While I intend to spend time rehashing the past week’s events and their impact on the various markets we follow, it would be ignorant not to mention the breaking news hitting the wires as I sit here and author this week’s report. Early Saturday, an oilfield operated by state-owned Saudi Aramco was attacked by a number of drones. The closure of this oilfield post the attack will impact 5% of the world’s daily oil production as reported by the Wall Street Journal. Yemen’s Houthi rebels claimed responsibility for the attack while US Secretary of State, Mike Pompeo, said that Iran is responsible given their support for the rival Yemeni government in Sanaa linked to the Houthi. Although it’s still too early to tell the extent of the damage and how long the facilities will be shut down, this will undoubtedly impact markets. And so, while much progress had been made recently with respect to US-China trade relations, I think that we will see a pause in the risk-on market trends that have dominated over the last week and a half. When markets open for trading this coming week, this resurfacing of geopolitical tensions with Iran will likely drive a flight to safety and will be the biggest driver of the gold money relationship, at least initially. Also, we will see if this news changes the Fed’s calculus in any way with respect to their upcoming rate decision this Wednesday.
So, why did the risk-on sentiment continue to dominate this past week’s trading? After heavy gains in the S&P 500 over the last 2 weeks, the index looked poised to pull back at the beginning of the week. However, after the stock market held key technical levels during the early part of the week, US-China news flow continued to improve. Prior to Wednesday’s US market open, China announced that it would waive import tariffs on 16 products, giving those products a tariff exemption that would last a year. This was quickly followed by an announcement from President Trump after Wednesday’s market close that the US would delay increasing tariffs on $250BN worth of Chinese goods by two weeks from Oct. 1 to Oct. 15. Keeping the momentum going, China then made further concessions on Friday by adding agricultural products like soybeans and pork to the list of imports exempted from tariffs. That having been said, the bulk of this week’s stock market gains came entirely during the Wednesday and Thursday trading session.
Not to be lost in the shuffle, on Thursday, the ECB cut its deposit rate and instituted a new quantitative easing (QE) program in an attempt to lift Eurozone growth. The extent of the announcement, however, was widely expected and failed to drive additional gains in European government bonds or weaken the Euro further. In addition, the chorus of people who question the effectiveness of negative interest rates and the remaining firepower of central banks continues to grow louder and louder. In the end, I believe the ECB rate decision was a non-event as compared to the news flow surrounding US-China trade. After all, one of the biggest reasons why global economic data has become so weak is because of the trade tensions.
Speaking of economic data, it was generally better than expected as Friday’s retail sales for August came in at 0.4% MoM growth versus a 0.2% MoM growth consensus. Furthermore, the University of Michigan preliminary consumer sentiment reading for September rebounded to 92.0 and beat consensus expectations of 90.9 per Trading Economics. Here is the updated chart on consumer sentiment which shows the slight rebound. Remember, a strong consumer is one of my two key flies in the bears ointment.
Finally, on the economic data front, earlier in the week inflation readings were mixed as slightly better than expected overall inflation was offset by slightly higher than expected core inflation. While Fed Fund futures did not re-rate until the end of the week (discussed more in the Government Bond section below), I believe that the slightly hotter than expected core reading ultimately had some impact.
Last but not least, copper (my other fly in the bears ointment) continued to benefit from the renewed optimism surrounding US-China trade talks. This news flow helped move the front month futures contract even further away from the dangerous $2.50/ high $2.40s technical level that I’ve previously mentioned. To remind you from last week, copper futures pierced the most recent high from mid August which is now easier to see on the below chart. I believe that holding the $2.50/high $2.40s support level remains critical for the bull narrative. For the moment, that appears to be the case.
Before diving into each individual market, I’d like to remind readers that anyone who is thinking about buying gold or silver as an investment and who is worried about initiating a new position at current prices should carefully develop their own view and consider their expected holding period. There are many and varied drivers of the gold money relationship. In support of developing that view, let’s review the major markets that precious metals take their cue from.
