First, Gold; Second, Japanese Equities; Who's Next For The 8-Sigma Risk Flare?

Tyler Durden's picture

It is not just the massive short positioning in Gold futures that has BofAML's commodity strategists concerned; but the regime changes in the precious metal's volatility structures suggests risks are significantly mispriced relative to equities, rates, and other commodities. Following the most abrupt price collapse in 30 years, near-dated implied volatility in gold spiked dramatically in the past month. The term structure of implied gold volatility has also changed shape and the market now shows a marked put skew. Even then, the spike in precious metals volatility had remained a rather isolated event until this week’s sharp drop in Japanese equities. As the following chartapalooza demonstrates, while large-scale QE has tempered volatility across all asset classes for months, we remain concerned about the recent sharp price movements in gold or Japanese equities, and see a risk that other bubbling asset classes may follow.

Via BofAML's Commodity Derivatives Insights,

Manic gold

Gold volatility has spiked following the price meltdown...
Following the most abrupt price collapse in 30 years, near-dated implied volatility in gold spiked dramatically in the past month (Chart 2).

Even then, the spike in precious metals volatility has remained until recent ly a rather isolated event. As we have discussed before, large-scale QE has tempered volatility across all asset classes for months, but price movements of this magnitude have yet to occur in other markets. In that sense, Japan’s equity market swing this week may be the second victim of large-scale QE. If so, volatility in other asset classes may follow. For now, implied gold and silver volatilities seem expensive relative to other commodity markets (Chart 3) or even other asset classes.

...and its term structure has dramatically changed shape
The increase in paper gold selling has met strong physical gold buying, as heavy investor flow has been somewhat offset by very robust jewelry and coin demand. As a result of the strong physical bid for the yellow metal, the term structure of gold prices has changed in recent months (Chart 4), and the discount of near-dated contracts relative to forward prices has narrowed despite higher interest rates.

Naturally, the term structure of gold volatility has also dramatically changed shape to reflect the abrupt prompt price swings (Chart 5) and it is now in backwardation, an unusual shape for this market.

The skew has also changed abruptly in just a few weeks...
The change in the term structure of gold is not the only drastic alteration of the implied volatility surface in the gold market. Of course, after a 12-year bull run, gold prices had naturally developed a marked call skew in the past decade (Chart 6), as the positive skew of returns kept OTM call options on gold very well bid.

This skew has now completely reversed on the back of the sharp pullback in gold prices (Chart 7), suggesting that the market is now much more concerned about downside than upside risks

...and puts are now much more expensive than calls
True, it is not unusual for a market to develop such a meaningful put skew after a one-in-thirty years price drop. However, this also means that gold is very unlikely to experience such a dramatic drop again over the coming months, in our view. As a result, we believe that the 3M 25D risk reversals seem extremely distressed relative to recent history (Chart 8).

Without a doubt, gold prices have experienced periods where returns maintained a negative skew in the 1980s and 1990s (Chart 9), but a soft floor set by a relatively high marginal cost of production of $1150/oz suggests the skew may be reflecting too much fear.

Changes in real rates tend to drive gold prices and vol...
At any rate, our quantitative gold models can only explain a small fraction of the gold price move. By extension, as we model gold price volatility, we can only explain a small fraction of the move that gold vol has experienced (Chart 11).

Our analysis suggests that gold vol is a function of broad market risk, broad commodity volatility, rates volatility, FX volatility, as well as movements in gold itself. Just as real interest rates in USD tend to be a major driver of gold prices (Chart 12), volatility in interest rates is also a very important determinant of gold vol.

...while commodity and FX price movements matter too
Historically, gold and oil have kept a very tight relationship for more than 100 years as well (Chart 13), so that oil vol is closely interlinked with gold vol.

