The Silver Flash-Crash - "There's No Such Thing As A Bad Tick"

Authored by Kevin Muir via The Macro Tourist blog,

It’s one of those periods when everything is conspiring against precious metals. For those of the bullish persuasion, this can be a difficult time. I have resorted to wearing my own self-imposed “cone of precious metal trading” in an attempt to stop me from buying too much, too early.

Let’s review why this environment is so problematic for gold and silver. The main reason is that the global backup in interest rates is about the worst thing you could ask for. Think about it for a second. Central Banks are signaling they want tighter monetary policy because they are worried about future inflation running too hot. They are in essence behaving marginally more prudently. For all those hard money advocates that have been railing against irresponsible Central Banks, they now have less to complain about. Gold has often been called the anti-Central Bank asset, and although many would argue Central Bank policies are still a long way from appropriate, trading is all about the direction of change, and there can be no denying that Central Banks are becoming more hawkish, not the other way round.

Central Banks are sending real rates higher. In the process, they are sucking money out of precious metals, and into short dated fixed income securities. Look at US 5 year TIPs yields - they are pushing to new highs.

In fact, given the relationship between US 5 year TIPs yields and gold, it looks like our little yellow friend could still be vulnerable to further declines.

Although this global backup in yields is the main factor weighing on precious metal prices, there is another more complicated dynamic at play.

And I think this relationship had something to do with last night’s silver flash crash.

Last night at 6 o’clock, someone wandered into the silver futures pit and sent silver down almost 11% almost instantaneously.

At first, I thought someone fat fingered it. But when the bounce was weak, it quickly became obvious that no one needed to buy back their error.

We had a saying on our old trading desk - “there is no such thing as a bad tick.” What we meant with that expression was that if the market allowed a seemingly violent tick to occur, it often indicated this was the path of least resistance. Many times that supposedly bad tick would be traded legitimately in the coming sessions.

It is my understanding the CME ruled yesterday’s silver flash crash excessive, and repriced all trades below $15.45 to this more fair price. Well ironically enough, although last night silver bounced back to $16, this morning in the aftermath of the flash crash, silver traded down below last night’s adjusted low, proving once again, there is no such thing as a bad tick.

But this doesn’t explain why someone would choose to sell a whack of silver futures at 6pm. It wasn’t like it was a badly traded 100 lot. More than 6,000 futures traded. Why on earth would anyone need to sell almost half a billion dollars of silver at the most illiquid time of the day? It almost makes me sympathetic to the tinfoil hat wearing precious metal bulls who are convinced governments are nefariously conspiring to keep gold and silver down.

However, I am an ardent subscriber to the Hanlon’s Razor theory of trading - never attribute to malice that which is adequately explained by stupidity. I don’t think governments are trying to keep precious metals low for some nefarious reason, but I do believe that they are involved.

And the following explanation might move me into the tinfoil hat crowd, but I have watched the strong relationship between the Yen and precious metals for too long to believe it is a coincidence. Somehow, and I am not sure of the exact details, the Japanese government is using precious metals as part of their monetary policy. Now they might be doing it through the Postal Service Pension plan (GPIF) - after all, they have openly admitted to the BoJ buying JGBs from the plan, and the postal service pension investing in foreign stocks with the proceeds. There might be some sort of similar arrangement with precious metals. Who knows? I certainly don’t, but I just don’t believe this tight relationship can be explained by chance:

I also think that government officials are the only ones price insensitive enough that they are willing to transact monstrous size at 6pm.

But here is the kicker as to why I believe this order somehow emanates out of Tokyo. The 6pm silver flash crash coincided with the opening of the Japanese bond market.

That in of itself is not that insightful. But yesterday with the global rout in bonds pressuring JGBs, the 10 year bond bumped up against the BoJ’s 0.10% ceiling. Don’t forget, whereas most Central Banks engage in quantitative easing where they commit to buying a certain amount of bonds at any price, the BoJ has moved to pegging the long end of the yield curve.

