Hedge Funds Continue to cut Gold Bets

Hedge funds and other large speculators are continuing to cut their bullish bets on gold as they position ahead of the Federal Reserve likely reducing its asset purchase program in just a few months time. According to the US Commodity Futures Trading Commission, net-long positions on futures and options contracts decreased by 4.1% as a result of expectations about central banks curbing record stimulus. Net-bullish bets across 18 US-traded commodities rose slightly by 0.1%, but this year has been tough for commodities in general with silver and gold leading the losers’ table with losses of around 30% and 19% respectively.

As the US economy continues to modestly improve, the pressure on energy commodities led to some gains in natural gas and WTI oil but copper has been under heavy selling pressure since November, something which historically has been a bearish sign for the global economy.

Gold has been in a 12-year bull trend but the yellow metal has been struggling since September 2011. After hitting an intraday high of $1,923.7/oz in September 2011, gold has now retreated 28% and is firmly in a bear market. Volatility has been increasing and the precious metal experienced a slump of 10% in just two consecutive sessions in April – hammering home the bearish slant on the price.

At its last meeting, the Bank of Japan left its monetary policy unchanged and has so fair failed to address the problem of volatility that has been rising in JGB’s. ‘Abenomics’ has been criticised lately and investors are again questioning whether the aggressive monetary easing will do anything for the Japanese economy. In the US, the latest comments in the direction of reducing the $85 billion bond purchase package to probably around $65 billion have also weighed on the yellow metal. The FED will meet tomorrow and investors are anxiously waiting for some clues about future policy. Even though the FED isn’t expected to announce anything major, investors remain alert to the possibility of the FED reining in its purchasing soon. Is quantitative easing coming to an end? Probably not, but the odds are rising.

The FED has been monetizing US debt for over 4 years now and has purchased $2.3 trillion of national debt from Dec 2008, expanding its balance sheet to over $3 trillion. Gold surged over this period, rising some 80%. With such a bold and prolonged asset purchase program in place, it was expected that inflation would pick up but, so far, that hasn’t been the case (or officially anyway). In fact, the latest consumer price report shows an increase of just 1.1%, although the man on the street cannot reconcile that with his shopping bill… If the FED puts a foot on the brake with QE we are likely to see renewed volatility in gold and possibly a tow below the old lows of April around $1320/oz.

Our old friend “Mr Subprime” John Paulson has been severely hit and wrongfooted by the missing link between QE and inflation and, probably the only one still holding tight on his bets given his pocket depth! He currently is the largest owner for the SPDR Gold Trust with 21.8 million shares. Unfortunately for Paulson & Co., this bet is performing around −17% YTD, which translates into a loss of more than $600 million now. Besides holding gold, Paulson also holds gold miners in his portfolio. Anglogold is his top holding and again another drag in the portfolio’s profits. The 28.3 million shares Paulson holds in the gold miner are losing him around $420 million. Adding both holdings together, we have a $1 billion loss.

The reasoning behind Paulson’s bet is very well founded but he has been unlucky with timing. Gold fundamentals are still strong with a tight supply and strong demand picture, but if the FED reduces QE, we may see fresh selling pressure with the unfolding of gold positions by many institutional investors. For the medium to long term, we are bullish on gold but in the short run we are likely to see more volatility and a possible further spike lower.

Unlike what happened in 2007, when Paulson got it right about the sub-prime market, this time Paulson is highly leveraged. In 2007, Paulson was using derivative assets worth only a small part of his portfolio and which wouldn’t have mattered much if they ended up worthless – classic asymmetric risk. That isn’t the case today, as Paulson has 25% of his portfolio tied to the development of gold prices. There’s an old saying – “sometimes you have to be wrong to be right” – Paulson’s learning this anew.