Gold’s price has dropped by almost 7% since the end of May.1 Most of the move can be attributed to an increase in interest rates following last week’s US Federal Reserve (Fed) FOMC meeting. As inflation concerns grew, the Fed signaled a more ‘hawkish’2 direction with an expected hike in the policy rate by 2023, earlier than the market had thought.3 In turn, US 2-year rates almost doubled from 14bps by the end of May to an intra-day high of 28bps on 18 June.4
Gold’s reaction is not surprising given that it has experienced higher sensitivity to interest rates over the past year, as we discussed in our most recent 'Gold Market Commentary', and our recent blog: 'Short-term gold performance model: how it works and why it matters'. In addition, investor positioning prior to last week’s Fed meeting indicated that gold had likely become overbought and could pause its ascent or even retreat in the short run (see 'Investment Update: Time to realise gold’s true volatility'), along with an assessment of market positioning as likely indicating that gold had, at that time, become.
Now that a pullback has materialised, the gold options market shows some interesting dynamics forming. Historically, from a volatility perspective, when gold sells off quickly, we usually see the ‘put skew’5,6 increase as investors are willing to pay a premium to protect against further downside. In the selloff over the past week, however, we have seen the put skew decrease or ‘cheapen’7, suggesting investors may be selling out-of-the-money (OTM) put options to gain long exposure to gold at a price they might consider more attractive. They have also been buying more at-the-money (ATM)8 puts, in lieu of downside puts to take advantage of the recent increase in implied volatility,9 as the ATM put prices will likely be more sensitive to price and volatility changes (Chart 1).
By the same token, while implied volatility has risen so, it has so far only done so slightly, moving up about one volatility point to a level of 16 (equivalent to a 16% annualised expected volatility). This is still in line with historical average levels. By means of comparison, during previous similarly sharp downward moves, we have often seen gold’s implied volatility reach levels closer to the 20’s. This could suggest that some of the selloff is being buffered by buyers, some of which may see this as a tactical opportunity but also by investors building strategic positions, as we discuss below.
While investors may still be concerned about further downside risk their positioning suggests that many of them believe the selloff could be overdone and could be using this higher implied volatility to gain long exposure to gold at a more attractive level.