Note: Don’t miss our special section on the platinum group metals (“PGMs”) at the end of this report.
With markets continuing to run away to the upside, much of this week was spent debating just how much of an impact the Fed has had on asset prices. Said differently, many participants wonder whether this is a Fed-induced rally or a genuine acceleration in the economy or some combination of both. In order to make time to participate in this raging debate, many investors put their portfolios on auto pilot and were comfortable doing so given the remarkable lack of volatility that we continue to experience. If it hasn’t been clear, I believe much (not all) of the market movement can be explained by central bank activity. This has generally been to the benefit of those holding a gold investment or silver investment as well as any other investment for that matter. I too participated in this debate and if you are interested in my contribution, have a quick read of this twitter thread as well as this Bloomberg article which also attempts to answer the question. But in addition to those thoughts, I have a couple of other Fed-related insights to share before getting into this week’s economic data and providing an update on the initial batch of corporate earnings. And oh yeah, did I mention the Phase One trade deal between the US and China was signed on Wednesday?
To start, here’s some additional data that underpins my opinion that the Fed T-bill purchase program has contributed to an inflation of asset prices (stocks, bonds AND gold). On October 18th, the 12-month forward earnings multiple on the S&P stood at 17.0x per FactSet Insight at the same time as 10-year Treasury yields hovered around 1.76%. Note that October 18th was one week after the Fed announced the T-bill purchase program and pretty much lines up with the initial purchases in the marketplace. Today, that same S&P 12-month forward earnings multiple now stands at 18.5x while 10-Year Treasury yields have increased to 1.84%. Under traditional finance theory, rising interest rates should lead to a decrease in equity multiples. Why? Assuming no change in forecasted corporate cash flows, valuations would suffer because the cash flows would be discounted back to the present using a higher discount rate. This anomaly as well as others which I will point out throughout the report leads me to this conclusion regarding the Fed’s impact on asset prices.
That all having been said, I do view the Fed’s repo program very differently from the Fed’s T-bill purchase program. In my opinion, the repo program amounts to the Fed stepping into the market as a source of liquidity for daily operations that used to exist elsewhere and therefore, is largely not incremental cash that finds its way into other areas of the financial system. The stresses highlighted by the need for this program shifted notably downward this week with total outstandings under the program falling below the $200BN mark for the first time in awhile. We will see if this trend continues. A further decline here should be positive for the risk-on environment.
Fed T-bill purchases, on the other hand, do provide incremental cash into the system because these purchases remove supply rather than replace supply in my opinion. Consequently, the cash that an investor receives upon purchase of their T-bill by the Fed needs to find a home somewhere else because the T-bill that the investor was holding is no longer available for purchase in the market. Some of this cash undoubtedly seeks out alternative investments. Of the two programs, I believe this is the real culprit behind asset price inflation. To be clear, none of this to say that the economy is suffering. So let’s check in with this week’s economic data.
Starting with the major impact releases, on Tuesday, both inflation and core inflation were in line with expectations. Core inflation registered 2.3% YoY, consistent with the prior two months readings and indicative of a relatively stable price environment. Note that later in the week, the University of Michigan 5-year inflation expectations registered an increase to 2.5% from its previous reading of 2.2%. Thursday provided the most debatable release for the week as headline retail sales showed a 0.3% MoM increase in December, in line with expectations. However, even though core retail sales (excluding automobiles, gasoline, building materials and food services) reported a solid 0.5% MoM increase in December, both of the prior months, November and October, were revised downward. You can read more about this particular data point here. Notably, the downward revision to prior month core retail sales caused a significant drop in the Atlanta Fed’s GDPNow Q4 estimate from 2.3% to 1.8% as shown in the chart below.
Although less impactful to GDP, Friday’s releases, by and large, were just a touch below estimates. The exception was housing starts which absolutely blew away consensus. These other releases included building permits, industrial production and consumer sentiment. At the end of the day, however, none of these were any cause for market concern.
In addition to all of the economic data that was released this week, Q4 corporate earnings season kicked off with 9% of the companies in the S&P having reported as of Friday. Per FactSet Insight, 72% of these companies have reported EPS above estimates and on average, the earnings beat is 1.1%. The quantity of companies beating is equal to the five-year average while the magnitude of the beat is below the five-year average. From a revenue perspective, 63% of companies have beaten estimates and the average revenue beat is 1.4%. Both of these revenue metrics are above the five-year average. Despite the positive early returns, earnings are still expected to decline 2.1% (on 2.7% revenue growth) in aggregate for Q4 as the positive surprises seen this past week were offset by downward estimate revisions for companies yet to report , particularly in the energy sector. For Q1 & Q2 2020, analysts are currently looking for mid-single-digit growth. We will see how these estimates evolve over the remainder of the Q4 reporting season and throughout Q1.
With that, I’d like to remind readers that anyone who is thinking about buying gold as an investment 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. A gold long term investment or a silver long term investment is very different from investing in precious metals on a short term basis. Depending on one’s objective, when investing in gold and silver, there are several drivers of precious metal price that investors need to be mindful of that will drive gold investment returns. In support of developing that view, let’s review the major markets that precious metals take their cue from.
