The dovish Federal Reserve lit a fire under gold and its miners’ stocks this week.  As universally expected the FOMC hiked rates for the 9th time in this cycle.  But it also lowered its 2019 rate-hike outlook bowing to the stock-market selloff.  Traders dumped gold initially thinking that wasn’t dovish enough.  But market reactions to the FOMC formed over a couple days, and gold surged overnight.  Its post-Fed rally has great potential.

Gold-futures speculators dominate gold’s short-term trading action.  They punch way above their weight in capital terms thanks to the extreme leverage inherent in gold futures.  This week, the minimum margin for trading each 100-ounce contract controlling $125,000 worth of gold at $1250 was just $3400!  These traders can run crazy maximum leverage as high as 36.8x, compared to the stock markets’ legal limit of 2x.

At 10x, 20x, or 30x leverage, every dollar of capital deployed in gold futures has 10x, 20x, or 30x more price impact on gold than a dollar invested outright.  Further compounding speculators’ hegemony over gold prices, gold’s world reference price derives directly from US gold-futures trading.  Naturally extreme leverage means extreme risk.  At 37x a mere 2.7% gold move against positions wipes out 100% of capital risked!

In order to survive, gold-futures traders are forced to have an ultra-short-term focus.  Their time horizons are measured in hours, days, and maybe weeks instead of months and years.  And there is nothing that motivates them to trade aggressively like meetings of the Fed’s Federal Open Market Committee.  Gold volatility often surges in their wakes, as speculators watch the U.S. dollar’s reaction and do the opposite in gold.

Gold-futures speculators are convinced Fed rate hikes are bearish for gold because they are bullish for the US dollar.  They logically reason that the higher prevailing US interest rates, the more attractive the US dollar becomes relative to other currencies.  And a stronger dollar usually means weaker gold since they are competing currencies.  That all sounds rational, but the big problem is history doesn’t bear this out.

The FOMC started today’s rate-hike cycle way back in mid-December 2015, raising the federal-funds rate for the first time in 9.5 years.  Gold-futures speculators fled leading into that, ultimately crushing gold to a deep 6.1-year secular low of $1051 the day after.  But that oversold extreme marked the birth of a new bull market that would catapult gold 29.9% higher over the next 6.7 months!  That same bull persists today.

In the 3.0 years since which includes this week’s 9th Fed rate hike of this cycle, gold is still up 18.1% and the US Dollar Index is down 2.1%.  That’s no anomaly either.  This is actually the Fed’s 12th rate-hike cycle since the early 1970s.  During the exact spans of the prior 11, gold averaged strong gains of 26.9%!  That was an order of magnitude higher than the stock markets’ 2.8% average gains per the flagship S&P 500.

Gold-futures speculators either don’t know market history or their extreme leverage forces them to run as a herd no matter how irrational that stampede is.  They can’t afford to be wrong for long or risk suffering catastrophic losses.  This week they apparently expected the FOMC to prove even more dovish on future rate hikes than it was.  That led to volatile gold action surrounding this latest critical Fed decision on rates.

The FOMC meets 8 times per year, about every 6 weeks.  But up until now, only every other meeting was accompanied by a Summary of Economic Projections and followed by the Fed chairman holding a press conference.  That meant the Fed was only “live”, likely to hike rates, once a quarter at that every-other meeting.  Incidentally Jerome Powell will start holding press conferences after every meeting starting in January.

That decision was made in mid-June, it had nothing to do with the recent stock-market volatility.  Since the Fed doesn’t want to spook traders and ignite selloffs, rate hikes are well-telegraphed in advance.  3 weeks after each FOMC meeting, its full minutes are released.  They are long and detailed, offering all kinds of clues about whether top Fed officials are thinking about hiking rates at the next FOMC meeting.

Market-implied Fed-rate-hike odds are always available through federal-funds futures trading.  The big wildcard at each live FOMC meeting is a part of the SEP known as the “dot plot”.  It collates where each individual top Fed official personally expects the federal funds rate to be in each of the next several years and beyond.  It’s literally a bunch of dots plotted on a table, hence the name.  It can really move gold futures.

Though Powell and other FOMC members stress the dot plot is not an official rate-hike forecast or outlook by the Fed, traders universally use it as such.  A hawkish dot plot implies more future rate hikes than the previous one, and dovish less.  Gold, currency, and stock-index futures speculators trade aggressively based on the quarterly changes in the dot plot.  FOMC statements and press conferences also play roles.

At the FOMC’s previous meeting accompanied by a dot plot in late September, those forecasts implied top Fed officials expected this week’s rate hike, another 3 in 2019, and 1 final one in 2020.  But market conditions were way different then.  That decision came just 4 trading days after all-time record highs in the lofty euphoria-drenched U.S. stock markets.  Top Fed officials are boldly hawkish when stocks look awesome.

