As far as I’m concerned, this past week was a bit wacky. Here’s a couple of reasons why. First, Jay Powell basically testifies that the Fed is going to cut rates at the end of July yet 10-year Treasury bonds end the week 8bps higher. Second, equity markets rally, volatility declines and longer-dated treasuries sell-off yet gold rallies. I’ve spent some serious time trying to make sense of these seemingly incongruous market moves. I think I made some good headway in explaining but I guess I’ll let our readers be the judge of that.
Before we jump in though, I’d like to keep everyone anchored as to my current thinking. I still believe that these new market highs provide a good opportunity to rotate more defensively as my base case go-forward expectation remains unchanged. On an intermediate term basis, that view should be supportive of gold. That having been said, on a near-term basis, I believe the gold money relationship is fairly balanced and will require an actual shove from incoming data to determine its path forward. What’s keeping it in balance? Concern over corporate earnings guidance (which I spend a good chunk of time on in the US Equities section below) vs. renewed expectations of a very dovish Fed appear to me to have gold trading in equilibrium. Not to be forgotten, there is clearly some level of geopolitical tension premium built into the yellow metal.
What’s your view on how gold as an investment will perform? Here’s my view and review of the related markets that matter.
The S&P gained 0.8% for the week, ending Friday at an all-time high of 3,013.77. Gains were logged from Wednesday onward after Powell’s written testimony was publicly released. Most viewed the release (followed by his live appearance before Congress) as the Fed cementing its case for a rate cut in July. I must admit, seeing Art Cashin wearing an S&P 3,000 hat on CNBC made me cringe a bit in contemplating whether or not we are closing in on a market top. No offense Art! With the market rising, the VIX continued its descent form 13.28 to 12.39. At these levels and using log normal data, the VIX is now greater than 1 standard deviation below its long-term average. From a technical standpoint, we continue to inch closer to a mean reversion environment but likely still have some ways to go. What about fundamentals?
In my view, there is a significant risk that deteriorating fundamentals may usurp the tame-ish technical environment. While Atlanta Fed GDPNow remained stable for the week, continuing to hover below 1.5% for expected Q2 GDP, this article caught my attention as it relates to corporate earnings season. While an outlier, as most early reporter’s earnings have been ahead of lowered expectations, it is still too early in the season to breathe a sigh of relief. As of Friday, FactSet Earnings Insight states that only 24 of the S&P 500 companies have reported. This coming week will be telling as more than 10% of the index, 57 companies, are scheduled to report. After a significant number of negative pre-announcements coming into the quarter, the index is currently expected to post a 3.0% decline in earnings. Normally, there are enough positive surprises that the growth rate should end up mildly positive for the quarter. However, should it not, Q2 will be the second consecutive quarter sporting year-over-year earnings declines. While I am not necessarily worried about the actual results vs. what is built into market expectations, I am keenly focused on corporate guidance for the balance of the year. In order for a recession to be in play, guidance would have to indicate the potential for declining revenues. To provide context, as of today, the expectation for Q2 revenue growth is 3.7%. Obviously, there is a bridge to gap there and I acknowledge that. I will provide an updated scorecard with respect to these measures as the earnings season progresses.
10-year Treasuries continued their sell-off this week despite Chairman Powell’s testimony with yields increasing from 2.04% to 2.12%. While yields crept higher during the early part of the week, the biggest increase came on Thursday after the release of hotter than expected CPI data combined with weak demand for the government’s 30-year bond auction. The bid-to-cover ratio for the auction, a measurement for demand, came in at 2.13. This was well below the reported 12-month bid-to-cover ratio average of 2.27.
The short-end of the curve, however, was a completely different story. 3-month T-bills (the best barometer for future Fed action) rallied on the back of the testimony and yields fell from 2.23% to 2.14%. With the current Fed Funds rate in the range of 2.25% to 2.5%, 3 month T-bills are expressing high confidence in a 25bp cut. Markets will continue to shift in advance of the Fed’s July 31st rate decision, but if all remains the same and the Fed cuts 25bps (instead of 50bps), there will likely be some disappointment. Why? After dropping to a near zero probability of a 50bp cut at the beginning of the week (as implied by Fed Funds futures), the chairman’s testimony drove this probability back over 20%. Ultimately, the testimony eliminated the healthy pullback in rate cut expectations that, in my opinion, the market had achieved last week. We will monitor this closely as we get closer to the actual meeting.
The combination of dramatic moves in both the 10-year and the 3-month came close to completely eliminating the inversion in the yield curve. Now only 2bps separates the yields between those two maturities versus 19bps one week ago. In fact, other market participants claimed that the curve actually regained a normal shape briefly on an intraday basis this past week. Should this be a cause for celebration? While ultimately time will tell, I’d point you back to this piece which I highlighted a couple of weeks ago. To remind readers, it argues that a re-steepening of the treasury curve, once it has inverted, is the “final recessionary shoe”.