The S&P 500 tacked on an additional gain of 2.0% this week to finish at yet another all-time high of 3,329. With the exception of Tuesday, gains were relatively orderly over the course of the week. This brings total YTD 2020 gains to just under 3.1%.
From a technical perspective, the S&P is back in “overbought” territory according to traditional non-trending indicators. However, trending indicators continue to argue that we should ignore these signals. The below chart shows how non-trending indicators such as the relative strength index (“RSI”) and Bollinger bands (“BB”) show that we are in overbought territory ( RSI > 70; S&P trading at the top of the BB). It also shows an often used trending indicator, the average directional index (“ADX”). ADX readings above 25 are considered to indicate a strong directional trend (in this case up). At a current reading of 38.77, the S&P well exceeds that hurdle.
As I stated last week, if we do get a dip, I expect it to be shallow with the Fed currently in QE/not QE mode. Note that the 50-day moving average currently sits at 3,177 (a 4.5% decline from current levels). This is the first level I would look to for support if we see the market turn.
Moving on to the VIX, the index traded modestly lower with the continued rally in stocks this week, falling from 12.56 to 12.10 by week’s end and continuing to be more than one standard deviation from the mean using log normal data (since January 1990). The back half of the week saw the index spend parts of each day below my key level of 12. As I’ve noted previously, over the past year, this level has indicated the potential for mini reversals in the market. Digging a bit deeper, post the start of the Fed’s T-bill purchase program, these reversals have become notably more muted. Early December saw moves back to closing levels of 16 while mid-May and early August (pre Fed intervention) saw moves back to levels of 20+. Be on the lookout for a similarly muted reversal only if the market decides to break away from its current trending nature.
US Treasury yields were barely changed this week with most of the curve only 1-2bps higher. Specifically, 10-Year Treasury yields increased from 1.83% to 1.84%. 10-Year Treasury yields continue to hold the late October lows of just under 1.7% and as I mentioned last week, 2.0% and 2.15% are my next two upside yield targets. Those targets, however, will be difficult to achieve so long as the Fed continues to anchor the short-end of the curve. Let’s examine this a bit further.
One would typically expect a more significant sell-off in Treasury bonds in conjunction with the strong upward move we’ve been experiencing in equity markets. Because we haven’t seen the typical historical correlation between these two asset classes, I can only conclude that the Fed’s T-bill purchases are a significant factor. In fact, as the prospects for global economic growth have improved with the positive steps taken in US-China trade relations, the US Treasury – German Bund spread has behaved unexpectedly as well – dropping to new cycle lows. Again, it would seem as if this is attributable to the Fed as opposed to notable US economic deceleration relative to Germany. As you can see from the chart below, this spread shrank below +200bps this week and is the tightest it has been since early 2018.
3-month T-bills (the best barometer of future Fed action) saw yields increase from 1.54% to 1.56%, inching a bit farther away from the bottom of the current Fed Funds target range (1.50% – 1.75%). Remember, this signal is somewhat distorted by the Fed’s current T-bill purchase program and I continue to prefer Fed Fund futures as a more reliable indicator in this environment. That said, the slight move higher in short-dated Treasury yields was mirrored in Fed Funds futures as the probability of easing by year end 2020 dropped further from 58.5% last week to 53.9%. As a result, the Fed may remain “on hold” from a rate cut perspective but as I argued over the course of this past week, I don’t consider the Fed to be “on hold” in general while it continues to purchase $60BN of T-bill per month even if it leaves the Fed Funds target range unchanged. On a combined basis with the 10-Year, the current spread with 3-month T-bills is 28bps and remains below the spread from early November. Remember that if you look at this relationship on a longer-term basis, this spread has traded in a range of 300-400bps post recessionary periods.
Finally, 2-Year Treasury Note yields increased from 1.56% to 1.58% by week’s end. With Precious Yield continuing to offer 2-year physical gold term deposit rates of 2%, the US Treasury – Precious Yield spread* is in Precious Yield’s favor at -.42%. 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. I believe yield alternatives continue to be a major investor focus.
Similar to last week, with rising equities and slightly higher US Treasury yields, the US dollar strengthened against most major currencies as measured by the US Dollar index (Ticker: DXY ). The index increased 0.25% to finish the week at 97.61. Breaking the dollar performance down by its major constituents, the USD strengthened nearly 0.28% against the Euro (57.6% index weight), 0.39% against the Pound (11.9% index weight) and 0.61% against the Yen (13.6% index weight). Again, the outsized move vs. the yen was likely the result of a further unwind in flight-to-safety trades. The index was held back by the other currencies which comprise the index (Canadian dollar, Swedish Krona and Swiis Franc). In particular, the Swiss Franc (3.6% index weight) was the only currency in the index to strengthen against the dollar, gaining 0.48%.