In early October Powell doubled down on this hawkishness, saying in an evening speech that the federal-funds rate was “a long way from neutral at this point, probably” and that “We may go past neutral.”  The very next day the stock markets started sliding and haven’t looked back since.  By this Monday that selloff had gradually mushroomed into a moderate 13.1% correction in the S&P 500.  Many blame it on Fed hawkishness.

Facing withering criticism led by president Trump himself, Powell tried to walk back his own many-more-rate-hikes-to-come outlook in late November after the S&P 500 had passed the 10% correction threshold.  Powell said “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy…”  Stock selling was softening the Fed.

While traders fully expected the rate hike of this cycle Wednesday, they were sure the dot-plot outlook of future rate hikes would be far more dovish than late September’s 5 including this week’s.  Gold rallied nicely in anticipation, climbing from $1214 before Powell’s second speech to $1249 the day before this latest FOMC meeting.  In the hours before this new dot plot’s release, gold was bid to a new upleg high of $1261.

Market expectations were for just 1 rate hike in 2019 compared to the previous 3 implied, followed by an actual rate cut in 2020!  That seemed excessive, so I figured top Fed officials would kill one of the hikes next year leaving 2 in 2019 and remove 2020’s lone hike as well.  While this latest dot plot was indeed dovish as expected, it wasn’t dovish enough.  2019’s outlook shrunk to 2 more hikes, and 2020’s kept that final one.

So instead of going from 4 future hikes down to 1 or 2 as hoped, the dot plot only retreated from 4 to 3.  Both dollar-futures and gold-futures speculators expected more dovishness, leading to moderate gold selling after the dot plot.  Gold fell from $1251 just before its release to $1242 a couple hours later, and closed 0.6% lower on the day.  Stock markets fared worse, the S&P 500 falling 1.5% to a new correction low!

But the impact of FOMC decisions usually takes a day or two to settle out.  They are released at 2pm New York time when Asian and European markets are closed.  So until foreign traders get their chances to react to the Fed, the market outcome isn’t known.  Even American traders have to get past their initial kneejerk reactions, so the next trading day following the FOMC is crucial as actual implications sink in.

Gold was slowly bid heading into Thursday in Asian markets, heading back up near $1248 by the time Europe was opening.  And then gold quickly surged to $1256, a new closing upleg high.  In U.S. afternoon trading the day after this FOMC decision, gold surged as high as $1266!  Top Fed officials’ future rate-hike outlook falling from 4 to 3 might not have been dovish enough, but it was still certainly dovish absolutely.

Seeing the Fed waver on future rate hikes in response to the mounting stock-market selloff this quarter is super-bullish for gold and its miners’ stocks going forward.  Both gold-futures speculators and normal investors remain way under-deployed in gold, with vast room to buy.  Odds are this week’s dovish FOMC will accelerate major gold and gold-stock uplegs.  That’s happened after past Fed rate hikes in this cycle too.

This first chart superimposes gold prices over the total gold-futures long and short contracts speculators hold, which are rendered in green and red respectively.  All 9 Fed rate hikes of this cycle are highlighted in blue.  Gold has often surged strongly on gold-futures buying in recent years following FOMC rate-hiking decisions, or more precisely dot-plot changes in the future rate-hike outlook.  Gold is set up to surge again.

Again, this entire gold bull was born the day after the Fed’s first rate hike of this cycle, resulting in that big initial 29.9% gold upleg over 6.7 months in essentially H1’16.  That left gold overbought so it started to correct like normal.  But that was greatly exacerbated by Trump’s surprise election victory which ignited a monster stock-market rally on hopes for big tax cuts soon.  Investors aggressively fled gold to chase stocks.

But gold bottomed in mid-December 2016 the day after this cycle’s second rate hike, and soon started surging sharply higher.  Yet gold-futures speculators didn’t learn their lesson, and continued to dump gold heading into FOMC decisions with expected rate hikes.  Gold rallied strongly immediately out of the 3rd, 5th, and 6th hikes of this cycle, and soon after the 4th and 8th.  Rate hikes have definitely proven bullish for gold!

The 7th rate hike in mid-June 2018 was a major exception.  Gold fell sharply in subsequent days as gold-futures speculators lapsed into a stunning extreme record orgy of short selling.  Initially sparked by a U.S. dollar rally, that epic gold-futures shorting soon took on a life of its own driving total short contracts to their highest levels ever by far!  That ultimately blasted gold to a deep and unsustainable 19.3-month low in mid-August.

