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,
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).