Hedge funds make aggressive bets on gold

From the Pick and Shovel June/July 2014 issue 

By Michael Foster
For the GPAA

After betting heavily against gold in 2013, several hedge funds are reversing their bets on hopes that 2014 will be the year when gold rises again.

While Wall Street heralded 2013 as the year of stocks, 2014 quickly showed that the buy and hold strategy wasn't going to work forever. In January, stocks slid nearly three percent as yields on bonds fell, following news that emerging market currencies were plummeting in value and inflation was hitting the developing world more aggressively than anyone had expected. The stocks most popular with speculators, such as 3D Systems and Netflix, fell 46 percent and 8.5 percent respectively by the beginning of May.

Beyond the numbers, several political developments have caused big investors to worry. In the Ukraine and Turkey, social unrest threatens economic expansion, while protests and riots in Argentina, Brazil and Thailand signal troubles brewing worldwide. This means shrinking investment opportunities and more obstacles to making money in the consumer-facing markets of fast-growing nations.

Bearish bet of '13

One trader made $90 million in 2013 by shorting gold. This trader bet that gold's value would decline throughout the year, bolstered by the theory that Federal Reserve intervention and declining real incomes with consumers, as well as higher unemployment rates and rising prices for essentials, would make it difficult for prices to rise on luxury goods and discretionary items. In other words, prices overall would fail to rise much because people were being squeezed further and further due to an interventionist monetary policy and declining opportunities for the average person.

This lack of rising prices would cause gold speculation to decline, causing the metal to lose value. This bet paid off extremely well, as gold fell and fell throughout 2013, driven by less people speculating on inflation and pouring money into the stock market.
Of course, none of this was sustainable, but that didn't matter for the bearish bet of 2013. The idea was that gold would suffer a dip in value as a result of people reallocated money towards stocks, but gold would see a rush of investment after the Federal Reserve stopped intervening in the markets and bets on inflation and economic instability returned to the metal.

Off copper; on gold

In early 2014, this is exactly what we saw, and hedge funds were fast to return to the metal as a result. In February 2014, Bloomberg News reported that hedge funds increased their gold positions by 40 percent by the end of January, with more bets on a rising gold price since September 2013 and less bets against the metal. At the same time, hedge funds were investing less on copper — bets on that metal fell by 62 percent, according to the news service.

Why off copper? Copper is one of the most commonly used metals in manufacturing. When people buy more stuff, companies buy more copper to make more stuff. Betting on copper is an indirect bet on a growing economy, so taking a bet off copper is the same as betting that the economy is about to go down.

With the bets against copper and on gold, hedge funds are expecting turbulent economic times as the U.S. economy pauses on the so-called economic recovery. The hedge funds that made these bets were smart — gold was up over six percent by the beginning of May. Copper was down even more.

Emerging market fears

Throughout the world, paper money is getting less valuable. Political woes and the fear of a coup have hurt the Thai baht. The Asian currency plunged a full percent in January as protests in Bangkok threatened the security of the country's strong economic growth. Even worse was the sell off in Argentina, where a botched economy had resulted in an uncontrolled inflationary spiral, making the peso worth less and less. In one week alone, the Argentine peso lost over 20 percent of its value.

Once warmly welcomed as an engine of global growth and higher earnings numbers for American companies, the emerging markets are beginning to look like dysfunctional stepchildren to investors looking for yield and value. More and more, investors are pulling billions of dollars out of these markets and putting them back in America. The dollars are flowing mostly in two directions: firstly into bonds and secondly into gold.

With the money going into gold, the value of the metal continues to soar, and it's a trend that many economists expect to continue throughout 2014. In such a market, betting aggressively on gold makes a lot of sense, and it explains why the smart money has been making strong bets on the shiny metal.

Betting on inflation

The idea behind the gold bet is that the global economy is going to suffer two problems at the same time. In addition to declining currencies in emerging markets, prices for commodities and processed goods are going to rise. Some of this has already happened. Bad weather and strong demand has meant coffee futures have risen by nearly seven percent in the first month of 2014, with other commodities — corn, wheat, oats, cocoa, and soybeans particularly — all seeing smaller gains.

The cold weather rose demand for energy, but oil and natural gas didn't see rising prices in the first month of the year. That didn't stop many investors from betting on rising prices for the energy commodities in the coming months, especially as questions loom over U.S. energy production amongst left-wing opposition.

With these trends, the stage is set for overall prices to begin to steadily rise for commodities. Processed goods are expected to rise in price as well. It's inevitable, particularly for American companies which have viciously cut costs across the board. There just isn't anything left to cut, but shareholders demand higher profits. That will mean rising prices, which in turn will cause the inflation that investors expect to buoy gold.

Michael Foster is a freelance business journalist based in Miami, Fla. He can be reached at michaelryanfoster@gmail.com.