Most of that shorting spree has been covered since, fueling most of gold’s young upleg since.  But the long-side gold-futures speculators who control much more capital than short-side guys have barely started to buy.  Short covering is legally mandated to repay the debts incurred by borrowing to short sell.  But long buying is totally voluntary, speculators have to believe gold is heading higher to make leveraged bets on it.

At the end of November the day before Powell’s about-face on how far rates were from neutral, the total gold-futures longs held by speculators had crumbled to just 204.9k contracts.  That was a serious 2.9-year low, levels last seen in late January 2016 just as this gold bull was starting to march higher.  So gold-futures speculators are nearly as under-deployed in gold as they were near the end of its last secular bear!

That leaves vast room for them to buy to reestablish normal positions.  Back in essentially the first half of 2016, speculators added 249.2k longs while covering 82.8k shorts to help catapult gold 30% higher.  It’s amazing to see similar long-buying potential today, with speculators’ total longs running just 7% up into their past year’s trading range.  We’re nearing the tipping point where short covering ignites far-bigger long buying.

Gold bull uplegs have 3 distinct stages that trigger and unfold in telescoping fashion.  They all start out of major lows with that mandatory gold-futures short covering, the first stage.  That eventually pushes gold high enough for long enough to entice long-side gold-futures speculators to return, the second stage.  I suspect this week’s dovish FOMC meeting could prove the catalyst that ignites big stage-two gold buying.

This latest dot plot may not have been dovish enough for traders, but Fed dovishness will snowball with stock-market weakness.  The lower the stock markets slide, whether or not Fed hawkishness is really to blame, the more pressure on the FOMC to slow or even stop its future-rate-hike tempo.  Gold-futures speculators will crowd into gold to chase its upside momentum with their feared rate-hike boogeyman fading.

But all the stage-one and stage-two gold-futures buying that fuels young gold uplegs is just the prelude to far-larger stage-three investment buying.  After gold’s upleg grows large enough and lasts long enough to spawn investor interest, their capital inflows soon dwarf anything the gold-futures speculators could ever manage.  There’s also precedent in this cycle for Fed rate hikes soon leading to surging gold investment demand.

A great high-resolution proxy for gold investment-demand trends is the amount of physical gold bullion held in trust by the dominant GLD SPDR Gold Shares gold ETF.  It effectively acts as a conduit for the vast pools of American stock-market capital to slosh into and out of gold.  Just a couple weeks ago I wrote an essay on how GLD works and why it is critically important to gold prices, especially during stock selloffs.

This next chart looks at GLD’s holdings superimposed over the gold price, with all 9 Fed rate hikes of this cycle highlighted.  While gold-futures trading usually dominates gold prices, it is still easily overpowered by material flows of American stock-market capital into or out of gold via GLD.  Investors have started to return to gold again on the stock-market selloff, and this prudent reallocation should accelerate on Fed dovishness.

The last time American stock investors were worried enough about stock-market selloffs to redeploy into gold for refuge was that first half of 2016.  Since gold is a rare counter-moving asset that tends to rally as stock markets weaken, investment demand soars when the S&P 500 slides long enough to ignite serious concerns.  We’re certainly getting to that point again, as worries are mounting about this latest major selloff.

Gold went from being left for dead in mid-December 2015 to surging 29.9% higher in just 6.7 months solely on American stock investors returning!  This is no generalization, the hard numbers prove it without a doubt.  The world’s best gold fundamental supply-and-demand data comes from the venerable World Gold Council.  It releases fantastic quarterly reports detailing the global buying and selling happening in gold.

Gold blasted higher on stock weakness in Q1’16 and Q2’16.  According to the latest data from the WGC, total world gold demand climbed 188.1 and 123.5 metric tons year-over-year in those key quarters.  That was up 17.1% and 13.2% YoY respectively!  But the real stunner is exactly where those major demand boosts came from.  It wasn’t from jewelry buying, central-bank buying, or even physical bar-and-coin investment.

In Q1’16 and Q2’16, GLD’s holdings alone soared 176.9t and 130.8t higher on American stock investors redeploying into gold after back-to-back S&P 500 corrections.  Incredibly this one leading gold ETF accounted for a staggering 94% of overall global gold demand growth in Q1’16 and 106% in Q2’16!  So there’s no doubt without American stock investors fleeing into gold via GLD this gold bull never would’ve been born.

Gold was holding those sharp gains throughout 2016 until Trump’s surprise presidential victory unleashed a monster stock-market run on hopes for big tax cuts soon.  Gold was pummeled in Q4’16 as American stock investors pulled capital back out to chase the newly-soaring S&P 500.  That quarter total global gold demand per the WGC fell 103.4t YoY or 9.0%.  GLD’s 125.8t Q4’16 holdings draw accounted for 122% of that!

