reverted to negative. The relation remained negative until late summer 2009, but since October, the correlation has turned positive again, although less decisively so than in the preceding period (currently at around 0.15). As a result of new inflows into the market (both Comex and ETFs), over the last week we have observed the lowest ever ratio of volatilities to gold prices. In other words, during the recent quarters it has paid off to be long gold, but short gold volatilities. Unfortunately, in order to have more confidence in this trade going forward, it would be helpful to have a slightly higher implied volatility than it is the case now (old adage goes that shorting volatility is best when the implied volatilities are significant, but historical volatilities are unimpressive).

Gold options, including options on gold equity products, such as ETFs, differ in volatility skew from the rest of the market. Implied volatility of calls and puts has a forward skew (volatility is higher for higher strike options). This is not only the case of gold, but also of most other commodities, many of which have experienced much stronger swings in long-dated prices than the yellow metal. The most liquid SPX options, on the other hand, have a reverse skew (higher implied volatility at lower strikes). Not surprisingly, the options on gold mining companies, and on GDX index, have the volatility skew more akin to the broader equity market.

In the near term, if gold continues to notch up regardless of USD/EUR direction, I would expect volatilities to pick up and the record price/vol ratio ease in the short term. If not, we are in uncharted territory. But shouldn’t we get used to it by now?

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