There has been an uptick in conversations in the past week or two about the re-emergence of inflation and the more hawkish/less dovish commentary from FOMC officials. This may have led the market to price rate cuts out of the Fed Funds futures market. The CME FedWatch Tool has an 87% chance of a cut by December of this year. As a reminder, there were more than six rate cuts priced into the market at the start of the year. This has led to a re-pricing of Treasury products across the curve with the 10-year yield breaking above resistance at 4.5% and heading higher. Adding to this pressure is the $1 trillion of coupon issuance that is set to come in the next three months and this is only exacerbated by the weakness of the Yen, as Japan is the largest foreign holder of Treasuries. 

What does this all have to do with the price of gold? For the better part of the last 20 years, there has been a reasonably good inverse relationship between the price of gold and interest rates. As rates went lower, and the cost of carry was less, gold benefited. As rates moved higher, and carry got more expensive, gold suffered. This has all started to break down in the past two years and has recently gotten to quite the extreme as gold prices head to all-time highs while yields are also heading higher, a situation that is not common in these markets.

Perhaps a more traditional view of the rates vs. gold relationship compares real interest rates and gold prices. Again, it is an inverse relationship, as rates go higher, gold suffers and vice versa. In this graph, I have used the real rate on Bloomberg which is 5-Year Treasuries less CPI. There are of course other measures to consider, but all suggest a similar move. Real rates have gone higher, moving from previously sharply negative levels post-Covid-19, to a more normal level above 1% positive. However, in this hiking cycle, gold prices have again disconnected from this part of the rates market as well.

What might be happening is that the Gold market is sniffing out a stimulus-led response from the government. Pro-cyclical fiscal balances taking the debt higher have led to a market concern that the Fed has monetized the Trump and Biden deficits. Gold is not the only market that has sensed this as bitcoin also benefits from the fiscal largesse. You can see both gold and bitcoin moving higher over the past six months as the fiscal spending concerns have come to the forefront. The disconnect over the past month may be due to the concerns in the Middle East, as gold is seen as a safe haven while bitcoin may be viewed, by institutional money at least, as a risky asset.

Speaking of this fiscal largesse, the price of gold has followed the U.S. debt to GDP ratio into the Great Financial Crisis (GFC) and ever since. That said, I can see that the price of gold has moved away from this longer-term trend. Just after the GFC, gold prices began to dislocate from the debt to GDP ratio, continuing higher as the debt levels flattened out. Gold then corrected and was quite a bit below trend through 2015 to 2018. As the debt began to trend higher again, gold started to head back higher. I can see on the far right of the chart that, recently, gold has again gone considerably higher while the amount of debt to GDP has stabilized. Is this a similar situation to what played out in 2011 and 2012?

A look at the daily Ichimoku chart may give some signs that it is not only the overlay vs. debt to GDP that looks a little stretched. At the top, I can see on this daily chart, generic front month futures have been unable to break through the 2400 level, as it has proven to be strong resistance. In the middle panel, I can see that the MACD lines are rolling over and about to cross lower, a negative signal and a sign of a countertrend move that may be underway. Finally, in the lower panel, I see that the RSI, which has been at the most overbought level for a year over the last month, is also finally starting to break down. While none of this suggests a change in trend is underway yet for gold, it might suggest that a trader considering entering a countertrend trade for a move lower has a number of catalysts to support their view.

The previous two charts suggest that the move in gold may have gotten a little extreme is further validated by a review of the commitment of traders chart at CME group. Looking at managed money positions, I can see that Gold futures positioning is as bullish as it has been at any time in the last three years of this rally. It is clear to me that sentiment is extremely bullish at a time that we might be seeing signs of exhaustion in this move.

A quick assessment of the level of volatility in the market, as measured by CVOL, shows that across Metals products, volatility is at the highs of the last year with the one exception being platinum. Gold CVOL is near 18 and it has ranged from 10 to 21 over the past year, so while not at the highs, it is certainly in the top quartile of levels we have seen. This is important information for me because in markets that have gone more parabolic, as gold has until recently, I have a bias to want to buy straddles. The thought process is that if prices continue higher, I benefit from the long gamma as we go further into uncharted waters. However, if there is a correction in a parabolic market, there may be trapped longs. Thus, moves in either direction can be severe. However, with CVOL looking on the high side, I may look at ideas other than simply buying straddles.

Further digging into the numbers, I can see that not only has CVOL trended higher with underlying prices, so has the level of skew in the top chart. The demand for options has not only taken at-the-money options higher but the real demand appears to be for upside options, as the relative price of upside vs. downside options has gone higher in lockstep with CVOL and gold.  In the lower chart, I dig a little further to show that the move in skew to the upside coincides with a move higher in UpVar or the relative pricing of upside options vs. at-the-money. This further suggests to me that the demand for Gold options, taking CVOL to the highs of the year, has come from demand for upside options.

Starting to put things together, I am starting to feel that a countertrend move has potential and I want to position for it. Prices are showing exhaustion and sentiment is extreme. Volatility isn’t extremely expensive, but it is expensive enough that I don’t want to buy straddles here. However, I also appreciate that the upside can be dangerous, so even though the skew and UpVar look high, it may be too dangerous to simply sell upside options. I look at the vol by strike for weekly options, as the volumes and open interest for weekly expiration Gold options have increased meaningfully, providing traders with ample liquidity to express their views.  Ideally, I can find an expiration where the at-the-money volatility looks relatively fair vs. the days around it and where the downside options look particularly appealing. I will want to cover the upside on any options I sell in order to create a fixed-risk idea. In markets that have gone vertical, open-ended risk is not a good idea in my opinion.

As I mentioned, the weekly expirations have increased in liquidity markedly. As I looked across the vol surface, I zeroed in on the Wednesday, May 8 contracts. I felt that the relative pricing for the days around it looked appealing and this is far enough out to capture the May FOMC meeting, where we might hear more about interest rate decisions. However, it is not so close that I am paying a premium for that catalyst. I decide I want to be long puts to play the countertrend move, but I want to fund these puts, given CVOL near the highs of the year, by selling call spreads. Again, I don’t want to have open-ended risk to the upside. In putting this all together, I sell the 2415-2445 call spread and buy the 2345 puts. I am able to do this for a small credit. My feeling is if futures begin to move lower from here, given the extended positioning in futures, the high demand for upside, and the multiple negative technical signals, a move of 3% to the downside is not too much to ask. The risk of this idea is the 30 ticks between the call strikes that I sold but the potential reward of being long puts is unlimited. 

Admittedly, I am looking at a trade that expires in the next two to three weeks, so a lot has to happen in a short period of time. However, there are a large number of potential signals and catalysts, relatively fair to better than fair pricing, and a good reward to risk opportunity in front of me. Since 2400 in the front month has proven to be good resistance, I am leaning into that level a bit by shorting this call spread. If it breaks, there is a good chance I will achieve my maximum loss. However, if it doesn’t, and the high futures positions are reduced even modestly given the extended nature of short-term charts and the dislocation from rates markets, then this position would move towards the upside. 

Good luck trading!

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