Geopolitical tensions and the Fed dominated this week’s news flow. I will cover the key points on both shortly and how they impact the gold money relationship. But before I do, I want to get the following thought out upfront. In my mind, global economic data and the aforementioned news flow particularly as it relates to Fed actions this week continue to argue for investor alert and provide a mandate to rotate more defensively. Luckily, the opportunity to take advantage of that view is good with US stocks sitting just a shade below all-time highs. So with that, let’s see what happened this week.
As you know from last week, there was high anxiety leading up to Monday’s open after an oilfield operated by state-owned Saudi Aramco was attacked by a number of drones last Saturday. The closure of this oilfield impacted 5% of the world’s daily oil production and caused oil prices to skyrocket when markets reopened. Oil price volatility was significant with benchmark Brent crude briefly surging almost 20% to nearly $72 per barrel in early trading before losing 60% of its gains to trade below $65 per barrel early Monday morning. The intra-day sell off was short-lived, however, as oil prices rose again in the early afternoon, reaching nearly $70 per barrel before ultimately settling a shade above $68. Of note, this oil price volatility did not bleed into other markets as strongly as expected as the US-Saudi response was not immediate despite the blame being placed squarely on Iran. In fact, it wasn’t until Friday that the US announced new sanctions against Iran in response to the attacks. Over this weekend, the US also announced that the US would send both weapons and troops to Saudi Arabia in a defensive deployment to boost air defences following a request from Riyadh.
More importantly, in my opinion, on Tuesday, the Fed needed to run a repurchase operation involving $53BN of securities in order to keep overnight repo rates under control and the Fed’s benchmark rate from exceeding the top of its range. I’m no expert on these matters, but anytime there is a problem in the most mundane parts of America’s financial plumbing, you have to take notice. Most experts have offered the opinion that a confluence of events related to the timing of corporate tax payments and cash required to settle recent US Treasury auctions were the main culprits. To me, the timing was curiously coincident with the massive spike in oil prices. Unexepected and significant volatility like that can often catch hedge funds and/or risk managers offsides, creating stress in the system. Interestingly, a story about a Singapore-based oil trader who lost $320MM in unauthorized trades surfaced later in the week. Again, there may be no causal relation between the two, but I would be remiss if I didn’t share my thoughts.
As for the Fed, they continued to run overnight repurchase operations for the balance of the week, ultimately upping the program to $75BN from $53BN on Tuesday. Each day, the bids submitted exceeded the total size of the facility leaving some market participants without the cash that they needed. Thursday was the worst day with bids submitted totalling nearly $84BN. Friday’s operation saw total bids fall to $75.5BN. Subsequent to Friday’s operation, the Fed announced that the $75BN overnight repurchase operation would be conducted every day from Monday through Thursday until October 10th AND that it would also introduce two week term repos with a total size of at least $30BN. Long story short, the Fed doesn’t see this problem going away immediately. I will continue to monitor this situation closely.
In the middle of all of this, the Fed on Wednesday cut its benchmark rate by 25bps to a range of 1.75%-2.00%. Of note, the members of the board were divided over the decision and the outlook for further reductions. In addition, and partly in response to the funding stresses in the repo market, the Fed also cut the interest on excess reserves rate by 30bps to 1.80%. Markets initially sold off on the news before recovering to finish the day relatively unchanged.
Last but not least, midday on Friday, news broke that Chinese trade negotiators canceled a scheduled US farm visit and cut their trip short. This news finally broke the sideways trend in the market and caused stocks to fall and government bonds to rally throughout the balance of the day. So for all the recent news that indicated trade talks were back on track, this was a short-lived setback. Why short-lived? On Saturday, both the US and China issued statements saying that senior negotiators had “conducted constructive discussions” and that the “discussions were productive”. This will likely ameliorate the concerns of the market leading into this week.
Before diving into each individual market, I’d like to cover off a few other points briefly. First, US economic data was better than expected with industrial production and residential construction data both supporting a slight uptick in the Atlanta Fed GDPNow estimate. Second, there was no meaningful data released that gives us additional insight into the state of the consumer which as you know, continues to hold the US economy afloat. Third copper prices declined this week but still remain well above the dangerous $2.50/ high $2.40s technical level that I’ve previously mentioned. This is despite weak economic data that came out of China which I discuss in more detail in the US Dollar section below.
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.
Here are a few key takeaways from this weeks trading in the S&P 500. First, the S&P traded within a narrow 1.5% band, THE ENTIRE WEEK, despite the significant amount of news flow that I discussed in the overview. Second, the S&P climbed within a whisper of its all time-highs (3,028 intra-day; 3,026 closing basis) on Thursday before retreating. Finally, the near-term risk off move that I had anticipated last week was much more muted than expected. All in all, the S&P finished the week at 2,992, a 0.5% decline. Losses were felt on Monday on the back of Saturday’s oil field attacks and Friday, post announcement of the departure of the Chinese trade negotiators. The bulk of the volatility during the week surrounded the Fed announcement on Wednesday, but even then, the market recovered from its initial sell-off to essentially finish flat on the day. Last week, I stated that “if tensions with Iran stay contained and US-China trade talks stay on track, I would expect the risk-off environment to be temporary.” Well, tensions with Iran, in my opinion, did stay contained. After all, the US reverted to an increase in sanctions as opposed to a military response. US-China trade talks, however, are less clear. While it’s tough to say, the combination of these factors, combined with the relative expensiveness of the market, could lead to a period of sideways trading absent additional catalysts.
