If you looked only at the price action across markets this past week, you would think that large parts of the world had shut down and gone to sleep. The market price of any investment such as gold accounts for all known information available at any given point in time. What can it mean then that stock, government bond and gold prices barely moved this week? All the news and data that I’m about to share with you was expected? The one thing that seemed to shake things up (in terms of market prices) was continued Brexit momentum with the US dollar experiencing a second consecutive week of major movement against the Pound. I will cover the recent Brexit timeline in further detail in the US Dollar section. That all having been said, in my opinion, there were a handful of notable events that our readers should be aware of despite the lack of impact they had on market prices. Let’s start with the Fed.
Last week, I spent some time talking about how inflation data impacted the shape of the yield curve. While correctly pointing out the significance of the 10-Year, 3-Month part of the treasury curve no longer being inverted, I missed a key piece of information that in retrospect was likely the most important driver of the change in the yield curve’s shape (as opposed to the inflation data). What was it? Late in the day on the previous Friday, the Fed surprised markets by announcing its intention to buy $60BN of T-bills per month. This decision was the result of an unscheduled meeting that the Fed held on October 4th to discuss the situation in the short-term lending markets. Remember, initially the Fed was forced to inject liquidity into the markets via an overnight repurchase program. This “temporary” program which began on September 17th remains in full swing a full month later and now, the liquidity support has been expanded via these T-bill purchases.
So what’s my take-away? First, anytime the Fed holds an unscheduled meeting to deal with a market liquidity issue, investors should take note. Next, an updated view of the Fed’s repo operations shows that outstandings hit a new peak this past Thursday, further indication that the problem isn’t going away. I would note too that Wednesday’s overnight repo auction was oversubscribed for the first time in three weeks.
Last, there is an elephant in the room that requires significant additional study to understand its implications. As shown in the chart below, before the financial crisis, the Fed’s balance sheet was a shade under $900BN. Through QEs 1-3, that balance sheet ballooned about 5x to just over $4.5TN. Granted, banking regulation changed significantly in reaction to the financial crisis, but it is shocking to see that we ran into market liquidity problems with a Fed balance sheet that had only shrunk to $3.75TN via quantitative tightening. At the far right hnad corner of the chart, you can see that the Fed is back to growing its balance sheet again via the repo auctions and now, T-bill purchases.
Turning to economic data, this week’s one major domestic release was clearly a disappointment. Retail sales fell 0.3% month over month in September vs. an expectation of a 0.3% increase. I remain very focused on economic data that points toward the health of the consumer given that the consumer is what keeps the US economy afloat. While disappointing on the face of the release, retails sales still grew 4.1% on a year over year basis. While that is a deceleration from last month’s upwardly revised 4.4% growth rate, it is still healthy and I would not sound the alarm yet. While less of an important number, industrial production was released on Thursday and was also a disappointment. We have spoken about how the last few recent manufacturing surveys have shown a contraction domestically and the industrial production decline of 0.1% year over year corroborates it. On a month over month basis, the market was expecting a 0.1% decline and got a 0.4% decline instead. Undoubtedly, the GM strike (since resolved) and the problems at Boeing combined with the US-China trade war have impacted these numbers.
Moving on to corporate earnings, this week saw the number of S&P 500 companies reporting increase to 15%. So far, more companies are beating earnings estimates than the 5-year average but the magnitude of the positive beat is less than the 5-year average per Factset Insight. Revenues are above the average on both metrics. In aggregate, earnings are anticipated to decline 4.7% on 2.6% revenue growth. Revenue growth remains key for the projected rebound in earnings that are currently suffering from the stronger dollar. I will provide more detail on corporate earnings as we get deeper into the season but so far, the early returns suggest that the market will be able to digest both results and guidance.
Final quick hits: 1) The US Treasury-German Bund spread remains stable at these new tighter levels. 2) Copper prices remain above key technical levels.
With that, 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. Many times over, I have discussed that there are several 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 500 rose modestly this week, gaining 0.5% to finish at 2,986. The index twice peaked over the 3,000 mark but was unable to hold the psychologically important level on a closing basis. Tuesday was the best day of the week as most of the other trading days saw the market trade basically flat. Last week, I speculated that the doubts on Wall Street around the partial trade deal which impacted the final hour of trading last Friday might follow through into the coming week’s action. Against my better judgement and despite Monday’s news that China isn’t ready to sign a partial trade deal without further talks, the markets were not further impacted.
Looking ahead from a technical perspective, the market remains very much stuck in its range going all the way back to early June. I keep repeating my recent comment that “the market never made it back to its all-time highs in this most recent run-up, a potential foreshadowing of resolving the sideways trading to the downside when it happens”. To me, it continues to hold true. As a reminder, the areas of downside support for stocks are the 200 day moving average (now 2,865) and the 2,825 level. If those levels get breached, that would lead to a much greater technical breakdown in the index. Absent any catalyst, I anticipate that the market will continue to trade sideways in the range of 2,825 to 3,025.
With the S&P 500 index slightly higher on the week and most of the week’s price action occuring in a very narrow band, the VIX fell from 15.58 to 14.25. At its intraday low, the VIX was still within one standard deviation of its long-run average (since January 1990) using log normal data. From last week, you know that it has been in that range since late July/early August. As for VIX futures, they remained in contango (i.e. upward sloping) on a week over week basis. When the curve is in contango, it indicates that the market does not believe there will be meaningful near-term volatility. Said differently, there is nothing extreme about current market conditions. This makes it harder to call the near-term direction of the market from a technical perspective and really fundamentals should be the sole driver of price.
