By Adam Hamilton
Gold’s mighty new bull market this year has been amazing, the result of heavy buying by investors and speculators alike. But these latter traders have pumped so much capital into gold futures that this metal now faces a record selling overhang. Since the hyper-leveraged nature of futures trading demands an ultra-short-term focus, speculators’ excessive bullish bets on gold pose major near-term downside risks.
Gold’s price trends are overwhelmingly dominated by global investment demand. Even though it has only accounted for about 1/5th of total demand in recent years, investment is wildly variable. With the rest of gold demand relatively stable, it is fluctuating investment demand that ultimately sets gold prices at the margin. Gold’s young bull in 2016 is largely the result of an influx of massive investment buying.
These investors are usually strong hands, expecting to hold gold for the long term as a unique and essential portfolio diversifier that moves counter to stock markets. Gold investors generally buy gold outright, or at worst using the decades-old legal limit of leverage in the stock markets of 2.0x via the leading GLD SPDR Gold Shares (NYSE:GLD) gold ETF. Thus normal short-term price volatility doesn’t spook investors into selling.
Futures speculation is an entirely different game. These traders don’t actually buy and sell physical gold, but merely the contractual rights to buy or sell it later in the future at set prices. This is a side game of pure gambling, nothing like investment. Futures speculators never have any intention of buying gold to own it, and they short sell gold they don’t own. Their world is virtual, totally divorced from supply and demand.
But unfortunately the gold-futures price set by their trading has long been considered the benchmark world gold price! The gold-futures bets speculators are collectively making as a herd not only drive but dominate most short-term gold action. Since real investors make their buying and selling decisions based on this essentially-fictional gold-futures price, futures trading has a disproportionate impact on gold.