A Closer Look at July’s Selloff

There was a significant selloff in July in the gold market. While we’ve seen selloffs of this magnitude a number of times over the course of this bear market, I’d like to review this selloff in some detail with you. During our last conference call on July 14, I told you that our near term outlook was favorable for gold. Gold was at cycle lows and we believed that its positioning on COMEX [formerly Commodity Exchange, Inc.]looked favorable. Keep in mind that we had already had a three-plus-year history of selling pressure on gold and gold stocks, and we were seeing the usual summer seasonal weakness traditionally observed in the gold market. We believed that with all that pressure on gold that the near-term looked favorable for a more positive trend.

China is the World’s Largest Gold Buyer

On July 17, the People’s Bank of China announced that it had increased its gold holdings by 600 tonnes. The last time it had announced its reserves was in 2009. This meant that over the past six years, the Bank had been buying, on average, about 100 tonnes a year, making them the largest gold buyer on the planet. However, while the increase was of significant size, the Bank’s estimates did not meet the markets’ expectations, and it did not meet our expectations. I had expected the Bank to announce something that was at least double what it had announced. The market reacted negatively and the selloff in gold ensued.

Since then, we have changed our thinking on what the Chinese government is doing with its gold holdings. China owns 1,658 tonnes of gold. That represents 1.6% of China’s forex (foreign exchange) reserves. Previously, I had thought that China was working toward having a gold reserve in terms of forex reserves that was somewhere in the double digits, more on par with what we see in western countries. Germany, France, the U.S., and Italy have gold as a percentage of forex reserves in the 30-70% range. I no longer think that China’s being that aggressive. I now think that China is content to have a level of reserves that’s more normal for Asia. If you look at Japan or Korea or other Asian countries, they have less than 5% gold in forex reserves.  I believe that’s more in line with the range that China is targeting. Having said that, even though China is not as aggressive as we had thought, China is still a significant buyer in the gold market.

The People’s Bank of China has started announcing changes in its gold position on a monthly basis, like other central banks.  The Bank added 15 tonnes in July and another 19 tonnes in August. The Bank is on track to purchase a few hundred tonnes annualized, making it a huge buyer in the market, and we think these levels will continue into the foreseeable future. Having said that, the announcement of a 600-tonne increase over the last six years in our view was still a disappointment. As a result, we saw very heavy redemptions from gold bullion ETFs. We also saw broader pressure across the commodities complex. Gold was down 6.5% in July, copper was down 9%, and WTI crude oil was down 21%. The additional pressure across the commodities complex put extra pressure on gold.

July’s Heavy Trading in After-Market Hours

Another peculiar thing that happened in July was heavy trading in off-market hours, and it’s very suspicious we feel. On July 19, on a Sunday night, at 11:27 PM, gold fell $62 an ounce in an instant, to its cycle lows of $1,072 an ounce. This is something we’ve seen before. This was in the middle of the night, when most market participants are in bed. Somebody came in and hit the market with sell orders and drove the price down. In addition to that, I think we’re seeing some algorithmic trading kick in here. Everybody knows that when you move a security through certain technical levels, whether higher or lower, trading algorithms can kick in that are monitoring the market 24/7 and automatically take the price lower or higher, in whichever direction the price is being pushed. This is an issue not just for the gold market; it impacts many other commodities markets as well. These activities need to be addressed:  trading in times of very low liquidity and the impact of algorithmic trading. Other metals got hit at the same time as gold. I’ve looked at the minute-by-minute charts for July 19, and as gold was being hit, so was copper, zinc, silver, and the platinum group. So I’m not sure if this was a specific attack on gold, or an attack on the metals complex more generally, but nonetheless, it did drive gold to new lows. It ended up in a painful selloff for investors.

The gold market has bounced back since July. In August and September gold traded higher on increasing financial risk. In August, it was China. You all saw the crash in the Chinese stock market that resulted in panicked markets around the world, and gold outperformed in August as a perceived safe haven investment. In September, the U.S. Federal Reserve [the “Fed”]didn’t raise interest rates, and since then we have started to see markets lose a bit of confidence in the Fed. This has been supportive of gold. The Fed built all these expectations around a rate increase, and then it held back, and that has been a good driver for gold. In August and September, we made up for much of what we lost in July. Since its July lows, gold is up about 6%. Our ETFs are also up: GDX [Market Vectors Gold Miners ETF] and GDXJ [Market Vectors Junior Gold Miners ETF] have posted gains since July.  While certainly not an indication of future results, gold has been gaining momentum over the last couple of months.

Does this Rally Have Legs?

As we look forward, I would say that we are into what I call a short-covering rally. There are big short positions in the market, not just gold, but across many commodities. These short-covering rallies are typically driven by financial risks for gold. Historically, they haven’t lasted in the longer term. In order for the current rally to last, I think we need to see more problems in the U.S. financial system, or with the U.S. economy, or have the market lose more confidence in what the Fed is doing. As we look forward, it is hard to give any clarity right now given that the Fed seems to dominate everything with this rate decision. It is a kind of wall: You can’t see through it, and you can’t see over it. Once the Fed finally raises rates, the market will likely look forward to say, how high will it raise rates? Will the Fed have to reverse course? Once we know how the market will react to an actual rate rise, we will be able to move on from there.  In my view, the Fed is in a box and will have a hard time doing anything that satisfies the market at this point. If the Fed doesn’t raise rates, I think confidence will erode further, and that would be good for gold. On the other hand, once the Fed does raise rates, it may create problems that increase financial risk.

How do you know if a fundamental event like a Fed rate hike is going to help drive gold in the longer term? It’s very difficult to know whether it’s another short-covering rally or a longer-term driver. It helps to look at the fundamentals as well as the technicals.

If you were to run a five-year gold prince chart since mid-2013, you can see that gold has clearly been in a downward trend over the last two-and-a-half years. If you draw a trend line across the top and the bottoms of that gold chart, the top of that channel or trend is $1,230 an ounce. Given this, if we have a fundamental event, a macro event, that causes the gold price to trend through $1,230 an ounce, I would see that as a positive sign, and that might be a point at which we might think about calling an end to this bear market and looking forward to a better performance from gold longer term. By the same token, the bottom of that trend is $1,050. If gold fell through the bottom of that trend line, then obviously that would be negative. I tend to think that the bottom is fairly solid for gold for a couple of reasons. One is that the gold industry at $1,100 an ounce is making a little bit of money. At $1,000 an ounce, many mines are losing money. And as the gold price gets down to $1,000, I think you would see companies start to cut production at their unprofitable mines.

Gold Price Range Since Mid-2013

Source: Bloomberg

Glencore is a significant example of this [represented 0% of Van Eck International Investors Gold Fund as of 9/30/15]. Glencore is the largest zinc producer in the world, and several days ago it announced a significant cut in its zinc production. The company is shutting down mines and taking zinc off the market. And most commodities markets reacted positively to Glencore cutting zinc production. I think this is the market coming to realize that these metals prices are not sustainable in the longer term. You can’t afford to build new mines at current prices for gold and many other metals. The industry is suffering at current prices. The gold industry isn’t in a Glencore-type zinc situation yet, but at $1,000 an ounce, it would be, and at that point, we would start to see significant closures, I believe, in the gold mining industry.

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