4 Reasons Why Hedge Funds Will Continue To Dislike Gold

The speculative community has literally crushed the gold and silver price in the second quarter of 2013. The outlook for gold and silver remains bleak, at least for traders on the long side. We are not talking about investors who own the metal (in PHYSICAL form) with the aim to be their own central bank (just one that really cares about its stakeholders).

Yesterday’s COT report in which futures positions of commercials and speculators are updated (see below chart) gives an insight in the outlook of the precious metals prices. This is important information because those “paper markets” (i.e. futures markets like COMEX and LBMA) still continue to dominate price setting. Whether we like it or not, for now “price discovery” (whatever that may mean) is still dominated in those markets.

COT_gold_2_august_2013

The chart shows that large speculators keep on increasing their net short position while commercials increase their net long position. The commercials are known for seducing the speculators into one direction while simultaneously changing their own positions. It remains to be seen if they will succeed again with this trick.

For gold bulls it is valuable to analyze the arguments of the bears. In the case of gold one should simply turn on a mainstream media channel to get this information. In that respect Mr. Scaramucci, a Wall Street pro, discussed during a TV interview on CNBC four reasons why hedge funds will continue to push the gold price lower. When analyzing his arguments, we quickly come to two conclusions.

  • First, this is the trader’s view. There is nothing wrong with trading, but it’s fundamentally different than investing. Also, traders have a benefit in the fractional and leveraged system, so they will not mention the risk related to the gold fractional system for instance, which is one of THE arguments for owning the metal in physical form.
  • Second, every argument can basically be reversed to become a valid counter-argument. Why? Very simple, it all depends on the time horizon. Read on to see what we mean.

Below are the four arguments brought forward by Scaramucci. Let’s look at his points and see if we can find equally valuable counter-arguments.

Argument 1: Central bankers are exercising caution

The first point is related to inflation. It touches the core premise of gold, which is a perfect hedge against inflation. The following quote comes from the interview:

“There’s a lot of very wealthy people that are going to own gold as a defensive hedge for what they’re fearing is that whole Weimar Republic thing, where either the Europeans or the United States aggressively prints money, where the multiplier effect kicks in on the banking side, and you get this out-of-control inflation,” Scaramucci said, referring to hyperinflation that occurred under the German democratic system in place between 1919 and 1933.

But Scaramucci says these gold bugs just aren’t doing their research. “If you read the minutes from the Federal Reserve, or if you look at the essays that Ben Bernanke just recently published, you will discover that your central bankers, particularly in the United States, understand this issue very well. And that’s one of the main reasons that gold has not worked in this environment.” The Fed minutes make clear that the Fed is keeping a close eye on inflation, and is keeping risk factors in mind. For instance, the latest Fed meeting minutes, from the July 18-19 meeting, note: “Although the staff saw the outlook for inflation as uncertain, the risks were viewed as balance and not particularly high.”

The obvious counter-argument?

The underlying assumption in the above statement is that the US central bank is kind of omniscient. But what if that is not true and their policy (which they cannot justify empirically) will not bring the desired results. The fact is that the US is currently exporting their (monetary) inflation. Lots of the newly created dollars end up at foreign central banks making abroad currencies weaker. But … the dollar is increasingly disliked and bypassed in trading agreement of the BRICS as we reported here, here, and here. Going forward, one should not exclude the scenario that inflation will stay within the US and that price inflation will pick up fast. That should result in much higer gold prices.

True, it is not the case for now. But it is a looming risk which can materialize rather fast. History learns that inflation can remain invisble for a long time but start rising fairly quickly.

Argument 2: Deflation has become a risk

The second point is related to disinflationary signs we get from the global economy which could, ultimately, lead to deflation. From the interview:

“What’s happening now is the specter of deflation is way, way, way more fearful to the central banking community than inflation,” Scaramucci said, “and gold typically works when there’s a devaluation of currency, or inflation.” As the Federal Open Market Committee noted in its July 31 statement: “inflation persistently below its 2 percent objective could pose risks to economic performance.” “In a deflation economy,” Scaramucci said, “gold is not going to work.”

The obvious counter-argument?

Central banks are scared to death about deflation. Japan was so tired about deflation that they launched the biggest monestary easing in history, beating helicopter Ben’s performance. What if central bank’s policies get out of control in their attempt to defeat deflation?

From another point of view, let’s assume that Western central banks will allow deflation. In such a scenario, gold will go down indeed but history has shown that it goes down to a LESSER extent than other assets. Owning physical gold is still a good idea to preserve purchasing power.

Argument 3: The Fed won’t sell its bonds

The third point is related to the risk that the bond bubble will burst, leading investors to bullion. From the interview:

“People are buying gold because they predict there’s a bond bubble,” he said. “And they predict that at some point, the Fed is going to shed their $3.9 trillion balance sheet. But that’s not going to happen either.” He believes this incentive for the Fed to sell its bonds simply isn’t there. “The Fed’s duration on its balance sheet is only about seven years,” Scaramucci said. But “they’re a 100-year-old institution, they live inside a 237-year-old country and there’s no reason to shed that portfolio. They’ll just let their portfolio unwind. And so the prediction here will be that gold prices will languish.”

The obvious counter-argument?

The US Fed is the most important buyer of domestic bonds. What if the market takes over control and pushes yields much higher, to such an extent that even with intervention the Fed cannot control their own manipulation? Higher bond yields (and hence lower bond prices) started to “spiral out of control” since May of this year. The US Fed’s chairman reaction on that was: “it got us puzzled.”

Argument 4: Economic growth would hurt gold

The fourth point is related to additional monetary easing as a response on economic growth.

To Scaramucci, holding gold has become a lose-lose proposition. “If the economy picks up, rates pick up, that’s bad for gold. If the economy doesn’t pick up, the Fed is going to be in exactly the position that it’s in now, which is effectively QE but no real money creation.” Simply put, while people thought quantitative easing would create gold-boosting mega-inflation, that simply hasn’t happened. So now, the risk remains to the downside—because rising rates make gold, which does not produce yield, even less attractive in comparison to bonds. Scaramucci does not take a view on where short-term action could take the gold market. But from his “30,000-foot view,” the prospects for gold look awfully dim.

The obvious counter-argument?

A sudden and uncontrolled rise in inflation, even if combined with rising bond yields, will get the central bank puzzled (just like they are now with the unexpected sharply rising bond yields). Such an evolution is not likely to happen in the short run, but it remains a looming risk nevertheless and is very likely to occur longer term.

You pick the argument(s). Longer term, we see enough arguments for monetary protection in the form of physical precious metals.

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