Movements in FX also matter for gold, particularly those of the trade-weighted US dollar. The recent strength in the USD, in particular against the JPY, has likely put some downside pressure on gold prices (Chart 14). More importantly, the pick-up in FX volatility relative to other asset classes has probably been a contributor to the spike in gold prices in recent months.

In the end, it is all about fiscal, monetary, and CA balances
While near-term changes in FX, rates or commodity prices can help explain changes in gold prices and volatility, the structural factors behind gold remain fiscal and monetary policy, as well as current account balances. In that sense, fiscal consolidation is the enemy of gold just like fiscal profligacy can destroy confidence in fiat currency, and the recent tightening of budgetary gaps has not helped support the gold market. Having said that, current account balances are not shrinking anymore, with Central Bank assets once again growing fast. In part, this reflects the inability or unwillingness of China, Japan, and the Eurozone to run current account deficits. It also reflects persistently high crude oil prices and the accumulation of large surpluses at producing nations.

While gold vol has spiked, other assets have not noticed
In that sense, we believe that implied gold volatility is very strained when compared to the volatility in other asset classes. Put otherwise, if large-scale QE is distorting asset prices, volatility pockets are likely to emerge across many markets, not just gold. For example, gold volatility is at present higher than volatility in oil markets (Chart 17), a rather unusual situation given the completely different nature of these two commodities.

Even when looked at against equities, gold vol looks particularly expensive at this point (Chart 18). If the recent crash in Japanese equities is a canary in the QE coal mine, S&P500 vol may be undervalued relative to gold price volatility.

1M gold vol feels expensive, with OTM puts most overpriced
Also, our broad market risk index seems low relative to recent movements in the gold market. Yet, as we have argued throughout this note, gold prices and gold volatility are as much a victim of QE excesses as any other asset class. Thus, while gold has already had its “eight-sigma” event this year, other markets may yet have to experience it.

With near-dated implied gold volatility trading at very distressed levels, we believe gold vol provides an attractive short particularly against longs in volatilities in other markets such as equities, rates, or even commodities (Chart 20).

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.

Well. That was the deluxe Reggie middleton chart porn package, for sure. BTFD's, Bitchez - is the word of the day.

I think I need to buy a gun's picture

i'm a bubble and i'm ready to pop,,,,,,,,,

philipat's picture

This all assumes that the Charts reflect free markets. When The CB's manipulate Gold downwards in an attempt to maintain Fiat, as at present, Charts mean nothing.

lewy14's picture

For what it's worth...

Thanks Tyler(s) for posting stuff like this.

Curated research with highlights, summaries and informed commentary from a center-cynical perspective would be worth paying for, if you wanted to expand your business model. 

machineh's picture


This professionally-written article, citing factors such as option vols, skews, forex and real interest rates (all derived from the so-called 'paper markets') is an another league from the heavy-breathing, 'shortage of physical,' 'fifty times as many buyers as sellers' swill from the charlatans, trying to entice one last group of shoeshine boys to plunge their nickels into 'phyzz.'


Bring the Gold's picture

Keeping trading paper. See how that works out for you. I agree there is plenty of hyperbole in the gold arena, but the underlying premise is sound and more on point now than ever.

mmanvil74's picture

I have always contended that the only thing that will crush gold prices are higher real interest rates. It is not clear yet if we are headed there but rumblings in both the gold market and bond market (especially Japan) indicate that at least someone thinks higher rates are ahead. Nobody thinks the fed will let interest rates rise in any significant way,twitch means the ultimate contrarian should short tbills. I don't see a Paul volker in the distance I think inflation would have to kick up massively before interest rates rise, however, could it be that we all underestimate the problem that QE has created, namely, the fed attempts to end QE, which results in a sudden interest rate spike which drops gold further, even though there is no "inflation"? In the event there is an attempt to end QE, The bond market cracks, driving stocks ever higher, gold lower and fiat loses value finally to inflation globally. The other contrarian possibility is that energy prices stay low, enabling the fed to sustain QE, restrain interest rates and then what happens to gold?