This means they have to theoretically buy an unlimited amount of bonds at that rate to ensure that part of the curve does not go any higher.

And sure enough, last night the BoJ wandered into the bond market and said, “11 basis points bid for whatever you want to do.”

This obviously sent the Yen lower, after all, this transaction increases the supply of Yen, so it is extremely Yen bearish. But more importantly, it was at this point that silver shit the bed.

Now maybe this is just one of the consequences of this elaborate financially intertwined science experiment of a new global economy. Maybe there was no silver order from Tokyo. Maybe it was just a domino effect.

But I somehow doubt it. Someone still needed to sell 6 thousand contracts. And not only that, they needed to sell them in the stupidest way. And when I am looking for culprits for stupid, Japanese government officials seem like the most likely candidates.

However, putting away my cockamamie theories, I want to point out one important indisputable fact. The BoJ has committed to pegging their 10 year rate to 0%. If the global bond bear market gathers speed to the downside (higher yields), then the Japanese will increasingly find themselves having to defend this peg. As they defend it, this will increase the money supply, which will ultimately be inflationary. That might force more JGB holders to sell, creating a self reinforcing vicious circle. The Japanese have relinquished control of their money supply. If credit is demanded, they are forced to provide it in unlimited quantities.

Over the short run, this might cause precious metals to go even lower, and stocks might gain as the BoJ’s printed money finds its way into risky assets. Yet eventually this will become a dangerous game to play and I suspect it will prove an unstable equilibrium.

Last night, talking it over with my trader pal Ari Pine, he told me that he thinks a likely candidate for the next flash crash might be the Japanese Yen. I can’t say I disagree. All the ingredients are in place.

Think about buying some volatility in non-equity instruments. Stocks are a sideshow for the real disturbances in the financial system. Central Banks have been suppressing bond volatility for so long, and as the financial system weans itself off the constant quantitative easing of the past decade, there are going to be some large moves. Silver volatility was relatively inexpensive yesterday. Today, after the flash crash, it’s not as cheap. Some day soon, we might be looking back at Yen vol, or US long bond vol, or gold vol after the next flash crash, and be kicking ourselves that we didn’t buy it when we could.

Deutsche Bank Calculates The "Fair Value Of Gold" And The Answer Is...

Over the past three years, gold has found itself in an odd place: while it still remains the ultimate "safety" trade and store of value should everything go to hell following social and monetary collapse, when it comes to "coolness" it has been displaced by various cryptocurrencies, all of which have vastly outperformed the yellow metal in recent months. Meanwhile, central banks continue to pressure the price of gold to avoid a repeat of 2011 when gold nearly broke out above $2,000, putting the fate world"s "reserve currency" increasingly under question. As a result, gold has traded in a rather somnolent fashion, range bound between $1,100 and $1,300 over the last few years, failing to break out on either side.

But is that a fair price for gold?

That is the question Deutsche Bank"s Grant Sporre set out to answer in a special report released overnight, which among other things finds that gold is a "metal" full of paradoxes.

Here is what Deutsche Bank found: as Sporre contends, in order to determine whether gold is cheap or expensive, one must first define what gold actually is.

At its simplest form and yes we are stating the obvious, gold is a shiny yellow metal, relatively scarce and mined from the earth’s crust. Valuing the metal should then be just as easy? Gold is a simple commodity, governed by supply and demand, and valuing it should bear some relationship to the cost of digging it out of the earth? But it turns out; gold’s nature is far more mercurial. Gold can be many things to many different people – a store of value, a financial asset, a medium of exchange, a currency, an insurance policy against disruptive events or global uncertainty and even a “barbarous relic*” according to John Maynard Keynes. (*As with any famous quote, there are suggestions that the term was not originally coined by Keynes himself, nor that he was actually referring to gold, but rather to the constraints of the gold standard at the time).

