Biggest gold price rout of the year

2011-AUG-25

Stock markets rose yesterday and the gold price plunged as investors regained some optimism about the state of the global economy. The German DAX settled 0.84% higher yesterday, with Britain’s FTSE 100 also tacking on a 0.55% gain. In America, the Dow Jones Industrial Average posted a 1.29% increase to settle at 11320.71, while the Russell 2000 index of small-cap stocks recorded a 1.39% gain. Japan’s Nikkei has settled 2% higher today, while Hon Kong’s Hang Seng Index closed up 1.1%.

Price action in the commodity sector was mixed. Copper, Brent crude and Nymex gasoline futures all settled higher – indicative of “risk on” trades being implemented – though precious metals such as silver, platinum and palladium all sold-off. Silver fell by more than $3 an ounce, while the front-month platinum and palladium contracts were down $53 and $21 respectively.

All of this was small fry, however, in comparison with the losses in gold. The August Comex gold contract lost a whopping 5.6% ($104.20) to settle at $1,754.10 per troy ounce. In dollar-terms, this decline is second only to the $143.50 plunge that occurred after the gold price reached an inflation-adjusted peak in January 1980. However, in percentage terms there have been even sharper declines than yesterday’s 5.6% loss in recent years.

Given the incredible gains in the gold price witnessed in recent weeks, such a down move is unsurprising, and is indeed a healthy part of a sustainable bull market. Such moves force speculators and other weak hands out of the market – with more and more committed gold holders using the price dip as an opportunity to buy more physical metal.

Stronger-than-expected US durable goods data for the month of June was partly responsible for the bullish mood on Wall Street and the rout in the gold market. Economists had only expected a 2% increase, when in actual fact the data showed a 4% rise. As Robert Wenzel points out at his blog, the surge in the US money supply in recent months is starting to result in improved economic statistics, as well as rising prices at both the producer and consumer levels.

Margin hikes at the New York Comex and the Shanghai Gold Exchange have also contributed to the downward move in gold prices. The Comex has raised the amount of money needed to trade gold contracts by 27% to $9,450 per 100-ounce contract, following on from the Shanghai Gold Exchange’s decision to raise margin requirements by 26% on Monday. Higher margins mean futures traders must stump up more cash in order to buy and hold gold futures – which tends to encourage selling. Clearing houses will tend to raise margins in response to big price rises, as a means of reducing volatility.

In addition to the above pressures, this week is options expiration week at the Comex. The largest banks operating on this exchange write a lot of the call options on gold futures; thus, they have an incentive to aggressively short gold in the days leading up to and on the day of the expiration of certain calls, so that they expire worthless – meaning that the banks make the maximum profit from selling these options.

None of this should detract from the long-term fundamentals that are underpinning steady rises in precious metal prices. As the old saying goes, bull markets take the stairs up and the elevator down. Or, as the American investor James Dines notes: “the very function of declines in a major bull market is to keep investors out – until the top. The very function of rallies in a major bear market is to keep investors in – until the bottom.”