With Gold contracts setting new highs seemingly every day, the product is drawing attention from outside the typical crowd of gold bugs and trend-followers. It is not surprising to see discussions on social media about the beneficial effects of gold as an inflation hedge, central bank debasement hedge or geopolitical risk hedge. With all of those issues having attracted market attention in the last year or so, combined with the steady advance of gold, the correlation makes sense. However, is there causation? Traders may know that gold prices are essentially a reflection of investor sentiment on risk, inflation and global economic stability, but what in particular matters more? I thought I would test a number of theories for what moves gold, such as inflation, central banks, dollar, supply and demand, ETF flows, real interest rates, economic or geopolitical risk, and trend-following. If I look at each of these events one-by-one, will a pattern emerge that may set up a trade this week? Let’s find out.

The first event I wanted to consider is inflation. What is the right measure to consider? Just in the U.S. we could take CPI, PPI or PCE among other things. What about other countries? Also, are those measures backward looking? Should one consider other measures such as inflation expectations? Many good questions, but I decided that markets move on the margin, so I would look at the Citi inflation surprise indices both global and for the U.S. alone. With the global measure (white) and the U.S. (blue), you can see the pattern is remarkably similar for each. I compare these surprise indices to the price of gold (orange). I do see a correlation between these lines through 2022; however, since early 2023, inflation surprises have continued to move to the downside while gold has marched higher. Thus, it would seem to me that the driver for gold over the last 18 to 21 months has not been inflation surprising investors and traders to the upside.

Another common idea is that the actions of central banks debasing fiat currencies is a reason to own gold. In order to test this hypothesis, I created an index combining the balance sheets of FOMC, PBOC, BOJ and BOE, all converted into dollars to normalize them. Then I compare this index to the price of gold over the last decade. One can see that from 2014 until 2020, there was a correlation that as central bank balance sheets expanded, gold moved higher and vice versa. However, during Covid-19, these balance sheets exploded higher a while gold initially kept up and then it went sideways for several years. Starting in 2022, central bank balance sheets began to fall and are now back to levels that existed in mid-2020. While central bank balance sheets are falling, gold is moving much higher, showing a beta closer to -1 rather than the beta closer to +1 that it used to have. While one can see some merit in the argument, the price action over the last 18 months does not suggest that central bank debasement is driving gold (if in fact central banks are even doing so).

If it isn’t global central bank balance sheets, perhaps it is related to the Dollar Index itself. On this front, I think there is some merit as one can see a consistent pattern not only over the last five years (longer if I showed it), but also more recently. Periods of dollar strength led to gold weakness and periods of dollar weakness have coincided with gold strength. Right now, markets are in a period of dollar weakness against a range of currencies and this is showing up in strength in gold. Whew! I finally found one theory that seems to hold.

Of course, in any commodity, one would suggest that supply and demand are primary drivers of spot, which, in turn, impacts the future. In the top chart, I look at the level of gold production compared to several sources of demand: jewelry, fabrication and ETFs/investment. The picture I see here, which is a few months old, is probably one that would surprise many on the long side of the gold trade. I can see that gold supply is relatively fixed and seasonal, but the most recent reading was higher. There is not really much trend to this, but that is one of the appeals of gold (i.e., a relative fixed supply). The surprising thing may be that demand is also not moving in such a way as to drive prices higher.  Fabrication (blue) and world jewelry demand (pink) both went lower in Q2 and are near the lows of the last several years. ETF flows have turned up but from a low level. This is not a picture of strong end-user demand one may have expected. 

In the lower chart, I dig into the ETF flows looking at the holdings of gold in ETFs (white) and the shares outstanding of ETFs (orange). These two measures have recently turned higher, but have been declining for several years. In fact, in the rally in Gold futures for all of 2023 and early 2024, ETF demand was going lower and not higher. The supply and demand picture is not what has been driving gold. 

There is at least a logical relationship between real interest rates and gold given the high storage and insurance costs of the metal. When the cost of carry moves higher, gold would be expected to move lower. When the cost of carry moves lower, gold should move higher. This is the relationship traders saw from 2014 until 2023 showing by looking at the U.S. five-year real interest rate, inverted, compared to the generic front month Gold futures. Once again, this relationship has fallen apart and as real interest rates have moved into positive territory for the first time since Covid-19, gold continues to move much higher. This does not make sense based on the relationship to carrying costs that one might expect.

Another theory on gold is that it is a hedge against economic uncertainty, geopolitical risk or market risk. I test this theory by comparing the front month futures  (purple) to the Economic Uncertainty Index (white), the VIX index as a measure of market risk and the MOVE Index as a measure of geopolitical risk. All of these measures have moved lower in 2024, and both VIX and the Economic Policy Uncertainty Index moved lower throughout both 2023 and 2024. All the while, gold moved higher. While various measures told traders that risk was pulling back from the highest levels of 2022, gold continued to move higher. It seems that gold is not correlated to these measures of risk recently, even if there appeared to be a better relationship from 2018 to 2021.