All of this means that finding an absolute valuation method which will be accepted by all is rather optimistic; and that the value of gold is more likely to be determined on a relative basis depending on the individual’s perception of gold.

Whilst we contend that there is something of an art to valuing gold, we have used a more scientific framework to come up with that true fair value. There are flaws in any one of the individual approaches, and even averaging out the different approaches still seems like a bit of a cop out. However, in our table below the average of all the selected metrics would suggest that gold should trade around USD1,015/oz, with relative G7 per capita income valuing gold at USD735/oz, whilst the bloated size of the big four central bank balance sheets suggesting that gold should travel at USD1,648/oz.

Here is a summary of DB"s findings:

And DB"s take: the reason why gold is trading with a roughly 20% premium to "fair value" is because "there is a heightened perception of risk or uncertainty in the broader markets."

Although gold screens as expensive, there is a short term scenario (3 month) which would justify gold trading higher, in our view. In the near term, our US rates economist Dominic Konstam sees scope for the US 10-year bond yield to fall to 2% (before rising to 2.75% by year-end), as falling excess liquidity points to softer US growth momentum ahead. If we apply a US 10 year bond yield of 2%, a USD 2% weaker from current levels (not our FX strategist view) and the S&P500 down 5% from current levels, our fair value model points to a gold price of USD1,320/oz.

Our own simple four factor model points to a value of USD1,185/oz. Our conclusion is that gold is still trading at a premium versus a wide variety of metrics; 20% versus the average or 6% versus our fair value model. This suggests to us that the certainly through the lens of gold, there is a heightened perception of risk or uncertainty in the broader markets.

And some additional thoughts from DB on how it scores gold"s value across its various roles in society:

* * *

Gold as a commodity – scarce but always in surplus?

Many investors are uncomfortable with treating gold as a commodity in that gold is not “consumed” like other commodities – it is not eaten, or burned or forged as food, energy or industrial metals would be. At first glance the price of gold relative to the marginal producer on the cost curve would provide a perfect yardstick to determining the fair value of gold. There are however two fundamental problems with this method. The first is that the conventional supply demand analysis does not work very well for gold. Partly due to its value and enduring nature (and high incentive to recycle), very little gold is actually consumed or lost every year. Thus every year, we add to the stocks of gold, with the industrial surplus being “consumed” by financial investors. We would argue that even the jewellery market is not “pure” consumption and the motivation is linked to a store of wealth.

Gold’s price trajectory relative to the marginal producer on the cost curve should be reasonable determinant of value. However, the mined supply of gold is relatively stable and only responds to pricing signals with a four to five year lag. Gold has been falling since 2012, the bump in 2016 notwithstanding and we only forecast mined supply to finally decline in 2017. It turns out, the gold miners are very good at adjusting their cost bases to the prevailing gold price, not least by targeting the richer parts of their ore bodies. The practice of “high grading” is much frowned upon in the industry, as certain less economic  parts of the ore body may be sterilized thereby reducing the NPV of the mine. However, when faced with significant cash burn, many miners have little choice.

If indeed gold is a commodity, gold’s perceived value relative to copper and oil should revert to a long run equilibrium level, based on the relative abundance of various commodities in the earth’s crust. There is no doubt that gold is scarce relative to copper for instance (10,000x less abundant). However the perception of utility will vary according to global growth. In a high global growth environment, copper should be seen as more valuable relative to gold.

* * *

Gold as Money – a medium of exchange with little intrinsic value?

