Gold ix is sold to counter the oil price shock – but no amount of margin demand can handle physical shortages.
The time we have all been wondering about has arrived. Oil has risen above $100 a barrel and the markets are facing serious problems. When I he wrote In the initial reaction to the Iran war last week, markets were still pricing in the open “nothing to see here” environment.
With the global governance system faltering and institutional checks lacking, I wrote that markets may now be the only force left to impose sanctions. Think of the markets as a forum that should approve the continuation of the war – except this forum cannot be easily bought.
US officials, of course, still downplay the killings (in the markets, that is – the killings in Iran are a source of pride). President Donald Trump called the increase in oil prices a small price to pay for security, while US Energy Secretary Chris Wright said the recent rise in oil prices reflects a temporary situation. “Fear Premium” and the predicted price will drop again in a few weeks.
Maybe they are right, but the whole thing starts with Ceausescu’s last speech on Palace Square. Sometimes history moves very quickly and the language of ‘temporary fear pay’ ends up sounding very silly.
The price of Brent oil reached as high as $119 a barrel on Sunday night before returning slightly lower after it was reported that G7 finance ministers would discuss releasing petrol reserves. Reports said there could be a release of 300 million barrels. This would be a large release by historical standards but not enough to deal with sustained shortages. Also remember that the world uses about 100 million barrels every day.
Crude oil prices have now risen by about 50% since the US and Israel began their strike. JP Morgan was widely mocked for his prediction that oil would reach $130 a barrel, but if things continue as they have been this will end up looking overly conservative.
At the same time, many people are surprised that all this chaos has not caused the price of gold to rise. In fact, gold was down more than 1% by around 10:00 GMT on Monday. This is due to predictions that a wave of inflation caused by rising energy prices will force central banks (ie the Fed) to hold interest rate cuts, thereby boosting the dollar and reducing interest in non-yielding gold.
I know we’re used to seeing central bank rate policy as having the appeal of big stars, but does anyone believe that, in the midst of a major crisis and uncertainty about what’s to come, that bets on interest rate cuts actually drive price action? The movement of gold actually has a very bad smell loved by the forced behavior of liquidation. When peripherals start coming (and they certainly do), dealers sell what they can, not what they would prefer. Gold is one of the most liquid assets out there, which means it is often unloaded when losses elsewhere need to be covered.
In the meantime, here are some interesting ideas. The Chicago Mercantile Exchange (CME), the largest commodity exchange in the world, has been reported elevated Marginal demand on oil and fuel products while decreasing on gold and silver. When you trade futures, you don’t pay the full value of the contract. Instead, you print the amount, which is only part of the contract value. Let’s say you buy $100k worth of oil futures; you might need to post $10k on the side, for example. This allows you to manage $100k of fuel and $10k. When margin requirements are tightened, traders must put in more money to hold the same position. Brokers often reduce positions as a result. This may result in cold volatility or speculation.
Increasing the quantity demand on oil increases the cost of speculating on oil futures. Accordingly, the dilution of gold and silver allows traders to take large positions in these equally capitalized assets.
Now to be clear, an increase in volume is generally an automatic risk response and not an attempt to steer the market towards some big outcome. These are generally technical exchange decisions tied to risk and volatility management structures.
But other analysts see a deeper, more interesting mechanism at work, which, even if exaggerated, highlights an important idea. Luke Gromen, for example, he said: “This looks like they are trying to let gold be a release valve for the coming oil inflation. If so, this would be good IMO, because if gold hits $7,000, nothing will happen…but if oil hits $130, all hell will break loose globally.”
The point Gromen makes is that if the oil boom explodes, prices can rise sharply and cause real economic damage: gasoline prices go up, transportation costs go up, food prices go up, inflation goes up. But what happens if gold rises to, say, $7,000 an ounce? There really aren’t many immediate real-world effects. Indeed, jewelry is becoming expensive, gold investors are getting rich, and central banks are holding large gold profits. But everyday life doesn’t change much.
There likely isn’t some kind of conspiracy where the people running CME get a tap on the shoulder about fiddling with margin requirements. Think of it more as a matter of incentive alignment. Exchanges like CME are neutral in the sense that they don’t care about market volatility. They are part of the system and depend on that system.
When markets are geopolitically stressed, capital needs somewhere to go. If there are going to be panic-driven capital moves, it’s better for that capital to go into gold than into oil because the big consequences are so small. In this sense, gold can act as a pressure valve for geopolitical panic.
How the combination of risk management models, volatility indicators, and human understanding of the dangerous real-world connections of instability in CME is beyond my pay grade, but it would make sense for institutional mechanisms to lean on system stability as a mosquito moves unconsciously into the light.
Currently, gold is being sold to absorb the oil shock – a state of affairs necessitated by the harshness of the market’s actions in recent days. From the point of view of keeping the whole system going, however, gold should absorb the oil shock through a different mechanism: money should plow into gold as an escape valve on the idea that markets can absorb higher gold prices more easily than a random oil shock.
The problem, of course, is that we can get an irregular fat shock. No amount of margin demand manipulation can handle physical shortages.
Ultimately, the global economy cannot sustain a sustained period of high energy prices without plunging into recession – or worse. And the money that will be printed to deal with the recession (what else would they do but print money?) will be where the real inflationary bomb is being sneaked.
