Swarming to market: Why the gold market could face a short squeeze

Much of what is observed in economic and financial markets is explained away in rational economic terms: improvement in economic data led to a rise in the stock-market, gold prices rise on declining bond yields or something similarly mundane. Yet the recurrent bouts of volatility across all asset markets suggest that something deeper is going on, something much more powerful than the observed fundamentals suggest.

To understand what might be going on we turn to the world of ants.

In the opening passages of the book Butterfly Economics, Paul Omerod, describes a series of experiments carried out by entomologists in the mid-1980’s. The question the scientists were trying to answer was how would an ant colony divide itself between two identical sources of food – each source exactly the same distance away from the colony, and each constantly replenished?

On the face of it nothing to do with volatile movements in asset prices.

Ant communication

Rather than choosing from the two sources at random, ants typically went back to the same source again and again, and once back at the colony they would signal to other ants the direction of their food source. Positive feedback dominated and once a large majority of ants visited one site it tended to remain stable for some time. Every so often though ants suddenly shifted and moved almost on mass to the other food source.

The economist Alan Kirman modeled the ants behaviour. Essentially each ant has three possibilities upon leaving the colony: it can visit the source it previously visited, it may be persuaded by a returning ant to visit the other source, or it can decide itself that it will try the other food source.

These three possibilities also guide participants in financial markets. The precise shape of the distribution between ants at one or the other food source, or financial market participants between being bullish or bearish depends upon the persuasiveness with which ants (investors/banks) can convert others, and on the propensity of individuals to change their own minds.

With that framework in mind consider whats happening in the gold market at the moment.

According to Longview Economics (h/t John Authers) there is a risk that the gold market shoots higher as bullion banks (traditionally short the gold market) suddenly have to make good on the promises they have made to investors betting on higher gold prices through futures. Longview estimates that the short position is around $39 billion, the highest since records began in 2006.

If gold prices don’t decline materially and investors opt to take physical delivery of the gold (rather than rolling over the contracts), then the banks may be forced to pay almost any price they can to get hold of the metal:

Bank runs occur when lots of depositors demand their money back at the same time. The bank, of course, doesn’t keep all their money in the bank. Deposits are lent out as loans (and so on). As such banks suffer short squeezes of liquidity if too many depositors ask for their money at the same time (unless, and until, the central bank steps in with newly created liquidity).  

Just like in a bank run, therefore, if too many gold future holders decide to take delivery of physical gold at the same time (rather than simply rolling their contracts), then it’s likely the swap dealers won’t be able to satisfy all those demands (i.e. the physical gold isn’t there/available).

It’s with that backdrop that we wonder if the ‘other reportables’ investors/speculators are deliberately, or just coincidentally, trying to create that situation (akin to how hedge funds/other investors exploited the lack of storage capacity at Cushing, helping to push the oil futures contract into negative territory in April).

If so, then this will be one of those ‘rare’ occasions when the message of the positioning, sentiment and other models is wrong – and markets don’t immediately mean revert but enter into one of their occasional parabolic price moves.

The banks, as with the ants may decide by themselves or be persuaded by other participants to switch dramatically from being short the gold market to being long. The message from the world of ants is that once a critical mass of individuals switch from one side to the other, the market can switch on a dime, and in this case driving the gold market even higher.

Whether it occurs or not, the analogy of the ants demonstrates why its important to understand the behaviour and incentives of individual market participants.

Related article: Positioning analysis in commodity markets: An interview with Mark Keenan

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