Gold Trading and the USD This Week

08/08/2007 12:00 am EST

Focus: COMMODITIES

John Netto

Author, The Global Macro Edge

Recent weeks have brought forth tremendous volatility across the markets. This expansion in range has been a welcome relief for traders that thrive on short term movements. Being that our fund, Triple Witch Metals Capital Appreciation Fund, LP, has the focus of our exposure in the metals, as well as metals related stocks, it is our belief that we are on the precipice of a major breakdown in the value of the US Dollar, and consequently, a massive rally in the metals complex.

We called out our initial long position based on a number of fundamental and technical factors on July 6, with gold sitting at 654 on the August Contract, we have since rolled over to December and are presently trading at 683 as of this writing.

As I have articulated at conferences and when sharing my perspective with colleagues, gold is leading ALL asset classes out of the lows from the "shanghai swoon" was the true clear picture of what is happening. It's my belief that some type of favors were called in and a preponderance of factors converged on gold that flushed out the single largest 100 day central bank supply of gold over the past 7yrs and dwarfed any prior 6mo period of gold sales. It is this distribution that forced the gold sector to lag from its end of march consolidation onward while the equity markets rallied.

The figures corroborating this have been released and Spain sold off nearly all of its gold in April and May in response to a budget crisis that emerged as a result of their real estate market (no need to mention the potential parallel to what the US is facing in this potential risk) so Spain along with regular selling from other central banks just absolutely slammed the mkt with supply. Despite crushing the bid on gold to hold it down, the metal looks demonstrably robust.

However, it is my opinion the gold stocks, unable to ignore the heaviness with which gold began trading, succumbed to the weakness and rolled over (the HUI was making multi-month lows at the end of June) and in the process flushed out a lot of long term players who had been focused on the sector's continued ability to correlate with the broad mkt but watched them diverge and breakdown from that relationship

It is the funds belief what was taking place was the precursor to the 2nd phase of this bull mkt which will require the full participation of wall street along with main street investors. Encouraging for gold bulls is what we have seen since the gold sector's jun27 lows in the hui, xau, gdx to spx ratios, as all began to turn up and challenge their respective downtrends with xau breaking through (due to the fact that it is the only one of the 3 indices to include FCX (and at a major weighting on top of that)) so I think the divergence from the S and P 500 prior to June was a head fake.

The foundation for the gold sector getting ready to diverge to the upside in sustainable fashion is palatable, while the deteriorating domestic fundamental situation begins to take hold of corporate profitability for all the companies without big chunks of foreign/international revenues. At the moment, the market is suffering from a lack of liquidity, as the bond markets dry up for mortgages and the hedge fund industry goes through the mark-to-market process for all their interest-sensitive derivatives/products that were being carried on the books at parity based on a "mark-to-model" full of assumptions that was being used industry wide across the globe.

When the news broke that Bear Stearns had a couple of funds that were insolvent, everybody tried to be quiet about it and hold things until a better time to sell. However,the ratings agencies were finally forced to act as the defaults on sub prime mortgages, as they had grown so much that they couldn't be ignored any longer (and shouldn't have been for as long as they were) so they were forced to downgrade a lot of bonds that had sub prime components in them.

This is what has caused the problem to rise to the surface because if the credit agencies didn't have to downgrade any of the debt, then none of the owners of the cdo's, swaps, cds's, etc would have to mark to market and could stick with their model's assumptions which would allow them to carry things on the books at parity until they all matured. It was fearing lawsuits for breach of fiduciary responsibilities that forced them to downgrade. The firms had resisted as long as possible because if you downgrade, you crimp your clients' abilities to do future business so there was a major conflict of interest that allowed this to go on for about a year longer than it should have based on mortgage default rates.

Until we get through with all the forced liquidations as margin calls are met we don't know where things will go, but that process is underway and usually happens in a quick manner as lenders have no patience in making sure their own money is not at risk. Rest assured that every fund of funds is digging deep finding out where, if any, of their funds are exposed to mortgage derivatives and they are redeeming the monies. So the ball is in motion and gold and the stocks have had an up month in aug every year in this bull market, some less than others but always an up bias. I expect this will be no different after the dust settles.

It is my belief that the market is sniffing out a rate cut and a strong reversal rally will be coming soon, as the conundrum we have been talking about earlier, (does the fed cut rates and kill the dollar or raise rates and kill the economy) seems to be coming to a head with the Fed being forced to lower rates in an inflationary environment. This creates the potential for stagflation, a recipe ripe for a massive gold melt up. With the Japanese Yen rallying against the dollar as of this writing, as well as the Euro higher, the Dollar Index should undercut it's intraday lows on Monday morning.

It's the combination of the aforementioned points, coupled with the latest Commitment of Traders Report showing one of the largest single week changes in open interest since the beginning of the gold bull market as a reduction of 50,000 contracts, commensurate with levels that have been present for every previous up leg, that can send portfolio managers jumping into the metal in a massive accumulation this and following weeks.

It is why we have our most aggressive posture in gold since the 654 level and are looking for a move to test the 760 level on the December contract.

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Best Wishes
John F. Netto

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