On Monday the U.S. Treasury Department reported that net foreign capital flows into the United States were $59 billion in August, down from $63 billion in July. The Treasury Department also noted that for the first time in a year foreign private investors sold more Treasury bonds and notes than they bought. While this dated data alone would have been enough to give FX traders pause, other lingering issues - including $55+ oil and US current account deficit fears - have also played a role in currency dealings this week. For those of you keeping score, the currency being dealt down the most has been the U.S. dollar.

With the dollar in a renewed slump the price of gold has rallied to 6-month highs. The current gold rally is potentially dreadful news for the commercials, which have - unlike most rallies in recent years - positioned themselves for a gold decline before one is due.

Commercials No Longer 'Gun Shy' (Oct 8)

The commercials seem to be well prepared to attack gold; to raise their short position to 5+ times their long position at any time.

However, a look at the combined futures and options data paints a different picture; one wherein the commercials have steadily added to their net short position as a percentage of open interest while speculative long interest has moved slowly higher. Gold was trading at $375 on May 11 and is hovering near $420 today.

As highlighted last week, when net commercial short interest as a percentage of total open interest tops 40% this usually presages a significant price decline in gold. In fact, since 1995 this figure has only been above 40% on 10 different occasions, and only twice - on Dec 10, 2002 and Dec 2, 2003 - has the price of gold not been trading dramatically lower 1 month after the fact.

To note: the important difference between Dec 2002/2003 and today is that the commercials were trying to put the kibosh on a gold rally that kept hitting 'new highs' in Dec 2002/2003 while gold is not reaching 'new highs' today. Moreover, in December's gone by the commercials were reacting to an increase in net speculative long interest as a percentage of open interest, whereas today they are not. For example, in December 2002 NSLI as a % of OI was 18%, versus only 10.3% today.

The COT statistics suggest that the commercials short gold first and ask questions later. Even so, during the current gold bull the commercials have not been brazen enough to amass as mammoth a short position as todays with net speculative long interest representing such a small percentage of the total market. Why are the commercials trying to guard against (meaning aggressively short gold) the highs that gold set in April 2004? Most importantly, why did the commercials begin guarding against these price levels before the speculators arrive on the scene?

Election Stability Gone Wrong

One reason why the commercials may have been adding to their short position over the last two weeks is that they wanted to be positioned to profit from a stable dollar/lower gold outcome before the U.S. elections (many have speculated that hidden forces would keep the U.S. dollar stable at least until after the election). However, with this theory showing signs of stress/death, the story now could be that the commercials are awaiting a November rebound in the dollar and a subsequent sell off in gold (or the post election 'all is well' rally in the dollar). Some statistics back this, albeit weak, theory. Notably the flows which spooked the markets this past Monday:

Over the last decade September and October are, on average, the two worst months for net foreign capital inflows, while November is the second strongest month for net foreign inflows.

Some crazed equity bulls have undoubtedly placed bets on the weak stock market breaking out of its funk in late October (as it often does). For that matter gold speculators have probably arrived on the scene over the last 6 trading sessions hoping that December gold will bring them profits (as it often does). Failing to profit from a stable dollar/unstable gold outcome for most of October, the commercial shorts may be betting on rebound in the dollar leading into November and/or after the elections.

Commercials Could Be In Trouble

It should be remembered that the commercials do not care if they profit from a rally in gold. Rather, the commercials aim to make safe profits by consistently increasing their net short leverage. On August 3, 2004 with gold trading at $390 an ounce the commercials held a net short position (future and options) of 87,198 contracts. Today, with gold above $420 an ounce, the commercials likely hold a net short position near 200,000 contracts (194,824 as of Oct 12). If gold goes to $430+ an ounce can the commercials amass a net short position well in excess of 200,000? No problem! Such a position was last amassed in April 2004, or right before the price of gold crashed lower (stats below).

But alas, for the commercials the danger this time round is not that they cannot acquire enough leverage to profit from a price decline, but that the next price pull back in gold will not be large enough and/or last long enough to profit from (or to cover). Why are the commercials facing this potential quagmire? Because the commercials didn't (yet) dump enough of their cheer onto speculators - or the 'weak hands' that are most likely to buy high and sell (back to the commercials) low...

Although many have tried to predict the end of commercial rigging in the gold market and failed, it is worth remembering that never before have the commercials been so aggressively short during what could be a potentially sustainable rally in gold. Quite frankly, unless the dollar rebounds the commercials may have a difficult time stopping the gold rally, let alone sending gold down by a lot.

This is not a prediction...after all, more speculators have probably entered the market recently, and these speculators would probably sell into weakness should the commercials decide to slam gold in desperation. The word 'probably' is applicable given that the COT is more than 1-week old.