Why Did Gold Plummet Last Week?

The glee was palpable in the air as financial commentators pointed to gold’s 9% drop last week. The sub-text of their observations was: didn’t we tell you that gold has no inherent value and that its price has only been catapulting higher because of a coterie of momentum chasers and central bank hating doomsters?

Before rashly concluding that a bubble has been popped, let’s see if we can put gold’s move into context and determine why its price plunged. Over its current twelve year bull run, gold has suffered three significant corrections: the spring of 2006, mid-2008 to early 2009, and Dec.2009-Feb. 2010. Respectively, gold fell 25%, 34%, and 15% from prior highs during these three periods. Currently, gold is off 15% from the September 5 high of $1920. So the latest price action is well in line with previous counter-trend movements. From a technical analysis perspective — that is, from a standpoint that focuses on price patterns alone — there’s nothing here to necessitate the conclusion that  gold’s upward trajectory is finished.

Which brings us to the fundamental drivers of the gold price, to wit, the complex of financial, economic, and political factors affecting demand and supply. One explanation that’s being put forward is that hedge funds having to make up for losses on stocks and commodities were compelled to take profits in their gold positions. This makes some sense, for we also saw this dynamic at work during the height of the financial crisis in 2008. Back then, higher quality shares and bonds were being hit hard as fund managers sold them to meet margin calls precipitated by their losing sub-prime mortgage trades.

Still, given the rapidity and extent of the drop, such portfolio adjustments can only partly explain what happened to gold. A more complete account must take into consideration that gold has been a play on both deflation and inflation. To use the language of options trading, gold is a straddle  — which is to say, it’s become a wager on the ultimate realization of one of two opposing, extreme scenarios. The value of this type of bet depends on the likelihood that either of the extremes, rather than a more normal condition, will occur.

Last week, the probability of the inflationary outcome declined as the prospects of an economic slowdown grew. The latter was reflected  in the drop of commodity prices. At the same time, the chances of a deflationary spiral that brings down Europe’s financial system lessened somewhat, especially towards the end of the week when signs emerged that the EU was going to augment its rescue fund. Together, these portend a world in which Europe’s banks continue to hold up on life support, but lend little. The money supply neither implodes nor explodes.

One can justly doubt whether this kind of  middling scenario is a tenable foundation out of which an enduring fix to our economic ills can be achieved.  For this reason, it’s too early to write off gold.

7 Responses to “Why Did Gold Plummet Last Week?”

  1. Jeremy says:

    Precisely George. CME is just defending the viability of the contract – nothing nefarious here, they do this kind of stuff all the time.

    More to the point, markets are emotions, irrational and prone to large dislocations. It is difficult to pin a move on one or two things – unless you are a central banker and have the esteemed wisdom of the ages :)

  2. George Bragues says:

    As Peter Tenebrarum points out in his The Acting Man blog, the margin requirements were a response to the move down in gold, not the cause:

    To this we want to note that the increase in margins on gold, silver and copper futures by the CME was not the reason for the decline, but its consequence. Consider for instance that at one point on Friday, the gold contract was down by $114. At that point a buyer on Thursday's close would have had a 'paper loss' of $11,400 per contract. However, before Friday, the initial margin per gold contract was only $9,450, with the maintenance margin at $7,000. Obviously, at the low point, more than the initial margin of our putative buyer would have been wiped out. In that sense, Friday's margin increase to $11,450 initial and $8,500 maintenance margin is probably insufficient.

    Here is the link

  3. Jeremy says:

    I have to disagree here with Bill. As per my post in the Chicago Merc post I think this move in gold has more to do with weak charts and search for liquidity by margin clerks in the face of puking equities and shakeup in fixed income. During these moments of liquidation in other markets, gold can be badly beaten up simply because it is a liquid asset which can be readily sold for meeting margins. Nothing fancy just a search for cash to cover margins.

    To the other point, the charts were a bit overstretched and some health from a technical standpoint needed to return to the market.

    Ultimately I agree with George's conclusion….got gold? :)

  4. Bill Baerg says:

    On Friday, September 23, the Chicago Mercantile Exchange hiked margins on gold, silver, and copper. The metals crashed.

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