Gold is often seen as a medium of exchange and one that is officially recognized (if not publically used as such) in our view. Simply, gold is widely held by most of the world’s larger central banks as a  component of reserves. The ideal medium of exchange must balance the paradox of representing value while having little intrinsic value itself. Fiat currencies physically have no use other than that which is ascribed to them by government and accepted by the public. Arguably, gold is a purer form of money because it actually costs something to produce, compared to fiat currencies which cost very little. However, the concept of relative scarcity or abundance comes into play. If the rate at which fiat currencies have been printed exceeds that rate at which gold has been mined, then ceteris paribus, gold should become scarcer and rerate versus fiat currencies. Since 2005, central bank balance sheets have expanded nearly fourfold. In contrast the global above ground stocks of gold have expanded a mere 20%. The gold price has rerated accordingly, but not enough to keep the value of gold at parity with the global (big four central banks to be precise) money stock. The average ratio since 2005 between global money stocks and the value of global gold stocks is c.1.8x. In order for gold to get back to this level, the price should appreciate to USD1,648/oz, nearly USD300/oz above the current spot price.

If we assume that gold reverts to the long run ratio of these two commodities, then at an oil price of USD50/bbl, gold should be trading at USD840/oz, and at a copper price of USD5,600/t, gold should be trading at USD960/oz. Gold remains expensive versus other commodities

* * *
Gold as a store of value – capital appreciation but no yield

We all need ways to store the fruits of our physical or intellectual labour for use at a later stage. We all have our preferences, be it bricks and mortar, the equity markets or gold. It depends on your confidence in how well you believe your asset of choice will preserve and in many instances grow your wealth or capital. We have examined the level of the gold price in real terms i.e. versus US CPI, relative to the per capita income and versus an alternative financial asset, the US equity market.

In terms of the relationship between gold and the S&P500, we have adjusted both for inflation and applied a further equity time value adjustment. Both should rise with inflation, but the S&P 500 should rise more and its retained and reinvested earnings should generate real EPS growth. We find that the adjusted gold to S&P500 ratio at 0.65x is still above its historical average of 0.54x. To bring this ratio back to its long run average would require the gold price to fall to USD990/oz. The average G7 per capita income since 1971 could buy just over 62 ounces of gold. Currently the average per capita income can purchase 47 ounces which implies that gold should trade at USD740/oz.

The real gold price average since 1971 when the gold standard was relinquished in the US is USD735/oz in PPI adjusted terms and USD810/oz in CPI adjusted terms.

Gold as a measure of market uncertainty

In order to adjust for the current gap between the actual gold price and our model forecast, we have adjusted our model (yes all models have dummy variables to account for the periods when they don’t quite work) for global risk perceptions. The adjustment we apply is simply a risk perceptions adjustment factor derived by plotting the model residual against the VIX index. We note that any significant period above 20 on the VIX index causes gold to trade above its “fair value”. The scale we apply ranges from -20 to 20, with each point accounting for USD10/oz. This is the minimum and maximum range of the deviation. The current gap of USD80/oz or 8 on our scale would suggest an above average sense of risk or uncertainty in the market. If we apply the DB house view forecasts at year end for the US 10 year bond yield of 2.75%, a US 10 year break even of 2.15%, an S&P year-end target of 2600, IMF gold purchases of 5 tonnes and a USD up 7.6% versus the broad trade weighted basket, then gold should trade all the way down to USD1,031/oz. Even if we increase our risk perception index from 8 to 12, this brings us back to USD1,150/oz by year end. In the near term however, our US rates economist Dominic Konstam sees scope for the US 10-year bond yield to fall to 2% (before rising to 2.75% by year-end), as falling excess liquidity points to softer US growth momentum ahead. If we apply a US 10 year bond yield of 2%, a USD down 2% from current levels and the S&P500 down 5% from current levels, our fair value model points to a gold price of USD1,320/oz.

Japan - It's Finally Happening

Submitted by Kevin Muir via The Macro Tourist blog,

Remember when the trade-du-jour was to be short JGBs? All the cool kids had it on the sheets.

You couldn’t turn on CNBC without being blasted with Texas’s favourite hedge fund manager foreshadowing Japan’s coming demise.

Japan’s collapse seemed to be Kyle Bass’ raison d’etre. And he stuck with it for a long time. Have a gander at how young Kyle looks in the picture above. But more importantly, check out the level of the Dow Jones Index.