As for the VIX, it rose from 13.74 to 15.32 this week. The bulk of the rise was in conjunction with the late day sell off on Friday after the announcement of the early departure of the Chinese delegation. At a level of 15.32, we currently sit below the long-run average of 17.99 (since January 1990) using log normal data. Vix futures remain in contango (i.e. upward sloping), despite renewed geopolitical concerns, indicating that the market does not believe there will be meaningful near-term volatility. With Saturday’s reassurance from both the US and China with respect to trade talks, I believe the VIX futures curve can continue to maintain its shape going into next week.
As I stated in last week’s report, the news of the strikes on the Saudi oil facilities would “likely halt this ascent in yield on a near-term basis.” Right on cue, US Treasuries recouped a portion of their losses in both the intermediate (2 year through 10 year) and long (>10 year) end of the curve with 10 Year Treasury yields falling 16bps to end the week at 1.74%. Flight to safety in both Monday and Friday’s trade drove the bulk of the gains in Treasuries as yields were relatively unchanged in and around the Fed’s Wednesday meeting.
In contrast, the short (< 2 year) end of the curve, particularly 3-month T-bills, were directly impacted by Wednesday’s Fed rate cut with yields falling from 1.96% to 1.91% by week’s end. Looking at the moves in the 10-year and 3-month in conjunction with one another, the inversion worsened to -17bps versus -6bps last week but is still well inside the deepest inverted levels (~ -45bps). With the Fed Funds rate having been cut this week to the range of 1.75% – 2.00%, a 3-month T-bill yield of 1.91% does not indicate any further potential rate cuts. Fed Fund futures, however, tell a slightly different story. October futures indicate a 43.8% chance of an additional rate cut, while December futures indicate a 62.9% chance of an additional rate cut. This is a slight increase from last weeks probability which sat at just over 50% (see chart below).
As you know from last week, US Treasury – German Bund spreads began to show signs of a reversal from their recent tightening trend. However, this week saw the spread tighten back towards the middle of the recent trading range. For purposes of our discussion going forward, I will call that range +215bps on the tight end to +235bps on the wide end. As of today, the spread sits at +225bps. Remember, a continued tightening of this spread is a key component to my recession watch list.
After a brief period of inversion before Labor Day, the 10s-2s portion of the yield curve remained upward sloping this week despite flattening quite a bit. 2-Year Treasury yields declined 10bps from 1.79% to 1.69% and only 5bps separates 10 year yields from 2 year yields. 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. The spread increased from -.21% last week to -.31% 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.
The persistently strong dollar trend was back in action this week. As measured by the dollar index (Ticker: DXY), the USD experienced a modest gain of just under 0.3% to end the week at 98.51. Both the Euro (0.5% weaker against the dollar) and the Pound (just under 0.2% weaker against the dollar) contributed to the strength in the index partially offset by a 0.5% gain in the Yen. As I’ve noted in the past, the Yen continues to trade as a flight to safety to instrument along with US Treasuries and precious metals.
Since September 5th when the US and China indicated a renewed attempt at trade talks, the dollar had been weakening against the yuan. However, that trend stopped at the beginning of this past week PRIOR to Friday’s announcement of an early departure by the Chinese delegation. You can clearly see the bottom that happened this past Monday from the chart below.
This reversal was likely in part due to weaker than expected Chinese industrial production (4.4% actual vs. 5.2% consensus and 4.8% previous) and retail sales (7.5% actual vs. 7.9% consensus and 7.6% previous) that were released last Sunday before US markets opened. This relative weakness in Chinese economic data was exacerbated by the step backward that trade talks took at the end of the week.
I have cautioned our readers over the last couple of weeks that a pledge for renewed talks is not the same as achieving an actual trade deal. Friday’s news highlights that point. I continue to believe that 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. Despite this week’s news, markets remain somewhat frothy and therefore, I would expect the initial 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.
I like getting in the habit of summarizing the foundational drivers for gold to see if the total market picture makes sense. Let’s cover the positives for gold first. To start, equity markets were surprisingly stable albeit modestly negative. In conjunction with the modest downtrend, there was a slight uptick in volatility. Second, government bond yields reversed meaningfully in the lead up to the Fed rate decision and subsequent market disappointment with the US-China trade talks. Third, geopolitical tensions in the form of the alleged Iranian authored strike on Saudi oil facilities, the subsequent US sanctions on Iran and US-China trade disappointment festered. On the negative side of the ledger, the dollar was slightly stronger this week. Given that backdrop, the price of gold in ounces should have increased this week. But did that happen?
As measured by the LBMA afternoon fix, the gold per ounce price was remarkably stable this week, edging slightly lower from $1,503.10/oz to $1,501.90. However, the afternoon fix (11:00AM EST) happened prior to the announcement that Chinese trade negotiators canceled their scheduled US farm visit and cut their overall trip short (~ 1:30PM EST). This propelled gold higher and by the end of the NY close, the gold price per ounce rose to $1,516.70/oz. Clearly, geopolitical concerns in the form of US-China trade relations dominated the price movement in the yellow metal. So where does gold go from here?
To repeat from last week, the following levels appear to provide technical support for gold prices. Note that $1,500/oz has already been breached to the downside. This is followed by the 50-day moving average which currently sits at $1,483/oz and then the $1,400-$1,425/oz. trading range. With gold solidly reclaiming the $1,500/oz level in Friday’s trade and geopolitical tensions back in play, the likelihood of testing these support levels on a near-term basis has diminished. Nonetheless these downside targets remain in tact. Equally important, I will also watch to see if gold can breakout to new highs above $1,552/oz. In the meantime, expect gold to be bounded within these ranges ($1,483/.oz – $1,552/oz.)
As discussed above, gold prices bounced around within a pretty narrow range over the course of the week until later in the day on Friday. And while gold volatility spiked briefly on Monday in conjunction with oil prices, Friday’s news provided another spike up. All in all, gold volatility increased from 14.94 to 16.79 by week’s end. This is still below the long term average using log normal data since June 2008. 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.
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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