As for the US Treasury – German Bund spread, not much excitement there this week. Spreads held in at +240bps, implying a negative yield of -.28% on German Bunds. While an improvement from all-time lows of -.4%, it still costs you money to lend to Germany, which incredibly, is not a unique situation. If you followed my @CIORobPerry twitter account this week, you would have seen this article from Bloomberg that highlights how you have to pay for the privilege of holding some European junk bonds. Yes, you heard that right.
With the Fed driven rally in the shorter end of the curve, the US Treasury – Precious Yield spread* descended further into negative territory at -.16%. 2-Year Treasury notes finished the week at 1.84%, down from last week’s close of 1.87% while Precious Yield continues to offer 2-year physical gold term deposits of 2%. Since Precious Yield offers investors in gold the opportunity to earn interest, the US Treasury – Precious Yield spread is tighter than the US Treasury – gold yield spread. To remind our audience, the gold yield is negative in most other holding forms outside of Precious Yield. This includes paying for storage of physical metal whether investor-owned or via a physically -backed storage program and paying management fees for GLD or similar ETFs. See our white paper for a more thorough discussion. Precious Yield provides a much needed yield alternative in this environment of ultra-low / negative global bond yields.
The US Dollar weakened after Powell’s testimony as cumulative odds on Fed easing ramped back up as discussed above. On a week on week basis, the dollar index fell nearly 0.5%. As far as the dollar was concerned, the drop in short-term Treasury rates outweighed the increase in longer term Treasury rates. There was no notable divergence amongst the major currencies as the dollar weakened fairly uniformly across the Euro, Yen and Pound. As I’ve stated in previous reports, the actual cut of rates at the Fed’s next meeting would likely cause the next bout of dollar weakness. However, Powell’s testimony and the July 25th ECB meeting may have changed that calculus somewhat. As market expectations grow with respect to easing, the hurdle on additional dollar weakness gets higher, and we will see where things stand post ECB.
As measured by the LBMA afternoon fix, the price of gold increased 1.4% for the week and reclaimed the $1,400/oz level, finishing at $1,407.60. Gold prices recouped most of last week’s losses on the heels of a weaker greenback and a drop in short-term bond yields. While a stronger equity market and an increase in longer-term rates should have offset those positives for gold, I believe the tie-breaker went once again to geopolitical tensions. While most of gold’s gain this week came on Wednesday in conjunction with the release of Powell’s written testimony, tensions with Iran that occurred after the congressional testimony clearly offset an equity market which continued to rally.
How bad have tensions gotten? To get a sense for that, all you have to do is look at oil prices with WTI spot up 4.6% this week alone. Remember, these tensions began with the suspected attacks on two oil tankers in the Gulf of Oman on Thursday, June 13th. This past Thursday, three Iranian boats tried to block passage of a British tanker in the Strait of Hormuz. The below chart shows just how much those tensions have driven the price of oil since the middle of June.
Considering the significant easing built into expectations, it would seem to me that gold prices are increasingly dependent on these tensions and therefore, poor economic data and/or corporate earnings announcements are needed to sustain additional gold investment returns.
As for gold volatility, it continues to ebb. Using the “Gold VIX” (Ticker – GVZ ), volatility dropped from 15.07 from 14.65. While the continued decline in this reading continues to inch closer to 1 standard deviation below the average reading since June 2008, it still does not portend mean reversion for those who like to marry fundamental analysis with technicals. As discussed last week, the Gold VIX measures the market’s expectation of 30-day volatility of gold prices by applying the VIX methodology to options on SPDR Gold Shares (Ticker – GLD ). GLD is an exchange-traded fund (ETF) that represents fractional, undivided interest in the SPDR Gold Trust, which primarily holds gold bullion. As such, the performance of GLD is intended to reflect the spot price of gold, less fund expenses.
While an investment in gold has historically been associated with negative carry, Precious Yield offers investors the opportunity to earn a yield on gold. If you are a long-term holder, turning gold as an asset for diversification purposes into an alternative investment with Precious Yield allows for some cushion against gold price movements via the gold yield. To learn more, please browse our website or contact us for more information. For up to the minute thoughts, please follow me (@CIORobPerry) or Precious Yield (@PreciousYield) on twitter.
* Note that while I use the US Treasury – Precious Yield spread as a relative value metric, a better apples to apples comparison of similar instruments would be US Treasuries vs. a fully hedged gold position. For more information on a fully hedged gold position as a yield alternative, please visit our www.kilofutures.com website and read about The Cash and Carry Trade.
Gold 1-Month Price Chart
Silver 1-Month Price Chart
Platinum 1-Month Price Chart
Palladium 1-Month Price Chart
About the Author
Rob Perry is an avid student of the markets and an aspiring tennis player. He is currently Chief Strategist for Precious Yield as well as Chief Investment Officer of Pecan, a single-family office based in San Diego, CA. Most recently, he was located in New York City working as Chief Strategist of and a Portfolio Manager for Kingsland Capital, a multi-billion dollar boutique asset management firm focused on below-investment grade corporate credit. Twitter: @CIORobPerry
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