What is the fair value of gold? This is the question many investors and traders asked themselves as they reassessed their portfolios and risk exposures in the light of Covid-19. The world economy was faced with an unprecedented shock in 2020 and no single asset class was immune. Global gold markets took center stage when the precious metal climbed above $2,000 per troy ounce in August. One item at a time, we look at recent developments in COMEX gold futures trading.
Macro Environment For Gold
Back in March, governments and central banks across the world took quick action when the global economy went into lockdown mode. The support they gave to protect citizens and businesses also fed through to financial markets. The Federal Reserve and other central banks have promised to keep interest rates at record-low levels until further notice. Low interest rates make gold more attractive, since low financing costs reduce the opportunity costs of holding gold in a portfolio. Another factor has helped push gold higher: since it is priced in U.S. dollars, a decrease in the value of the dollar naturally increases the price of gold. The U.S. dollar has been weakening against many of its global competitors this year: it lost strength versus the Euro, the Yen, the Swiss Franc and the Chinese Renminbi. Finally, the uncertain economic outlook may have led many investors to increase their exposure to the yellow metal as a safe haven asset.
All in, this created something like a perfect environment for gold to reach a $2,000 price level. Since then, the metal has fallen back slightly, just as the U.S. dollar and interest rates have shown tentative signs of strengthening. For the remainder of the year, the upcoming U.S. elections will be one of the key events to watch. Of course, the Covid-19 pandemic is not under control yet, and so it should also continue to have a significant impact on financial markets and on the price of gold.
Source: Bloomberg, CME Group
Increased Participation In Micro Gold Futures
In a turbulent year for global gold markets, one COMEX product stands out for its increased market adoption and rising volumes. Micro Gold Futures (MGC) have had a stellar year to date. In August 2020, volume traded amounted to more than 5% of that of the benchmark Gold futures contract (GC) in notional terms (so after adjusting for the different contract sizes). In total, 1.7 million MGC contracts were traded that month. The August numbers are not an outlier. They are part of a broader trend of increased MGC volumes, both in absolute figures and in relation to GC volumes. The trend started around early 2019. Back then, contract volumes were around 25,000 lots per month, less than half a percent of GC notional volume.
Source: CME Group
MGC futures are essentially a COMEX GC lookalike contract with one tenth of the contract size. The lower contract size makes MGC accessible to a class of investors that may find trading the benchmark GC contract too onerous in terms of initial capital outlay and daily margining requirements. With increased trading volumes, liquidity in MGC is converging towards GC levels. In the chart below, the MGC top-of-book (TOB) bid/ask spread width is expressed as a ratio to the equivalent GC number. 200% means that MGC is traded twice as wide as GC;100% means that they both have the same screen liquidity. Data shows that MGC is drawing closer to GC. For example, during August, the TOB spread of the active MGC contract was 1.82 ticks wide, at similar levels to GC at 1.74 ticks.
Source: CME Group
Asia Premium Switches To A Discount
Typically, the price of gold in China is higher than international benchmark pricing. China is a net-importer of gold, and the higher price is necessary to attract gold to the country. Since the onset of the Covid-19 crisis, local physical demand for the precious metal has greatly diminished. Jewelry demand was particularly impacted by pandemic controls and the widespread economic uncertainty. With less demand and ample domestic supply, the China premium has now completely switched to a discount. The fact that China seems ahead of many nations in its economic recovery from the virus has not weakened this discount – at least until now.
Last year, COMEX launched gold futures contracts linked to the price on the Shanghai Gold Exchange (SGE). We are now witnessing a strong increase in market interest for these contracts. Open Interest in COMEX SGE futures - the number of futures contracts outstanding - has now reached record levels of above 1,000 contracts across both the U.S. dollar and the Chinese Renminbi denominated products.
Source: CME Group, Bloomberg
No matter what happens in the coming few months, it is safe to say that 2020 will be a memorable year in gold markets. And the last chapter is not written yet as there is a large event on the horizon - a potentially controversial U.S. presidential election in November. In 2020, gold broke through the historic price level of $2,000, and regional prices disconnected at a scale that had not been seen for a long time. Trading gold on COMEX can offer an unsurpassed level of liquidity and a range of products for many types of investors and trading strategies.
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