Gold to $1,400 by July 26?

Gold is down slightly today, but it's just a minor setback before the precious metal's run for the rest of the year.

Ben Cross

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Jul 7, 2016 2:43 PM EDT

After hitting a fresh two-year high of nearly $1,365 per ounce yesterday on high volume of over 25 million ounces, gold futures have retreated a bit. It's just a short hiccup on the way to $1,400.

As a gold bull, I am hoping for a broader pullback but doubt it will come. I have macro and micro reasons for this belief. The micro is the daily inflow of investment into the global gold ETFs. The gold ETFs have now surpassed 2,000 tons (64,000,000 ounces) with this week's inflow of 1,720,000 ounces. The GLD SPDR ETF(GLD) lead the inflow over 1 million ounces on Tuesday alone and now accounts for half of the global total. But, ETF securities, Source ETF, Canada's central gold fund, Swiss ZKB and the IAU ETF are all attracting inflows. The global ETFs would now be considered to have the fifth largest gold reserve holding behind the U.S., Germany, France and Italy. China which raised its holdings to 1,828 tons last month would still be lagging. Option activity on the ETFs has also been increasing with the GLD ETF getting more large tranche transactions than gold futures options both on speculative bets as well as traditional equity players buying the underlying and selling calls against it to gain a rate of return. With the disappearance of commodity risk takers from the banking sector, the front three months of the GLD ETF alone accounts for more option volume than the Comex. The silver ETF is also starting to gain traction on the back of gold as it saw an inflow of 5.2 million ounces yesterday which is the most since March.

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Also, on the micro side we are starting to see more exotic type of bets from hedge funds trying to get more leverage payouts while spending less premium. An example is a knock out call struck at $1,400 which is changing hands at $9. One speculator bought this with a knock out at $1,330 and it cut the premium by 50% to $4.5. So they are making a bet that on the July 26 expiration gold will be above $1,404.50 ($1,400 strike +$4.5 premium) without breaching $1,330 first. If gold does fall below $1,330 at any time before expiration (which I think is very possible), then they lose their entire premium. One other fund which is already very bullish on gold made a bet that gold would trade above $1,500 by year end. He was given a 4-to-1 payout on this bet so for every $1,000 that he invested he will get $4,000 if gold trades $1500 anytime between now and year end. I recommend that only the most sophisticated option investor look at these but I used them as an example to show that more hedge funds are looking for leveraged upside in gold.

On the back of the liquidity of the the GLD, I am recommending buying the September 2016 (which expires on September 16) 130 call for $3.9 or 18.4% implied volatility and selling 2-times the September 2016 $140 call for $1.3 or 20.8%. The net cost to you will be $1.30 net ($3.90 - $2.60). The underlying in the GLD is presently 129.5. At 140 which will equate to a 7.2% rise from the present price you would get the maximum payout of $10 which is 7.5-to-1.

As far as the macro rational behind owning gold, I may be starting to sound like a broken record. But, the historical reason for not owning gold (or silver) is that it is zero-yielding and costs money to store and insure. But we are now dealing with global central banks in Europe and Japan that have accepted either NIRP (negative interest rate policy), or in the case of the U.S. ZIRP (zero interest rate policy). The havoc that Brexit has wreaked on the Eurozone yields and the subsequent knock on effect as U.S. bonds received so much inflow to force new historical low yields in the U.S. The fact that the Federal Reserve has lost credibility has increased the rush for precious metals as safe havens both via futures, ETFs gold equities, and coins (which have increased 70% this year). It is now a certainty that the Bank of England will fall in line and lower rates to combat falling home prices and stave off a possible recession therefore, I expect the yield compression to continue for some time.

Another macro factor which has come back to the forefront is the weakness of European lending institutions due to the unconventional policies of the European Central Bank (ECB). The focus is presently on the Italian banks and how the ECB will coordinate with the Italian government to keep banks solvent. The bigger factor may be the $2 trillion balance sheet of Deutsche Bank (DB) which is now a sub $20 billion market capitalization. The German government will bail out Deutsche but the global tentacles of Deutsche are many and fear of their insolvency and others such as Credit Suisse and RBS will enhance the hunt for portfolio insurance. The last factor is one which historically has been a negative for gold but it seems we are moving further into a deflationary environment in some parts of the world. Despite a stronger USD vs the GBP and Euro, the Yen has strengthened dramatically which will put the Japanese economy into further deflationary worries.

Elsewhere in commodities, it has been a wild day in crude oil as traders initially bought on news from API of a 6.7 million barrel drawdown of inventories. Even gasoline inventories which have been bulging drew. But, the good news did not last long as the EIA figures showed a smaller than expected draw of 2.2mm barrels and a market that is oversupplied by 350k barrels. In addition, Chinese consumption fell in June and on the supply side both Nigeria has fixed its infrastructure to predict a July output of 2.2 million barrels per day from 1.55 presently.

Natural gas is little changed with the EIA figures showing injection of 39 below the 41 expectation. Electricity consumption last week was up 7.4% year-over-year and rig count is down 1 to 89 which is down 97% from its 2008 peak of 1606. I am bullish on natural gas over the next six weeks and like the idea of buying a calendar call spread.

I would look to buy a September $3 call (expires August 26) at 7 cents which is 39.75% implied volatility vs selling an August $3 call (expires July 26) at 3 cents which is 41.5% implied volatility. Natural gas is presently trading at $2.77, so I see a gradual move higher with the potential of hurricane disruptions as we move into what should be a sweltering August.