The S&P posted another week of solid gains, increasing a shade under 1% and once again claiming the 3,000 level to finish at 3,007. We are now just within a whisper of all-time highs again. The upside breakout that occurred last Thursday was confirmed early this past week, as stocks traded lower both Monday and Tuesday on an intraday basis, but never breached the 50 day moving average to the downside. With this newfound confidence in the technical picture and a boost from more positive US-China trade news, all of the week’s gains were booked on Wednesday and Thursday. That having been said, even before the breaking news of the Saudi Arabia oilfield attacks, stocks were looking overbought. This just adds to my confidence in a near-term risk off move. However, if tensions with Iran stay contained and US-China trade talks stay on track, I would expect the risk-off environment to be temporary.
In conjunction with the rally in stocks, the VIX declined from 15.00 to 13.74 as volatility ebbed from Wednesday onward. At a level of 13.74, we currently sit below the long-run average (since January 1990) using log normal data but are still within one standard deviation. Vix futures remain in contango (i.e. upward sloping), indicating that the market does not believe there will be meaningful near-term volatility. I guess that was a bad assumption at the end of the week given this morning’s news. Expect volatility to increase during the initial part of this week.
The sell-off in US Treasury Notes was quite astounding this week. 10-year Treasuries increased 35bps in yield to finish at 1.90% from 1.55% the prior week while 2-year Treasuries increased 26bps to finish at 1.79% from 1.53% the prior week. To me, the chart clearly looks like 10-year Treasuries are aiming to get back to 2%. Today’s news, however, will likely halt this ascent in yield on a near-term basis.
Precious Yield, on the other hand, continues to offer 2-year physical gold term deposit rates of 2%. As a result, the US Treasury – Precious Yield spread* continued to favor Precious Yield at week’s end albeit to a lesser extent than it has over the last several weeks. The spread narrowed from -.47% last week to -.21% given the rise in 2-Year Treasury note yields to 1.79%. Note that a negative spread favors Precious Yield while a positive spread favors US Treasuries. 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 how to gold investment white paper for a more thorough discussion. Precious Yield (whether hedged* or unhedged) provides a much needed yield alternative in this environment of ultra-low / negative global bond yields.
As for 3-month T-bills, near-term expectations surrounding next week’s Fed meeting led to no change in their yield. They remain anchored at 1.96%. Given the above movements in yields across the curve, there was some serious steepening that took place this week. The chart below shows the current shape of the US yield curve (blue line) versus the end of August (green line).
Looking at the moves in the 10-year and 3-month in conjunction with one another, the inversion now stands at a mere -6bps versus -41bps last week. Remember, with the Fed Funds rate currently in the range of 2% – 2.25%, a 3-month T-bill yield of 1.96% predicts one very near-term Fed rate cut. But what do Fed Funds futures say about next week’s meeting?
As you can see from the chart below, Fed Funds futures no longer believe that a cut is guaranteed this week. One month ago, there was a 20% chance of a 50bp cut. Now, there is a 20% chance of no cut at all. That is a serious recalibration of expectations. Given where we now stand, I think a 25bps cut will lead the equity market to rally initially post announcement but of course will be sensitive to future guidance and news flow out of Iran.
So what about that future guidance piece? Let’s try and gauge that by looking at where expectations for the Fed sit through the balance of the year. Last week, I stated, “As we’ve discussed for a couple of weeks now, Fed Funds futures are still expecting an 80% chance of more than just one cut by the end of the year.” Today, that probability sits at just over 50%. In my opinion, as long as the Fed cuts 25bps this coming week and they indicate that they are open to at least one more cut, the equity markets should react favorably initially post announcement.
Finishing with overseas action, US Treasury – German Bund spreads began to show signs of a reversal from their recent tightening trend. Remember, a continued tightening of this spread was (and continues to be) a key component to my recession watch list. To me, a reversal indicates some near-term relief and another element of the sea change that occurred across markets starting with last Thursday’s announcement on US-China trade relations. Below is a one-week chart that attempts to show you that reversal.
