GC: Gold Reaches Record High on Hope of Fed Rate Cuts

COMEX_DL:GC1!   Gold Futures
COMEX: Gold Options ( GC1! )
Gold prices rallied to an all-time high on Friday.

Spot gold climbed 1.6% to $2,069 per ounce, up 3.4% for the week. Gold price rose to $2,075 mid-session to beat the previous record of $2,072 reached in 2020.

U.S. gold futures also broke new ground. The February 2024 contract of COMEX gold futures settled at a record high of $2,089.7, up 1.6% for the week. On Friday, gold futures trade volume was 259,889 lots, with open interest standing at 498,685 contracts.

Options on the COMEX gold futures also attracted investor attention. On Friday, total options volume was 92,906, up 112% from the prior day. Open interest was 806,297 lots.

For the lead February 2024 contracts, investors bought 19,565 call options and 6,894 put options. A call-to-put ratio of 2.83:1 indicates that investors are very bullish on gold.

Gold prices have been pumped up on investor hype that the Federal Reserve may have completed its monetary tightening policy and could start cutting rates as early as March. How high could gold price go?

Since last year, I have written extensively about gold on TradingView. Let’s revisit the fundamental drivers of the global gold market.

Gold as an Inflation Hedge
Gold has historically been an excellent hedge against inflation because its price tends to rise when the cost-of-living increases.

The US CPI Index has a base value of 100 set at 1982-1984. Its latest reading in October is 307.7. Over the last 40 years, the cost of US goods and services has tripled on average.

The year-end gold price between 1982 and 1984 averaged $378. As of Friday, the bullion gained 447% for the same period. Over the long run, investing in gold does beat inflation.

Gold as a Precious Metal
As a commodity, gold is negatively correlated to the US dollar. Since gold is priced in dollar, a strong dollar raises the cost for foreign investors who must pay more with weakened foreign currency. This reduces the demand for gold. “Strong Dollar, Weak Commodities” is the general theme in global commodities market, gold included.

A closely related theme is “Higher Rates, Lower Prices”. Higher interest rates and Treasury bond yields raise the opportunity cost of holding non-yielding gold. Unlike other commodities, gold is not consumed or used up every year. Therefore, gold mining output is not a major factor in the pricing of gold.

Gold as a Safe Haven Investment
Gold retains its value in times of both financial chaos and geopolitical crises. People flee to its relative safety when world tensions rise. During such times, gold often outperforms other investments. In the past two decades, gold price peaked during the 2008 financial crisis, the 2010 European debt crisis, the 2018-19 US-China trade conflict, the outbreak of COVID pandemic, the Russia-Ukraine conflict, and the March 2023 U.S. bank run.

Gold as an Investment Class
As an investment class, gold competes for investor money along with stocks, bonds, cryptos and money-market funds. Even at record high, gold gained only 13.2% year-to-date, underperforming S&P 500 (+19.6%), Nasdaq 100 (+46.4%) and Bitcoin (+136.0%).

A False Narrative on Monetary Easing
The recent rise in the stocks and gold is largely shaped by the changes in market sentiment. Investors believe that the Fed is shifting gears from restricted to easing policy.

Looking back in the past two years, market sentiment might not be the most reliable gauge of the Fed’s next step of action. The market has called for the Fed Pivot prematurely and incorrectly multiple times. We will need to wait and see what’s happening next.

In his speech at Spelman College in Atlanta on Friday, the Fed Chair said that “the risks of under- and over-tightening are becoming more balanced,” but the Fed is not thinking about lowering rates right now.

Investors focus on the current rate well into restrictive territory, but pointedly ignore the warning that it was premature to speculate on easing rates. The confirmation bias is at work here. They hear what they want to hear and create a new narrative that rate cuts will come sooner.

Pricing in 5-6 rate cuts in a year is very aggressive. The Fed Chair has been accused of being too late to act, seeing inflation transitory earlier on. When it comes to cutting rates, the Fed would be very cautious, and at a very slow and measured pace.

Trading Opportunities with Gold Options
Market fundamentals haven’t changed. Market sentiment, however, has shifted.

The aggressive rate-cut assumption has the effect of lowering the expected interest rates. This helps raise the present value of future cash flows. Hence, stock value goes up.

Lower bond yield reduces the disadvantage of holding the non-yielding gold, and the US dollar weakening makes gold more attractive to foreign buyers.

This bull market is vulnerable. If investors adjust their rate-cut assumptions from 5-6 to 2-3 times, the market could turn nosediving.

However, investors set their sight on rate cuts and will not abandon it until the fact rejects the false narrative. Gold has a so-called “Santa Claus rally” and could continue for a while.

The Fed Chair’s statement could become more convincing if:
• Nonfarm payroll stays strong (December 8th)
• CPI stops falling (December 12th)
• The Fed keeps rate unchanged and emphasizes on fighting inflation (December 13th)

Options on COMEX Gold Futures (GC) could be a cost-efficient and risk-mitigated way to express one’s opinion on how quickly the Fed would cut rates.

Each options contract is based on 1 futures contract and has a notional value of 100 troy ounces of gold. At $2,089.7, each contract is worth $208,970.

For illustration purpose: For the February 2024 contract, an out-of-the-money (OTM) call at 2190 ($100 above futures price) is quoted at 18.80. To acquire 1 call options requires an upfront premium of $1,880 (= 18.80 x 100 ounces). An OTM put at 1990 ($100 below futures price) is quoted at 9.00. To acquire 1 put requires an upfront premium of $900 (= 9.00 x 100 ounces).

Options premium is significantly lower than futures margin, which stands at $7,800 per contract. It’s a fraction of the cost if you were to buy 100 ounces of gold in the spot market.

If the trader buys a call and gold futures goes up, his account will increase in value. Unlike investing in spot gold or gold futures, the payoff in options is nonlinear, determining by the Black-Scholes option model. Similarly, when the trader buys a put and gold futures declines, he would also make a profit.

On the flip side, the trader could lose money if the market moves against him. But the maximum loss is capped at the upfront premium.

Happy Trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/


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