Gold Breaks Character

After the payrolls report released on Friday turned out to be 'stronger than expected', the gold market initially duly sold off. The release of the jobs data has regularly provided short term pivot points for the gold market. This actually makes little sense, because they data will be revised several times. Even if they were painting a correct picture, they would represent a lagging indicator of the economy, which makes them largely useless for economic forecasting purposes. However, the market still regards the data as important due to the Fed's impossible 'dual mandate'. 

The superficially strong jobs report released on Friday must be taken with a grain of salt anyway: e.g. the household survey showed a loss of 75,000 jobs compared to the 288,000 gain in the establishment survey, while the participation rate continued to collapse. The latter is highly unusual in a 'recovery' (see Mish's regular write-up for details on the data).

Anyway, something odd happened after the initial Pavlovian sell-off: first gold regained the lost ground, then it embarked on a strong rally. The silver market mimicked this behavior, with a slight twist – it didn't dip below the previous day's low before reversing. Below are 20-minute charts of spot gold and July silver illustrating the action:

Spot gold, 20 minute candles: a knee-jerk sell-off after the release of strong payrolls data turns into a rally as the trading day progresses – click to enlarge.

The action in July silver was very similar, note however the divergent lows (silver made a lower intra-day low relative to gold on Thursday, and a higher one on Friday) – click to enlarge.

Precious metals shares failed to dip much below Thursday's close in the first half hour of trading, thereby signaling that market participants didn't expect the initial sell-off in the metals to stick:

HUI, 5 minute candles: the index only dipped slightly below Thursday's close before embarking on a rally – click to enlarge.

The Unclothed Emperor

We have a 'pet theory' which we have discussed in some detail on previous occasions (e.g. when gold broke above short term resistance in mid February: scroll down to 'gold's message').  In brief: when the euro area's sovereign debt crisis began to calm down, the gold price lost the risk premium attached to this particular almost-catastrophe. Later on it appeared to begin to discount expectations of a strengthening of economic activity in the US and the euro area and a coming tightening of the Fed's monetary policy.

Gold has historically often discounted certain events far in advance (the lead times are variable, but very long lead times could be observed on several occasions). It seems therefore reasonable to assume that it may now be in the early stages of discounting the eventual outcome of tighter monetary policy (obviously, the outcome will be another bust). 

Market participants no doubt expect that central banks will reinstate extremely aggressive monetary pumping once the next bust begins. However, it is possible that unexpected complications will be encountered. Central banks may find it difficult for the same tricks to 'work' again as intended. Confidence in central banks has probably never been higher than it is today. It is so high that it likely represents a contrary indicator. Should faith in the ability of central banks to 'steer' the economy and financial markets toward desired outcomes falter, the gold market would get a very strong lift. Gold is the only form of money that is independent of people's faith in the monetary authorities or faith in government more generally. In fact, its price is as a rule inversely correlated with said faith.

Central banks are powerful, but they are also one-trick ponies. All they can ultimately do is debase the value of the money they issue ever more. If one thinks about their activities solely in these terms, one wonders why they exist at all. Central economic planning is bad enough, but given that the planning in this case leads to nothing but more monetary debasement, it seems absurd that anyone would have even a shred of confidence in it.

Thinking about this further, it seems actually likely that the 'strong confidence' in the omnipotence of central banks is really little more than an example of wishful thinking. Most market participants are a bit like Fox Mulder with regard to that: they want to believe. They want to believe because they know that once they stop believing, all hell is likely to break loose.

In short, the emperor has no clothes – a fact that still awaits discovery by a critical mass of economic actors, but a fact nonetheless.

The Technical Situation

Looking at the daily charts of gold and silver as well as the gold stocks, more signs have emerged that indicate that the recent pullback is probably over. Confirmation in the form of overcoming short term resistance is still lacking, but the most recent lows have exhibited the types of divergences that are typically seen at short term turning points.

Gold and silver, daily: diverging with RSI, as well as with each other at the most recent lows. Long-tailed candles are indicative of strong buying interest in the lateral support zones – click to enlarge.

The HUI index of unhedged precious metals stocks is still held back by its 200 day moving average. However, the 61.8% retracement level has been tested successfully twice and the second test occurred in the context of an RSI/price divergence as well as a divergence between the index and the HUI-gold ratio. This combination is fairly regularly encountered at turning points, both of the short and medium to long-term variety (the longer term divergences were put in place last year already):

The HUI, daily: testing the 61.8% retracement level of the most recent rally a second time amid typically seen divergences with RSI and the HUI-gold ratio – click to enlarge.

Sentiment Data

There has been one change on the sentiment data front that looks noteworthy. So far, there has been no change yet in the Rydex precious metals fund data (they remain at the most subdued level in 12 years) and the positive divergence between the gold price and the 'public opinion' indicator (an average of several sentiment surveys) so far remains in place. However, there has been a sudden sharp decline in the discount to NAV of closed end bullion funds such as GTU and CEF (we show only GTU below, but the picture in CEF is very similar). Such sharp reductions in the discount to NAV have occurred just prior to short term rallies in the recent past.

The bullish case would be supported further if a change in sentiment occurred in terms of the Rydex and survey data as well, as long as the change is not too abrupt. Note that the cumulative cash flow ratio of the Rydex pm fund (not shown below) has not gone to a new low, so there remains a positive divergence in place in terms of that particular indicator.

The Rydex precious metals fund: the level of assets and the percentage these assets represent of all Rydex bullish sector assets remain near the lowest readings in 12 years – click to enlarge.

Gold, public opinion (several prominent surveys averaged) – a long term and a recent short term divergence with price – click to enlarge.

GTU's discount to NAV has just contracted sharply. This has tended to happen shortly before rallies got underway in recent times. A similar phenomenon can be observed in CEF (GTU holds gold bullion, CEF both gold and silver bullion). This appears to be a useful short term indicator – click to enlarge.

Bond Market

Lastly, the bond market has exhibited a similar reaction to the payrolls data as the gold market. Evidently, bond market participants continue to see the glass as half-empty, and this assessment couldn't be shaken by the strong payrolls report. In other words, the bond market seems to confirm the gold market's message – there is apprehension about the economy in light of the Fed stepping on the 'QE' brake. 

10 year note and 30 year bond yields: after rising initially on Friday, both fell to new lows for the move – click to enlarge.

Conclusion:

It looks like the gold sector could be in for additional short term strength, but additional confirmation of a trend change is still required (gold, silver and precious metal shares all still need to overcome short term resistance levels). This would further support the idea that the market is in a drawn-out bottoming phase and not just a consolidation in an ongoing downtrend. We continue to believe that this is indeed the case.

In the longer term, the markets will have to deal with the fact that monetary debasement is a very poor policy indeed – and yet, it is the only tool central banks have at their disposal. Having some insurance in the form of gold will be essential once a critical mass of market participants recognizes that the emperor has no clothes.

Charts by: stockcharts, sentimentrader, decisionpoint, barchart.com