The Gold Game: Reasons for the Short Squeeze
By Don Luskin
Special to TheStreet.com
5/21/01 9:06 AM ET
It never ceases to amaze me the way financial markets all fit together, like perfectly meshing gears in some infinitely complex machine. The day of the bottom in the long bond's yield was March 22 -- the very day of the bottom in the Dow Jones Industrial Average. Two weeks later on April 3, the second part of the double bottom in gold occurred just one day before the bottom in the Nasdaq Composite.
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Now, as I write these words Sunday evening in California, gold is trading above $298 in the night session on the COMEX as Asian markets open. If that move carries into the day session when U.S. markets are open, gold stocks like Homestake Mining (HM:NYSE - news - boards), Newmont Mining (NEM:NYSE - news - boards) and the ultra-levered Kinross Gold -- all of which we took positions in last week -- should continue their explosive upside moves.
Shock Therapy
The gears continue to mesh perfectly. This interaction of markets is exactly what we'd expect to see based on the analytical framework I've been developing here for months: the thesis that we have been trapped in a deflationary spiral, from which only violent monetary shock therapy from the Federal Reserve, in the form of continuous easing, can save us.
For monetary shock therapy to work, the Fed needs to supply more liquidity to the market than it needs, to make up for years of having supplied too little. If the Fed gets it right, the result will be a gradual reinflation that will restore the prices of basic commodities to their predeflationary levels. For gold, let's call it $338, its 10-year moving average.
This kind of reinflation would be a good thing. With gold at $338, the delicately balanced interests between producers and consumers, and borrowers and lenders, embodied in billions of formal and informal contracts made over dozens of years, will be put back into balance. That's why the Federal Open Market Committee's statement that accompanied its latest rate cut told us explicitly not to worry about inflation. If gold gets above $338, it'll start talking about inflation in a very different way. But for now, fuggedaboudit. Gold is giving all the right signals.
You probably won't read about gold this way anywhere else in the mainstream financial press. The fashion victims of finance love to diss gold, parroting the conventional wisdom that it's just a "barbaric relic," as John Maynard Keynes and two subsequent generations of oh-so-sophisticated economists have called it. To them, gold has no place in modern markets and its actions are essentially random. So to them I quote a far more intellectually rigorous authority, Bob Dylan: "Something's happening, and you don't know what it is, do you, Mr. Jones?"
They say that this move in gold is nothing but a short squeeze. Yes, the shorts are being squeezed. But they are not being squeezed at random: The reasons for the squeeze fit perfectly into the end-of-deflation thesis.
Here's what's happening, Mr. Jones.
Reasons for the Squeeze
First, and most simply, gold is going up because commodity prices rise when inflationary expectations are revised upward. Those revisions are made in the minds of both longs (who buy) and shorts (who cover). In a deflation, cash is king. In a reinflation, cash is trash. It's true in the gold markets no less than it's true in the stock market or anywhere else. Indeed, it's truer in the market for gold -- the most monetary commodity of all -- than anywhere else.
Second, the insolvency of Centaur Mining and Exploration two weeks ago set off a scramble by the overhedged company's creditors to limit their exposure by buying gold. But this was not an isolated event. Over the past two years, gold has traded at its lowest price in more than two decades -- the direct result of severe monetary deflation. The global gold-mining industry is simply not profitable at these prices. Marginal producers have had to go out of business.
Third, and directly related to the previous point, gold is scarcer today than ever. That's because at deflated prices, it's not profitable to bring reserves out of the ground or to explore for new reserves. And increasingly severe environmental restrictions on mining operations only make matters worse. As a result, annual gold production is currently less than the amount required just for jewelry manufacture -- that doesn't even begin to include other sources of demand for gold. With gold this scarce, even small shifts in the supply-and-demand balance can trigger important moves -- and send the shorts scurrying for cover.
Fourth, one of the key reasons for being short gold has been removed -- and it is here that you will see the gears of finance meshing at their tightest. The reason is that high short-term interest rates make it attractive to short gold, and low rates make it necessary to cover. With the Fed's 250 basis points of rate-cutting this year, short-term rates have collapsed -- and so has the incentive to be short gold.
Why does the level of short-term rates affect being short gold? When you short gold, you borrow it through a broker, who probably borrows it from a central bank somewhere in the world. You sell the borrowed gold for cash, and you keep the cash in short-term money-market instruments at your broker -- where you earn interest on it. You pay the central bank a fraction of that interest as a fee for leasing you the gold.
Suppose you earn interest on your cash at the fed funds rate. At the end of last year, you'd be making 6 1/2%, and you'd have had to pay the central bank that leased the gold about 1/2% as a fee. Your net take: 6%, on an investment of zero. Not bad. And you'll make a profit on the trade just so long as gold's price doesn't go up any more than 6% per year. If gold's price goes down, you make even more. A lot of the big macro hedge funds that were hipped to the deflationary thesis have called this trade "free money" for a couple of years now. But it's over. With the fed funds rate down to 4%, the risk/reward equation in shorting gold has fallen apart. And making matters worse, central banks are suddenly demanding higher fees for leasing gold to shorts. A year ago it was 1/2% -- now it's more than 2%.
So, yes, this rally in gold is about short-covering, at least in part. But it's no mere technical coincidence that shorts should cover now when the deflationary spiral is finally coming to an end. Some may not choose to understand what's happening in gold. But the shorts can't afford to delude themselves about how the gears of finance mesh. It's time to get the hell out.
How do you play this? Like everything else: carefully! Just because the end-of-deflation thesis is working out according to the playbook so far doesn't mean there won't be setbacks or that it will necessarily last forever. The dynamics of short squeezes are notoriously unstable, even when they occur in the context of a secular shift.
And, of course, this secular shift is still just being born. The Fed's capacity for error is nearly infinite. If it blows it now, the rally in gold -- along with the recovery in the stock market -- will come to an abrupt and very unpleasant end. The media will be howling about inflation. If you see signs that the Fed is listening to the howling before gold hits $338, get ready to run back to the bunkers. Until then, the gears are meshing just the way they're supposed to. |
