Dollar Strength Is Finally Weighing on Gold and Other Commodities

Commodity buyers look like they are going on summer vacation as the dollar stays strong.
By Ben Cross ,

The strength in the dollar against commodity currencies as well as the Euro is weighing on gold.

As the U.S equity markets set daily record highs and the dollar gains upward momentum, the liquidation of commodity length is having trouble attracting fresh length. Volumes this week in both the underlying futures and over the counter trading have been muted as if hedge funds have started their summer holidays early. It seems that once the Dollar index broke through 97, the technical funds/algorithmic traders hit metals and energy bids in tandem. Gold doesn't seem to have a big technical level beneath the market for some time but I believe $1300-to-$1305 will be major support.

The S&P GSCI commodity index which hit a high of 390 on June 8 is trading at 355 today which is just above its 100 day moving average. Options activity in gold which has been muted all week has a major futures expiration on Tuesday. While I was anticipating a possible move on back of geopolitical worries late last week to $1350 in GCQ6 for expiration, it seems that the focus now is on the $1300 strike where there is open interest of 11,000 contracts almost evenly distributed between calls and puts.

Despite the drop below the recent range of $1320-to-$1360, to a low of $1313 this morning, implied volatilities continue to get hammered (not a technical term). One month at the money, implied volatility in gold is just above 15% implied volatility but maybe more importantly, the 25 delta risk reversals (calls over puts) have declined to 1.4%. This is is down from 3% just two weeks ago. Some of the risk reversal move is due in part to producers hedging vis buying collars (buying puts/selling calls) from six months to two years forward.

The Australian producers have been especially active in this operation the past two weeks. As I have mentioned, the largest option volume and open interest in gold the past week has been in the GLD ETF 125 puts. The SPDR ETF (GLD) - Get Report for August 19 expiration 125 puts have an open interest of 63,000 contracts and for the September 16 expiration the 125 puts have an open interest of 38,000 contracts. The August 19 124 puts have the largest volume today with one fund buying 10,000 contracts against the underlying of 125.75.

The call position we put in place last week buying the September 130 calls against selling 2x the 140 calls for cost of $1.30 is now worth $1.05. I am not going to liquidate the position yet as I think there is a reason to add gold to a portfolio on these pullback days. So, as long s gold does not completely collapse the $130 calls will hold some value while the $140 calls will become worthless. I still believe that the Chinese and Japanese investors who have been in liquidation mode on iron ore and other hard asset holdings this week will come back into the market for precious metals on any whiff of easing by their respective central banks.

I continue to feel that the better-than-expected earnings from U.S. banks (albeit on low expectations) will not be followed by Deutsche Bank (DB) - Get Report , Credit Suisse (CS) - Get Report , or major Spanish or Italian banks and the European bank bailout will happen sooner than later.

The dollar strength will continue to keep a lid on commodity prices but with Fed members like Cleveland Governor Loretta Mester talking about more quantitative easing, it seems the Fed tightening is far down the road and a further dollar rally will reaffirm that.

I am not sure what effect geopolitical issues will have on gold going forward, but I do think that the discourse of the divisive U.S. election will heighten the fear of an uncertain future and that uncertainty usually has investors look for gold as a form of portfolio protection. Silver obviously has given back some of its recent gains falling 2.5% today with support holding at $19.22. The silver length of over 500 million ounces has probably dropped by about 20 million this week thus far.

Elsewhere in commodities, the industrial metals, which were getting a bit of a boost by the Chinese specs the past two weeks, are seeing some of that money hit the exits or disappointment over a lack of easing from the PBOC and weaker than expected housing prices in mainland China. The copper net length on LME increased significantly last week but news of production being increased by both Rio Tinto and BHP has kept the rally capped at the $2.25 Comex level or $5,000/ton on LME. Zinc is still the outperformer with with the international zinc group reporting that despite Chinese production growth, year-on-year production has declined 5%. The price of zinc is now up 39% for the year and is the best performing metal.

Oil broke through the $44 support level before regaining a bit of strength after the inventory states reported 2.3 million barrel drawdown, a bit higher than expected. Crude spreads have collapsed and Dec 16/dec 17 ended yesterday at $3.62 on some consumer buying, so December 17 was actually positive on the day yesterday. The gasoline glut continues to weigh on the complex.

Natural gas is under pressure as cooler weather has lessened the tightness in the August-September roll. As predictions for warm weather returns the next three days, the natural gas inventories out tomorrow will dictate the next move. Producer hedging has definitely weighted on the out of the money calls but I still like being long the September 26 expiry $3 calls (the August 26th short $3 calls will most likely expire worthless) as a cheap way to play for a return in upward momentum.

The agriculture complex has been decimated as weather in the plains and better production from emeraging markets has raised inventories.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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