I received considerable feedback to last week’s publication,
Ready for the Contrarian Gold Trade? I suggested that while gold remains in a long-term bull market as the market is transitioning to a hard asset cycle, gold prices are due for a multi-month period of consolidation and pullback much like the 2004–2006 episode.
Further discussions with readers prompted us to offer an alternative scenario of a shorter corrective period. Investors may not have to wait 1–2 years before the resumption of a gold bull.
Buy the Dip?
A number of gold bulls have highlighted the constructive price action of the gold mining ETF (GDX). GDX outran its rising channel in late August and peaked in October. It has since retreated and bounced off the top of the channel. The 14-day RSI fell to 40, which is an area where declines have stopped in the past. Similarly, the GDX to gold ratio neared the bottom of its Bollinger Band, and the percentage bullish on point and figure charts also fell to levels where it has bottomed before. Is it time to buy the dip?
While gold and gold miners may stage tactical rallies from current levels, I think it’s too early for a durable bottom.
Hedge America, Not Sell America
Hyun Song Shin, Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), offered a plausible explanation of the gold rally and its retreat from the perspective of USD investment positioning in a Bloomberg podcast.
Shin explained April’s sudden collapse in the USD, which is inversely correlated to gold prices, was not a wholesale “Sell America” stampede by foreigners. Instead, it was a “hedge America” trade by global institutions that many investors interpreted as a “Sell America” narrative.
To explain, imagine the example of a euro-based institution that buys a $100-million portfolio of Treasury notes and bonds. A simple long position would expose it to currency risk. The institution may choose to hedge its currency exposure, but typically it wouldn’t hedge all. The institution enters into currency swap by buying $100 million of USD on the spot market, and entering into a forward contract to sell the USD three months hence. While the average maturity of the portfolio is measured in years, such a transaction hedges USD exposure for three months. The “Liberation Day” announcement was a shock to the markets and the USD fell dramatically. Institutions were caught offside on their USD exposure and they rushed to hedge.
Shin revealed that BIS data showed USD swap volumes skyrocketed during that period. Moreover, forward contract transactions also rose dramatically. As a swap is the combination of buy spot and sell forward, this was a signal that institutions who were long USD assets panicked and tried to hedge their USD portfolios through forwards.The accompanying chart shows various indicators of the “U.S. inflation factor”, as measured by the prices of TIPs to a zero-coupon long Treasury bond, the 10s/30s Treasury yield curve, the 30-year Treasury yield and the USD Index. All rose after “Liberation Day” and peaked in the July–August time frame, and retreated shortly after.
These price patterns all led the price of gold by about a month. Arguably, these price patterns reflected the demand for hedging flows that Shin highlighted, and they led the price of gold by about a month. Investors may have mistook the hedging trade flow for a “Sell America” trade which led to a retail investor stampede into inflation hedges, like gold. When retail demand became exhausted, gold prices naturally fell.
Indeed, I pointed out last week that high trading volumes, which can be a sign of a retail frenzy, can be signals of tactical reversals in the price of gold.
Now that the correction is here, what’s next?
Waiting for Fed to Pivot
Investors are advised to monitor the possible effects of a transition in Fed policy for clues to the future direction of gold prices. The Fed’s Open Market Committee cut its benchmark rate by a quarter-point last week, which was widely anticipated.
Fed Chair Powell went on to underline the deep divisions within the Committee by emphasizing that a December rate cut is not a done deal, “In fact, far from it” and went on to emphasize the “strongly differing views about how to proceed in December”.
While the market interpreted the remarks as a hawkish cut, a new Fed Chair will be in place by mid-2026 and it’s likely the new regime will be more dovish. As a reminder, Trump ally and recently appointed Fed Governor Miran dissented on the rate decision and called for a half-point cut. While the current culture of the Fed is focused on its dual mandate of price stability and full employment, which are in conflict, the new Fed is likely to be more inclined to ignore signs of rising inflation or inflation expectations.
Consider a scenario where a new Fed Chair is announced or appointed in late Q4 or early Q1. While the market may focus on the old more hawkish Fed today, the narrative will pivot to an easier and Trump-friendly Fed in late 2025 or early 2026 and start to price in higher inflation expectations and a weaker USD. This will be gold bullish, and bond bearish.
How gold bullish and bond bearish? It depends on the composition of the Fed Board of Governors. By tradition, the old Fed Chair resigns his post as governor and the new Fed Chair assumes that post. But if Powell chooses to remain on the Board, Trump will be deprived of a friendly vote on the Board.
Even though there are too many moving parts to accurately forecast the specifics of Fed policy, the global trend in monetary policy is towards easing. If history is any guide, this should be bullish for commodity prices, and gold prices in particular.
In addition, the Fed announced that it would terminate its balance sheet run-off on December 1. The WSJ reported that Jerome Powell “in a rare speech devoted primarily to technical monetary plumbing dynamics, said the central bank could approach the point ‘in coming months’ where it needed to end the three-year-long campaign to shrink its holdings”. That’s because as the Fed began to shrink its balance sheet, otherwise known as quantitative tightening (QT), “most of the Fed’s balance-sheet runoff drained cash not from banks but from a separate deposit facility where money-market funds could park cash”, otherwise known as the overnight reverse repo (ON RRP) facility. Now that ON RRP is almost gone, further balance sheet run-offs will directly impact banking system liquidity. As the accompanying chart shows, banking system liquidity has been falling, which creates a headwind for risk assets like stocks.
The Fed’s focus on repo rates to adjust its money market plumbing procedures opens the door to a “tail wagging the dog” policy of allowing fiscal policy to control the Fed balance sheet. While repo rates are reflective of the level of stress in the banking system, they are determined by supply and demand, not just the level of bank reserves.
The overnight reverse repo facility (ON RRP) is primarily funded by a combination of money market funds and commercial banks parking their excess cash into the ON RRP for that little extra yield. The ON RRP has dwindled to nearly zero, but the federal deficit is sky high. Where will the demand come from?
The lender of the last resort is the Federal Reserve. Investors are likely to see the Fed’s balance sheet steady expansion as the U.S. Treasury’s financing demand grows. Fed Chair Powell acknowledged during the press conference that the Fed is focused on “reserves is the thing that we’re…managing that has to be ample” and “you’ll want to start reserves to start gradually growing to keep up with the size of the banking system and the size of the economy”. In other words, the end of QT will eventually have to turn into balance sheet expansion, or quantitative easing. Investors will interpret QE as raising inflation expectations, which will be bullish for gold.
In conclusion, gold is in a long-term bull but it’s experiencing a pullback. I offer a plausible scenario that explains the recent surge and correction in gold. The market misinterpreted the “Liberation Day” USD decline as a “Sell America” trade instead of a “Hedge America” trade and panicked out of USD and rushed into gold. The downward pressure on the USD is being unwound and gold eventually retreated. I expect a bottom in gold in Q4 or Q1 as the new Fed Chair pivots monetary policy in a more expansionary manner.