And it’s not like he was alone. As recently as last summer large hedge fund managers were still shorting JGBs by the bucketful. Crispin Odey had 35% in his fund in a long Australian bond / short JGB position.

I can’t claim I was immune to the siren lure of the short JGB story. After all, it was an awfully compelling story. It’s difficult to see how Japan will be able to manage its monster debt load without inflating it away.

Yet the great global bond rally of 2016 that drove European sovereign yields to batshit crazy negative levels, dragged Japanese government bonds along. Last summer, in a fit of panic when investors were convinced inflation would never again rear its ugly head, Japanese 30 year paper flirted with a 0% yield.

I still shake my head at the stupidity. One of the most overindebted countries in the history of modern finance trading with a 0% thirty year bond. Professor Malkiel - stick that in your pipe and smoke it.

But into that panic a crazy thing happened. Worried its bonds would trade at negative yields and pressure the financial system, the Bank of Japan pegged its 10 year yield at 0%.

In doing so, the Bank of Japan moved from a set rate of balance sheet expansion to one that varies based on whether that peg is either too high, or too low.

If the equilibrium level of 10 year rates was in fact below 0%, the Bank of Japan would be forced to sell bonds to keep rates stuck at 0%. If there was demand for credit and 10 year rates moved higher, then the BoJ would be forced to buy bonds to keep them from declining.

The BoJ program was a little more nuanced, and there were some caveats, but at its heart, the BoJ was giving up control of its balance sheet so it could peg a specific part of the yield curve. Of course Central Banks do this all the time. The difference is they usually operate at the front part of the curve, and when there is too much demand or supply, they change the rate.

When the Bank of Japan took this unprecedented step, I walked away from my short JGB position. I figured there were better fixed income markets to short. Yet I highlighted that by pegging the 10 year rate, the Bank of Japan had not eliminated volatility, but merely postponed it.

Eventually the Bank of Japan’s massive balance sheet expansion would kick in. At that point, inflation would pick up, credit would be demanded and the Bank of Japan would be forced to defend the 0% peg. Yet this defending would be expansionary as they would be forced to buy bonds and expand the amount of base money, which if not offset with a decline in the velocity of money, would create more inflation, etc… All of this would be occurring with an already highly supercharged Japanese Central Bank balance sheet.

I have been sitting and waiting for this expansionary feedback loop to kickstart. Until recently, the Bank of Japan had not been forced to buy any bonds to keep the rate pegged at 0%. When 10 year rates drifted far enough above 0%, the Bank of Japan made a bid to buy an unlimited number of bonds at a level below the market, which scared the market back to the pegged level.

But this week the market decided to test the BoJ’s resolve.

The JGB 10 Year bond spiked through the previous high yield on news the Bank of Japan would not be expanding their balance sheet quite as aggressively as expected in their regular QE program.

As yields popped through the previous 0.10% yield ceiling, the Bank of Japan came charging into the market. The BoJ bid 3-4 basis points through the market with unlimited size to push yields back down to the 0.10% level.

What does this mean? The market is finally saying the demand for credit is enough to force the Bank of Japan to buy bonds to keep rates down. And that was the signal I was waiting for.

I am shorting JGBs with both fists. It probably won’t happen tomorrow, nor the next day. Heck it probably won’t even happen next month, but we have reached the point where I need to be short JGBs. The pressure will continue to build and when it finally bursts, the torrent will be overwhelming and quick. Although many traders think they will be able to climb on board, it will most likely be extremely difficult - like jumping on a raft bouncing down a raging river, it always seems way easier than it is.

I hate German bunds, but I now have a fixed income instrument I hate even more. I expect bund yields to double or even triple in the coming quarters, but JGBs will eventually trade significantly though bunds.

It would be just like the Market Gods to finally usher in the JGBs collapse once all the hedge fund guys had given up on it…