I am admittedly uncertain about the future gold price at this time. To me the bubble is in bonds, and only the fed has the keys to that bubble, I don't think they can risk bursting it which, long term still has to be good for gold. Fiat will not outlast gold but the shorter term investor has to consider what other investment s will outperform gold in the interim. Stock of profitable companies should outdo gold unless/until all hang breaks lose again, but now that the fed has taken over the bond market there is no turning back so we are probably in for a Japanese style stagnation, but s&p stocks are more correlated to the global economy not us economy and are therefore attracting risk capital at this time.

lewy14's picture

I share your uncertainty.

Agreed that real interest rate is the key "fundamental" for gold. It's very difficult for me to understand how real rates are going to rise for any significant period of time, any time soon.

The asset class that truly seems to be working here is - hate to say it - stocks. Delivering dividend growth and promising some small capacity to "surf" a surge in inflation. Corporate profits benefit from the macro environment and so stocks get bid up - even though that macro environment is itself toxic and unstable.

Can't not own stocks. Can't not own gold.

Can not own bonds (specifically, duration).

There. Asset allocation done for another quarter. Check.

Mugatu's picture


You have one thing right - this entire 5 year clusterfuck is all about interest rates.  Everybody focusing on equity valuations have their heads in their asses.  Here are some common sense observations that will give you a clue about what will happen:

  1. Going into this grand scheme of QE, the whole strategy was to lower interest rates as fucking low as they could go on the absurd pretense that this would unlock the grand forces of capitalism,  Everyone assumed that inflation would run wild. Everyone was wrong - instead we got stuck in a Bonzo world where for the most part we have deflation with some pockets of inflation.  The opposite happened from what all the pundits thought,
  2. Whenever interest rates rise (and they will because every party ends), the obvious result should be the opposite - inflation should rise and the pendulum swings the other way.  Now your average meat puppet on TV says rising rates will curtail economic activity, and thus cause us to fall into a recession which will taper inflation.  That answer will get you a A in Econ101, but it the real world again the opposite will happen,  As interest rates rise, a bloated indebted America will be faced with rapidly rising interest costs, and all costs we now get passed along in prices eventually. We get the final Bernanke Solution of Stagflation - suck ass economy and inflation. 

So the answer is real simple: In ths Bizzaro Bernanke Economy DO THE FUCKING OPPOSITE OF WHAT SHOULD LOGICALLY HAPPEN!

This entire gig is up when interest rates finally rise.  Big inflation.  That fucking Bernanke makes me sick every time I see him.

icanhasbailout's picture

I vote Spanish bonds

q99x2's picture

At minimum it shows that the conscientiously economic minded are establishing a portfolio percentage in gold before this tech-centric society's version of the plagues of the dark ages are unleashed and the only  light in the skies are flashes from mushroom clouds.

markettime's picture

So.... what this post is saying is that gold is oversold?

disabledvet's picture

it says volume needs to decrease in the paper trading of gold before all those cash volumes simply drown out the longs. God forbid if the price actually falls. in other words "good look with the short squeeze ridiculousness." the technical damage has been all that remains to be seen is whether or not this is a rout. good article as well i might add. listen...real simple: Japan is the second biggest bond market in the world. if that that "goes parabolic in yield" it's game over for TRILLIONS in debt. the Fed will probably have to step in again to back stop "yet another batch of Wall Street's Biggest Losers" and at the same time "prepare for dispatch of an are you okay? unit to Tokyo." VERY much a confidence building measure for the US economy going forward. of course "that could be one hell of an equity dip to be buying on" this summer and fall.

monopoly's picture

This phony Goldilocks theme will last just so long. Then it all goes away. And I do not care where the price of gold moves short term. I have my stash and that never changes. Soon we will be over 17 T in debt and over our debt limit, again. How is my 24 year old daughter going to pay back 17 Trillion in debt in her lifetime and her children's lifetime. Never going to happen.