Fast-forward to summer 2018, and investors again started shifting out of gold to chase euphoric U.S. stock markets nearing new record highs.  That forced GLD’s holdings to a deep 2.6-year low, investors hadn’t been so underinvested in gold since early in this bull market when they started flooding back in helping to catapult gold sharply higher.  That gives them massive room to buy back in since their allocations are so low.

This mass exodus of American stock-market capital out of gold via GLD ended in mid-October the exact day the S&P 500 started plunging in what’s grown into this newest correction-grade selloff!  Ever since GLD’s holdings have continued recovering on more capital inflows, helping to drive gold higher.  This trend should only accelerate as stage-two gold-futures long buying on Fed dovishness further lifts gold prices.

Investors are often as momentum-driven as futures speculators, but over much-longer time horizons.  So as this young gold upleg grows, gold is going to look much more attractive to them.  Their desire to chase its upside performance is really intensified by material stock-market weakness.  That makes gold stand out as not just a safe-haven capital-preservation hedge, but a way to grow wealth while everything else burns.

And as goes gold, so go the stocks of its miners.  Last week I wrote a whole essay detailing the imminent major upside triple breakout in gold stocks likely to be triggered by a dovish FOMC.  That indeed started to happen this week before the Fed, as this updated GDX chart shows!  The GDX VanEck Vectors Gold Miners ETF is the leading gold-stock investment vehicle and benchmark, and remains poised for massive gains.

Three major resistance zones have converged at GDX $21.  They include its 200-day moving average, past-year descending-triangle overhead resistance, and the old consolidation basing trend’s support.  In anticipation of a gold rally on a dovish Fed, GDX closed above $21 on Tuesday.  And in the hours before that FOMC decision Wednesday, it hit $21.47 intraday which was very-bullish decisive-breakout territory.

But when futures speculators bid the U.S. dollar higher and pushed gold lower on this latest dot-plot rate-hike outlook not being dovish enough, the gold stocks reversed hard.  GDX plummeted a staggering 7.3% intraday across that FOMC decision!  It closed 5.4% lower, making for absurd 9.0x downside leverage to gold’s small 0.6% Fed Day loss.  That was a wildly-irrational downside anomaly that never should’ve happened.

In trying to figure out why after Wednesday’s close, I waded through dozens of gold stocks to see if there was some adverse news besides a not-dovish-enough FOMC.  There was nothing.  But provocatively in after-hours trading soon after the U.S. stock-market close, many if not most of the gold stocks had already regained 2/3rds to 3/4ths of that day’s crazy losses!  So traders realized that kneejerk selloff wasn’t righteous.

Indeed right out of the gates Thursday GDX surged 4.1% higher erasing over 7/10ths of the extreme Fed Day losses.  Remember market reactions to FOMC decisions usually aren’t fully apparent until the entire next trading day, after the implications have sunk in and overseas traders have reacted.  Gold stocks’ major-upside-breakout thesis portending a powerful new upleg remains intact, the Fed likely accelerated it.

The beaten-down gold miners’ stocks remain the last cheap sector in the entire stock markets, a coiled spring ready to soar as gold returns to favor.  The more shorts covered and longs bought by gold-futures speculators, and the more capital investors allocate back into gold, the greater the upside the gold miners’ stocks have as gold powers higher.  Their potential gains are enormous, dwarfing anything else in 2019.

Again the last time major stock-market weakness rekindled gold investment demand was essentially the first half of 2016, when gold powered 29.9% higher.  That drove a parallel monster 151.2% gold-stock upleg per GDX, making for huge 5.1x upside leverage.  The gains in major gold stocks generally amplify gold upside by 2x to 3x, and smaller mid-tier miners with superior fundamentals tend to do much better than that.

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The bottom line is this week’s FOMC decision is very bullish for gold and its miners’ stocks going forward.  While only seeing 1 of 3 projected 2019 rate hikes axed wasn’t considered dovish enough, it still showed the Fed’s hawkish resolve is cracking.  That dovishness will mount the longer stock markets remain weak, further shortening and shrinking this rate-hike cycle.  That green lights capital returning to gold in a big way.

There is massive room to buy back in, with both speculators’ gold-futures longs and stock investors’ gold held via GLD just modestly above major multi-year lows.  Dovish Fedspeak, weaker stock markets, and higher gold prices will really motivate them to reestablish normal gold positions and portfolio allocations.  The gold miners’ stocks will be the major beneficiaries of higher gold prices, nicely leveraging gold’s gains.

Adam Hamilton, CPA

December 21, 2018

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