As you know from last week, we’ve been dealing with a persistently strong dollar trend that was, in my opinion, unaffected by last Thursday’s US-China trade news, at least as far as the dollar index (Ticker: DXY) is concerned. Despite this strong dollar trend, the dollar index was a touch weaker this week, declining a little over 0.1%. There was a stark divergence, however, amongst its major components. As the need for flight to safety assets has receded since the announcement on US-China trade relations, the Japanese Yen (13.6% index weight) has weakened. This week, the Yen fell almost 1.1% vs. the dollar. Conversely, the British Pound (11.9% index weight) gained nearly 1.8% most of which was in Friday’s trade. The major driver of this fx pair has been Brexit and recent news has caused momentum to swell behind the idea that Britain won’t leave the EU without a deal (aka “hard” Brexit). Per the linked article, the Pound’s recent strength has been “underpinned by the passing of a law… which aims to stop the UK exiting the EU with no deal on October 31.” Finally, the Euro (57.6% index weight) gained 0.4% against the dollar despite this past Wednesday’s ECB rate decision. The initial reaction by the Euro was weaker but the balance of the week trade more than reversed it.
Unlike the dollar index, the continued weakening of the dollar vs. the Chinese yuan has been directly a result of last Thursday’s news as well as incremental positive steps towards trade reconciliation that were noted in the overview. The reversal in this fx pair has been quite remarkable as shown in the chart below.
To repeat from last week, a pledge for renewed talks is not the same as achieving an actual trade deal. If any progress gets made in the trade talks towards an actual trade deal, it should still be a positive for risk-on markets and conversely, the gold price per ounce would likely suffer. Given the rebound we’ve seen to date, I would expect the reaction to an actual trade deal to be somewhat more muted than originally anticipated given that more expectations have been built into prices across markets.
Let’s summarize our foundational drivers for gold this past week. First, equity markets continued their upward move while volatility decreased (negative for gold). Second, government bond yields increased substantially, reducing the relative attractiveness of gold. Third, geopolitical tensions in the form of US-China trade relations eased. Finally, the dollar was stable to slightly weaker, a slight positive for the yellow metal. On balance, you would think that gold should have declined in price this week and that’s exactly what happened.
As measured by the LBMA afternoon fix, the gold per ounce price declined $20.60/oz. or just under 1.4% to $1,503.10/oz. Gold continued to decline in the early part of the week until it briefly got a lift post the ECB rate cut and QE announcement. However, the persistent increase in government bond yields quickly erased the benefits of the rate cut as far as gold prices were concerned. Given that I mentioned the NY closing price for gold last week due to the notable price action subsequent to the LBMA afternoon fix, I thought I’d also give you an apples to apples comparison on that basis. At the close in NY, gold settled at $1,487.90/oz, a decline of $18.60/oz or 1.2% from $1,506.50/oz last week. If you have been following me on twitter, I laid out what I believe to be support levels for gold in a September 9th reply to a tweet: “$1,500/oz. is a key support level, followed by just under $1,470/oz. and then the $1,400-$1,425/oz. trading range.” These targets remain in tact as long as risk-on continues to dominate current market sentiment. Based on this morning’s news, however, I would expect the price per gold ounce to regain some ground in the early part of this week
Although gold prices bounced around a bit over the course of the week, they bounced around within a pretty narrow range. That said, it should come as no surprise that gold volatility was fairly stable as well finishing the week at 14.94, a slight uptick from last week’s close of 14.75. This is below the long term average using log normal data since June 2008 but still within one standard deviation. Remember, I use the “Gold VIX” (Ticker – GVZ ) to get a sense for this metric. 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 a 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.
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* 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 price per ounce 1-Month Chart
Silver price by ounce 1-Month Price Chart
Platinum price per ounce 1-Month Price Chart
Palladium price per ounce 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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