Gold is having its third-best year in the last twelve years, with a surge of more than 21% since the start of the year. The only better years were 2020, when COVID-19 shocked the markets and the world experienced one of the largest money supply increases to combat the economic slowdown, and 2016, when gold surged 28% from January to September but lost most of its gains in the final three months of the year.
Several factors have contributed to this year’s surge, including heightened geopolitical risks in the Middle East and Eastern Europe, the lingering effects of increased money supply and inflation, momentum following a significant breakout from the $2,075 resistance level, and a substantial increase in demand from central banks, possibly due to rising tensions between the U.S., China, and Russia. Additionally, trust in the dollar as a reserve currency has diminished due to frequent U.S. sanctions on various countries, alongside expectations of upcoming rate cuts.
This year’s 21% surge has been a great opportunity for gold bulls. However, the move didn’t start this year; since gold tested the $1,600 support level in late 2022, the upward move has exceeded 55% in just 26 months. Most reports from banks, research firms, and hedge funds indicate that the bullish gold trade is heating up, with targets even surpassing $3,000. However, it might be getting a bit too hot.
(COT Report Net Long Gold Positions – Managed Money and Non-Commercial)
I often recall the story of Icarus during extreme market movements to remind myself not to get overly greedy. When King Minos imprisoned the master craftsman Daedalus and his son Icarus on the island of Crete, Daedalus constructed wings from feathers and wax to escape. Before the flight, he warned his son Icarus not to fly too low, as the sea’s dampness would clog the wings, and not too high, as the sun’s heat would melt the wax holding the feathers together. Initially, Icarus heeded his father’s advice, but after some time, the sensation of flight and freedom intoxicated him. He flew higher and higher, approaching the sun. When he gets too close to the sun, the wax melted from the heat, and Icarus fell into the sea and drowned. What I take from this story is twofold: first, don’t get too excited with your winnings and become intoxicated by greed; second, be cautious about getting too bullish when the price rises too high too fast, and equally cautious about getting too bearish when the price drops too much too quickly.
According to the COT (Commitments of Traders) report, non-commercial net long positions have reached very high levels. After the 2008 crisis, these positions stayed high for an extended period, and as a result, gold extended its gains for three years until reaching a peak in 2011. In 2016, gold rose 28% by September but finished the year with only a 6% gain, losing most of its earlier gains. During those final three months, gold bulls sold off most of their positions in panic. The record for net long positions was set in 2020, and deservedly so. Now, gold positions are very close to those previous peaks, as well as managed money positions. Typically, these are the times when gold either makes a top or experiences a correction before moving higher.
(M2 Money Supply Index / Gold Price Ratio)
Gold had reasons to surge, but is it still cheap? The answer is likely no. The chart above shows the ratio of U.S. money supply to gold. When money supply increases too much, the dollar loses value. All countries increase their money supply over the long term, so currency pairs usually remain stable. However, gold’s supply increases much more slowly than that of currencies, so over the long term, gold tends to follow a positively sloped trend. To gauge gold’s real value, it is better to compare it with money supply rather than the dollar, as this comparison eliminates the trend and better captures gold’s true value.
Over the last 25 years, the M2 money supply/gold ratio has averaged 11.38. Since 2014, it has mostly hovered around this average, between 10 and 12. After the surge that started in late 2022 and accelerated this year, the ratio has fallen to 8.60, approaching the negative one standard deviation. This means that, relative to money supply—which has massively increased over the years—gold is getting pricey, deviating from the average. This doesn’t mean the upward move will not continue, but it serves as a warning to Icarus that he is starting to get too close to the sun.
(XAUUSD Weekly Chart)
Since the 2018 dip, gold has formed an uptrend channel, consistently supported by the 233-week moving average. Within this trend, gold first moved to 2075, the covid-19 peak, in 103 weeks. After that, a downward counter-trend within the main channel brought gold down to nearly 1600 over 115 weeks. Now, from that dip, it has once again reached the upper line of the channel in 98 weeks. If the pattern continues, the upward momentum may begin to wane in just a few weeks.
Regarding the 233-week moving average, the current deviation is near three standard deviations, and graphs typically revert to long-term moving averages over the medium term when deviations reach too high levels. However, the momentum has not slowed down yet as seen in the middle panel’s relative momentum index. So far, the upper line of the trend channel is holding.
Conclusion:
The long gold trade has become too crowded, and the price of gold is getting dangerously close to the “sun.” Many of the factors that have kept gold high may already be priced in, and some, like high inflation, high money supply (with lagged effects), possible de-escalation in the Middle East, and high central bank demand (China has already stopped purchasing more gold for its reserves), may be diminishing.
In the coming weeks, gold will likely have to decide whether to make another leg upward, potentially breaking the uptrend with a more aggressive move, or to correct first to $2,250, and possibly to the 233-week average, which is currently at $1,912 but could rise to over $2,000 over time. Gold bulls might consider taking some profits if upward momentum starts to fade, while gold bears should be cautious not to overextend their positions and should use stops, as momentum remains high. If another breakout occurs, gold could stay hot for a longer time. However, if momentum start to slow, there is greater potential for downside than upside.