And do not tell me about an improving economy. It is mostly bullshit. Just think of where we would be if we were minus 4 trillion at this point printed. Yet, so many have no clue what is coming down. They just go about their daily routine as if there never was the last financial crisis. Maybe they will pay attention when the next one hits. Man, it will be something for the history books. 

disabledvet's picture this truck is produced at a single production facility in Missouri. best year was almost one million in a single year. it's around 700,000 a year now...if the brand expands globally into China, South America, Europe and North Africa it could easily hit 2 million a year. if you don't think this can be done at a single production facility...think again. This product alone could fund Missouri's state budget for decades. and "what costs you and me 40,000 here in the USA costs Brazil and China 100,000 to start with." Probably not Mexico though. they still make small block chevy V-8's down there.

HulkHogan's picture

A tax against 2M could fund Missouri's budget? Please explain? And great chart porn Ty's.

css1971's picture

It's up against Toyota Hilux in the rest of the world, basically zero appeal. It's more likely that Toyota will take the US market as well.

i-dog's picture

In Ford news from elsewhere:

Thu May 23, 2013: Ford Australia to close Broadmeadows and Geelong plants, 1,200 jobs to go

"Ford Australia says it will close its Australian manufacturing plants in October 2016.


"Our costs are double that of Europe and nearly four times Ford in Asia," Mr Graziano said."

Urban Redneck's picture

I hope Ford has some other engines they can put it them  and export exemptions to get them out of the country.  Ford's ethanol & ultra low sulfur crappers from the last decade simply won't cut it in the real world with its real fuel.

longwind's picture

Not one chart even outlining Bernanke's thumb. You call this analysis?

criticalreason's picture

was that a buy or sell rec?

W74's picture

Call me stupid if you must, but could someone please explain what EXACTLY Sigma means.  I'm seeing the term thrown around a lot these days and I think a lot of readers (I know I do) might have questions.

DeadFred's picture

The greek letter sigma is used to denote a standard deviation in statistics, often used in market analysis despite the lack of normal distribution in the underlying data.

W74's picture

Ahhh, heck.  A lot of good 4 years of university did then.  I always thought "?" was just "alpha".  I guess the stats guy was fucking wrong.

I can see where he'd get it confused with '?' though.

Always did love STD's though, very useful for anything involving large groups and to demonstrate reversion toward the mean.  I wish Liberals understood deviations, they always want to say "nuh uh, your theory is wrong because look at this individual....seeeeee" yet fail to understand how statistics only plays out on groups, not on individual units.

machineh's picture

Always did love STD's though

Yeah, it's all fun and games till the sores break out.

Maestro Maestro's picture

Freegolders say they are AGAINST gold as money but that they are FOR gold at the same time.


Who is AGAINST gold or honest money?




Fregolders say that gold is neither commodity nor money.  What kind of bullshit is that?




NOTW777's picture

chart 13 has data for 2016?

WTFUD's picture

thank god i am reading this while sitting on the crapper.

monad's picture

“The German capacity for work is our gold and our capital. and with this gold I can compete successfully with any power in the world… My whole economic system has been built upon the conception of work. We have solved our problems while, amazingly enough, the capitalist countries and their currencies have suffered bankruptcy. Sterling can find no market today… But our Reichsmark, which is backed by no gold, has remained stable. Why? It has no gold cover, it is backed by YOU and your work… German currency, with no gold coverage, is worth more today than gold itself. It signifies unceasing production."

“Work alone can create new work: money cannot create work.  Work alone creates values, values with which to reward those who work. The work of one man makes it possible for another to live and continue to work. And when we have mobilized the working capacity of our people to its utmost, each individual worker will receive more of the world’s goods.” Adolf Hitler 10 Dec 1940 (Krug, Bern, et)

bugs_'s picture

I'm thinking Obama's hemorrhoids are next for the 8-sigma risk flare.