Consistent with the lack of volatility in US Equities, the US government bond curve barely budged this week. Of note, there were only four trading days as the bond markets were closed on Monday in observance of Columbus Day. How boring was it? Well, 10-Year treasury note yields were unchanged at 1.76% and 3-month T-bills (the best barometer of future Fed action) saw a miniscule 2bp decline to finish the week at 1.66%. With the Fed’s most recent target Fed Funds range of 1.75% – 2.00%, a yield of 1.66% indicates one future rate cut with increasing odds of a second rate cut. Maybe the most exciting thing to happen was in the Fed Fund Futures market as now there is a 91.4% chance of a rate cut at this month’s meeting, up substantially from 75% one week ago (see chart below).
The combined moves (if you want to call it that) in the 10-year Treasury and the 3-month T-bill continued the re-steepening of this part of the curve (now 10bps, up from 8bps last week). Of note, the Fed’s T-bill purchase program started on Tuesday. We will see if there is any further impact to the shape of the curve as the program gets executed. Clearly, the announcement itself did some of the work.
In competition with Fed Funds futures for this week’s most exciting move, 2-Year Treasuries fell 5bp to finish the week yielding 1.58%. As a result, the spread between 10s and 2s increased to 18bps from 13bps last week. As you can see, the re-steepening is happening all along the curve. With Precious Yield continuing to offer 2-year physical gold term deposit rates of 2%, the US Treasury – Precious Yield spread* remains in Precious Yield’s favor. That said, the spread increased from -.37% last week to -.42% given the fall in 2-Year Treasury note yields. 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.
This week’s winner for excitement – the dollar index. In just one week, it fell a little over 1.0% to finish at 97.28. Major currencies don’t usually make such big moves. After making a couple of runs at 100 in late September/early October, the index has suffered (primarily at the hands of the Pound) and broken through the mid August lows as shown in the chart below.
As hinted above, examining the major index components this week tells a very diverse story. Starting with the Euro (57.6% index weight), the currency strengthened more than 1.1% against the dollar, pretty much in line with the overall index. Not so exciting. For the second consecutive week, the much more interesting story was in both the Yen and the Pound. The Yen (13.6% index weight) way underperformed the index and was essentially flat as muted market movements obviated the need for flight to safety trades. The Pound (11.9% index weight), on the other hand, strengthened an additional 2.5% on top of last week’s whopping 3.2% gain against the dollar and is now within striking distance of the 1.3:1 level. During the prior week, currency gains accelerated sharply after UK Prime Minister Boris Johnson and his Irish counterpart Leo Varadkar said that they could see a pathway to a possible Brexit deal. This was followed by news of a potential breakthrough in talks with the European Union and a statement from the European Commission saying that negotiators “have agreed to intensify discussions over the coming days”. The positive Brexit momentum continued into this week, culminating in Thursday’s announcement that Britain and the European Union had agreed to a deal. As the title of the linked article suggests, the agreed to deal was expected to face an uphill struggle in Parliament. This foreshadowing couldn’t have been more spot on as just a few moments ago, lawmakers voted to withhold their approval on the Brexit deal until legislation to implement it has passed. With the October 31st departure date deadline fast approaching, expect more volatility in this currency pair.
As for the Chinese yuan, it was largely unchanged on the week. Despite the disappointing news on Monday that China wants another round of talks before agreeing to the deal struck the previous Friday, the yuan attempted to strengthen further at the beginning of the week before settling back towards the previous week’s close. From the chart below, it looks as though an interesting double bottom has formed just under 7.07:1. A strengthening of the yuan through that level will likely be in conjunction with further trade deal progress. In the meantime, I view it as a level of support.
The gold money relationship was also quite stable (and boring) this week. On the negative side for the per ounce gold price, stocks increased modestly while volatility decreased. This was offset by a slight reduction in yields at the shorter end of the US Treasury curve and a weaker dollar. Last week, I mentioned how gold rebounded off of its Friday intraday low, gaining an additional $10/oz after the LBMA afternoon fix going into the NY close (4:00PM EST). This late in the day rebound was driven by the same doubts over the partial trade deal that caused equities to sell off in the final hour of trading. If we use last week’s NY close (4:00PM EST) of $1,489/oz. as the starting point, the spot gold price per ounce was essentially unchanged. Friday’s LBMA afternoon fix (11:00AM EST) was struck at $1,490/oz and the price per ounce gold barely budged trading into the NY close. Going forward, gold is bounded by both the $1,466/oz recent intraday low and the $1,400-$1,425/oz trading range to the downside and the recent cycle highs ($1,546/oz.) to the upside. If we see 10-Year Treasury yields revisit the September 13th high of 1.90%, that would be a catalyst for gold to visit my downside price targets.
Checking in on gold volatility, the “Gold VIX” decreased to 14.85 from 15.72 the prior week. Looking at both the AM & PM LBMA fixes over the course of the week, the gold price per ounce continued to narrow its trading band, fluctuating $12/oz. between the high and the low (vs. $28/oz. last week and $51/oz. two weeks ago). This represents 0.8% overall (vs. 1.9% last week and 3.5% two weeks ago) as measured against this week’s low of $1,482/oz. 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 ). Obviously, looking at the price band of spot gold prices alone will not capture the supply/demand dynamics that take place in GLD options but at least it is an additional tool. 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.
While an investment in gold and silver has historically been associated with negative carry, Precious Yield 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 with Precious Yield allows for some cushion against price movements via the gold and silver 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 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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