Why Precious Metals Crash During Market Meltdowns

During last week’s Coronavirus market sell-off, where global stock prices plunged more than 10%, you can assume investors are moving into the usual safe-havens: Government bonds, Japanese Yen, and Swiss Franc, among others, are rallying in unison.

There is, however, one asset class that’s behaving rather strangely: precious metals. Despite their popular safe-haven status, gold, silver, platinum, and palladium — priced in U.S Dollars — have fallen 5% or more from their highs. But why, in a period of mass panic and fear, are metal investors experiencing heavy losses?

The answer is volatility.

When markets undergo extreme selloffs, liquidity evaporates as participants flee, causing volatility to skyrocket. The Volatility Index — or the VIX for short — which tracks the expected one-day move in S&P500 stock prices is the best way to monitor such events: The higher the VIX, the more markets melt down.

In popular finance, the VIX has another nickname: the Fear Index which originates from the index displaying extreme readings when the stock market is in panic mode. Though, it’s important to remember that a higher reading equals higher volatility, not extreme fear as volatility can also rise in periods of extreme greed.

Recently, the VIX showed that the Coronavirus created panic within the financial system producing an illiquid market, however, stress levels rose gradually over a week before the actual sell-off. While the cause, whether fear or deeper technical issues, is still unknown, we do know it was a liquidity-related issue.

Six months prior to the Coronavirus spreading worldwide, the Federal Reserve, in response to a mini-crisis, provided extra funding to primary dealers in the repo markets. The central bank achieved this by injecting billions of dollars into the financial system, and the cheap money flowed throughout markets manifesting itself in speculative asset classes — stocks and high-yield bonds to name a few — creating a temporary credit bubble.

What’s interesting, though, is just before the market meltdown, the Fed suspended its repo operations removing vital liquidity from the system, suggesting that a major liquidity shortage created fear instead of the Coronavirus. Still, the saying goes, “narrative follows price” as illiquidity paired with virus headlines created the perfect storm, and the panic selling began.

Fear alone fails to explain why precious metals sold off, but a liquidity scare makes perfect sense as liquidations always occur when volatility spikes to record highs. When asset prices moving aggressively, highly levered investors are vulnerable — usually to a 100 percent or greater move in the VIX — triggering margin calls: a request from your broker asking you to deposit more money to cover trading losses, which leads to investors liquidating their high-quality assets such as gold and silver to cover any collateral damage.

According to Standard Chartered, preceding a crash, precious metals are the best-performing asset class making them a popular liquidation choice. A concrete example is the Financial Crisis of 2008 where $8 trillion of stock market wealth vanished, but gold also fell by over 20%, bottoming in November 2008 — as shown by the chart below.

Gold predicting the financial crisis, then selling off. — Created by the author

When you combine both high volatility and illiquidity with extremes in bullish metal sentiment, a collapse in precious metal prices soon follows. The “buy the rumor, sell the fact” trade unwinds as markets have already priced in the crash, while other markets prone to speculative manias, such as stocks and high yield debt, tend to mask deteriorating fundamentals, which is exactly what happened in both the 2008 financial crisis and the recent market meltdown.

After this week’s turmoil, some investors will be questioning if precious metals are still classed as a hedge. Though markets are, first and foremost, leading indicators and the big moves occur before a meltdown takes place. Within a liquidity-driven environment, declining economic fundamentals and central banks responding with loose monetary policy are times when precious metals outperform, but not during the market crash itself — as you would expect.

Ironically, during a crisis, buying any element in the periodic table has proved to be one of the most unprofitable, short-term investments in recent times.

- Source, Concoda via Silver Beaf Cafe