The last idea I want to look at is trend-following and technical analysis. In the very first chart, I looked at the daily chart, which is in a well-defined trend higher. It is just getting into an overbought RSI but the trend is very strong. Next, I can look at the weekly chart in the top picture here and see that after futures broke out in early 2023, there was a re-test of the cloud in late 2023 and futures have moved much higher since. However, the weekly RSI is overbought again as it was in March/April of this year. At that time, gold resolved the condition by going sideways for a period before resuming higher. Perhaps the biggest difference this time is the monthly chart in the bottom picture. It also shows a breakout in 2019 and a re-test in 2022. Since then, it has moved higher but is now in an overbought condition on the monthly chart, something traders have not seen since 2020. Gold proceeded to go sideways for all of 2021 after registering that overbought monthly RSI. While the trend does look strong on daily, weekly and monthly charts, I am struck by the overbought RSI on each of those charts and fear that just as many traders and investors are getting more bullish. Markets might resolve this by going sideways for some time.

I previously discussed the ETF flows into gold and showed that those are just starting to pick up. Thus, it is probably not retail accounts driving the latest move. I decided to look at the Commitment of Traders report to see if managed money has been driving the chase higher. Sure enough, managed money is the longest it has been since late 2019 and early 2020. Recall at that time, markets got an overbought RSI combined with managed money length and proceeded to go sideways for a year. Markets are facing a similar situation now with managed money length and Gold futures overbought on the daily, weekly and monthly charts.

The volatility market does not seem convinced of the move in gold to new all-time highs. Why do I say that? First of all, gold volatility doesn’t stand out at all compared to all of the other metals when using the CVOL Indices from CME Group. In fact, looking at all of the metals’ volatilities versus last year, one might think not much is happening as the levels are solidly in the middle of the range. Then I look in the bottom chart and see that the gold CVOL and skew, which measures UpVar vs. DownVar, both have moved with the underlying price over the last three years. As futures prices moved higher, CVOL and skew moved higher. As futures moved lower, CVOL and skew moved lower. In the last six months, as gold has broken out to new highs, both CVOL and skew have flat-lined, not participating in the move. The options market is telling me there is little demand for traders to buy options on this move. Another data point that may say I should fade the move.

As I went through the charts on gold this week, there were several reasons I wanted to fade this move in Gold futures. I looked at all of the typical reasons given for why gold should move higher and the relationship has simply broken down in the last 18 months. Gold moved higher in spite of all of these other drivers suggesting it should move the opposite way. Recall the notions that suggest gold should be lower and not higher: central bank balance sheets, real interest rates, inflation and various risk measures. Supply and demand do not tell me gold should be moving higher and ETF flows have only started to pick up. Sure, I see the inverse relationship to the dollar, which has been weak lately, but it has hardly broken down into a new range as gold has broken out.

The chart looks like a trend higher, but it is very unique to see an instrument that is overbought on the daily, weekly and monthly charts. This is a big yellow flag to me. I couple this with a COT report where managed money is longer futures than at any time in the last five years, the fact the options market is just not buying this move and my contrarian antennae are up. The CVOL index tells me volatility does not look that expensive and the skew measure suggests that downside options on a relative basis do not look that bad. I put this all together to come up with a defined risk way to fade the move in gold.

While there is tremendous liquidity in the daily and Weekly options in gold, many of the drivers I have mentioned might take some time to play out. In addition, I thought it would make sense to look out past the U.S. election, into which traders might see some demand for options of all types, to accumulate some long options that do not seem to be over-priced. I wanted to find an idea that is net long options and defined risk, but that doesn’t just sit on long theta. All of these ideas point to a put butterfly, but if gold starts to move lower, I fear it may not stop at any given strike. Thus, I am willing to pay some premium to give me possible gains even if markets blow through the downside strike. 

The idea I came up with is called a split-strike fly. It is an asymmetric butterfly, but usually when traders hear that, they think that the lowest strike is further away as a way to reduce cost more. I am willing to pay more because I want to make money if markets go  lower, even if my base case scenario is that gold will drift lower and stay sideways, the way traders have seen it work off overbought conditions in the past. I propose buying one November 2625 put, selling two of the 2575 puts and buying one of the 2550 puts. The net cost to me is 12.5 ticks. The breakeven for the trade is 2612.5 and below that level I make money regardless of how low it goes. The maximum P&L is at the short strike 2575. Anywhere from 2550 and lower I will make 12.5 ticks. If it continues to move higher, my maximum risk is the premium paid of 12.5 ticks. 

Gold is a hot commodity these days, but prices may not be driven by fundamentals. It is difficult to fade these types of moves but if traders step back and use the option market to their advantage, they may potentially find defined risk/reward opportunities that may fit their views well. 

Good luck trading!

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