As has been typical over the last several months, a strengthening of the US dollar vs. other major currencies once again coincided with a weakening of the US dollar vs. the Chinese yuan. Initially, gains were driven by the lead up to and then the successful signing of the PhaseOne trade deal with the US this past Wednesday. This momentum continued throughout the balance of the week with the release of positive Chinese economic data on Thursday including: 1) Q4 YoY GDP of 6%, in line with expectations and despite the trade war, 2) stronger than expected industrial production for December (6.9% vs. 5.9% estimate), 3) stronger than expected retail sales for December (8% vs. 7.8% estimate) and 4) stronger than expected fixed asset investment for December (5.4% vs. 5.2% estimate). All together, the yuan strengthened an impressive 0.86% for the week and the currency has now regained quite a bit of ground towards its level in early May 2019 (just prior to the implementation of tariffs) of approximately 6.75:1. While I don’t expect the yuan to achieve this level without further roll-back of existing tariffs during phase two, the fx pair continues to bear monitoring for the overall strength of the Chinese economy (and therefore the global economy).
The price of gold in ounces was incredibly steady this week, rising a mere $4/oz. to finish at $1,557/oz. as measured by the LBMA afternoon fix (10:00AM EST). With equities rallying, volatility decreasing, Treasury yields rising and the dollar strengthening, this is a curious result for the yellow metal as each of these on their own should have been a headwind. Once again and for the same reason why 10-year Treasury yields may be unable to rise above 2% near-term, I believe current Fed actions are putting a floor underneath gold prices. On Tuesday, the price of gold per ounce dipped briefly below the old cycle high of $1,546/oz. but not in any sort of meaningful way. As much as I have been hesitating to use this old cycle high as the new floor underneath the gold market, the case continues to build as the Fed continues to buy T-bills (currently scheduled to last through Q2 2020). In the meantime, the more likely near-term downside at this point is the 50-day moving average, currently $1,494/oz. The 200-day moving average is probably not worth focusing on any more during this period of Fed intervention. Remember, fundamentals are also in gold’s favor with global central banks increasing reserves and reduced selling from retail holders of physical coins.
Turning our attention to the “Gold VIX” (Ticker – GVZ ), the index declined from 12.27 to 11.31 this week. Gold volatility remains over 1 standard deviation below the average (since June 2008) using log normal data and now resides outside of the 80% confidence interval. Looking at both the AM & PM LBMA fixes, the gold price per ounce trading band checked in at $12/oz. or 0.8% between the high and low (vs. $34/oz. or 2.2% between the high and the low last week). I use these price bands to better understand the movements in the “Gold VIX” (Ticker – GVZ ) levels from above. To remind our readers, 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 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.
So why are we dedicating a special section to the PGMs this week? The answer is primarily due to the incredible price action we have seen in palladium since the beginning of the year. If you look even a bit further back, you can see additional significant moves between Q3 ‘18 and Q1 ’19 as well as a resumption of trend beginning in Q3 ‘19.
Let’s start with fundamentals. A couple of major things have impacted the demand for palladium (and platinum) over the last several years – the advent of electric cars and the Volkswagen emission scandal, aka “Dieselgate”. Both have shifted demand away from diesel engines which use platinum as a diesel exhaust emissions control catalyst. This has shifted market share towards electric vehicles and gasoline engines which use palladium for emissions control instead. The supply of palladium has been unable to keep up with this shift and by the way, this supply only comes in material quantities from two places which at times can be very unstable (South Africa and Russia). While the above chart does not go back that far, Dieselgate happened at the end of 2015 when palladium prices were around $500. Palladium is now $2,490. Given how expensive palladium has become, there has been talk of substituting platinum as a catalyst for palladium in gasoline engines, but that takes time, engineering effort, sourcing, logistics, etc… In addition, you need platinum AND rhodium to replace palladium in a gasoline engine complicating things further. I would note that rhodium prices have also been on a tear since the beginning of the year so maybe we’ve hit that tipping point. Here’s another article from Reuters which explains the market in even greater detail. In any case, much of this industry dynamic explains what has happened over the last few years, but what about this recent parabolic move up since January 1st?
In our opinion, this near term price action seems more driven by liquidity at hedgers and aggressive trading by well-heeled traders. Ultimately, it’s impossible to tell where it stops, but when it does reverse, it can drop fast. One additional dynamic to consider. The exchange sets margin requirements based on a combination of the absolute metal price and the recent volatility of the metal price. The exchange has increased these requirements twice in the last couple of weeks with the last time being an announcement on Thursday with an effective date as of the close of business Friday. The announcement of these margin increases can cause volatility as players with insufficient liquidity are driven to cover their positions. Once the dust settles (i.e. weaker players with less liquidity exit), volatility generally subsides. In short, we don’t think this story is over so expect more volatility (both potentially up and down) ahead.
While gold and silver investing have historically been associated with negative carry, a Precious Yield precious metal account offers investors the opportunity to earn a yield on gold and silver instead. If you are a long-term holder, turning gold and silver as an asset for diversification purposes into an alternative investment and yield alternative with Precious Yield allows for some cushion against price movements via the gold and silver yield. To learn more, please browse our website. Alternatively, contact us directly for more information or to answer your precious metal investment questions. 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 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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