Euphoric Dollar Slams Gold
The comments below are an edited and abridged synopsis of an article by Adam Hamilton
The higher US dollar has slammed gold, hammering it into a serious technical breakdown. But a major reversal is imminent in the overbought dollar, which will catapult gold higher.
Gold is driven by investment demand and gold-futures speculation. Investment capital flows are much larger and ultimately more important. But because of the extreme leverage inherent in gold futures, speculators punch above their weight in influencing gold price action. They dominate gold when investors are missing in action. And the dollar’s fortunes are their main trading cue.
Each gold futures contract controls 100 ounces of gold, worth around $180,600 right now. But traders are only required to maintain $7,200 cash margins for each contract traded. That makes for maximum leverage of 25.1x, over an order of magnitude greater than the 2x legal limit in the stock markets. At 25x, each dollar traded in gold futures has 25x the gold price impact of a dollar invested outright.
That kind of leverage is risky, as a mere 4% move against speculators’ bets wipes out 100% of their capital risked. Always facing ruin, these traders’ time horizons are forced to be ultra-short term. They only care what gold is doing in coming hours or days, and that extreme leverage-necessitated myopia often leaves gold inversely slaved to the dollar.
The leading dollar benchmark is the US Dollar Index, now dominated by the euro, which commands 57.6% of the USDX’s weighting. The yen, pound and Canadian dollar are less consequential at 13.6%, 11.9% and 9.1%. Normally the US dollar meanders, but recently it has soared in a monster rally.
So US dollar euphoria just slammed gold. Currency traders rushed into an overcrowded long-dollar trade to chase upside momentum. That catapulted the US Dollar Index to unsustainable overbought levels. New dollar highs spooked gold futures speculators into dumping contracts, hammering gold into deeply oversold territory.
But such technical extremes can never last long, and will soon reverse sharply. The likely catalyst is Fed hawkishness moderating on weakening US economic data. That will ignite USDX selling, which will bludgeon it sharply lower. Gold futures speculators will be forced to buy to cover their shorts, catapulting gold higher.