This past week’s theme is very clear to me. Price action across markets, including the gold money relationship, was primarily driven by economic data releases and speculation surrounding how the Fed would react to that very same data. Geopolitical concerns played second fiddle although the continued protests in Hong Kong and President Trump’s public call on China to investigate the Bidens didn’t help. We will see if the Hong Kong situation doesn’t take center stage this coming week as I am reading about bank runs in Hong Kong on twitter as I write. Given my view of its importance, I’ll start out with the latest on the Fed’s need to continue to inject liquidity into the market via various repurchase agreement (“repo”) auctions. Then I’ll jump into the economic data only to round out with a few other sundry observations before hopping into the individual markets.
Here’s an interesting fact. This past Monday was the official end of the third calendar quarter. Why does that matter? Because some investors have theorized that the liquidity injections required by the Fed would be most acute around quarter-end. The following chart shows how the total liquidity injected via the various repurchase agreement auctions trended through the end of this past week.
You can see how the total liquidity injected peaked at just over $200BN right at quarter-end and has subsequently subsided somewhat. I would note that on Friday, the total amount of liquidity injected turned back up a bit, so I don’t think we have enough data yet to determine that the trend here has changed. When the Fed originally announced its repurchase operation, they said that overnight repos would be $75BN in size and would be conducted every day from Monday through Thursday until October 10th. They also introduced two week (14 day) term repos with a total size of at least $30BN. Since then, the Fed has 1) expanded the program to include Fridays, 2) increased the overnight repo limit to $100BN for a few of the auctions and the 14 day term limit to $60BN for the last two auctions and 3) announced that it will extend these operations from October 10th until November 4th. Based on all of the above, this bears keeping tabs on for the foreseeable future.
On the economic data front, the biggest news of the week came in the form of Tuesday’s US ISM Manufacturing PMI. Without mincing words, it was awful and well short of tepid expectations. It was the second straight month of a reading below 50 (the line between economic expansion and contraction) and really set the tone for the rest of the week’s market action. Making matters worse, on Thursday, the Non-Manufacturing (i.e. services) version of the ISM PMI was released and was ALSO a major disappointment. While still in expansionary territory at a level of 52.6, it was well below expectations and the trend looks eerily similar to the Manufacturing version (see chart below).
As you can imagine recession fears gripped the market with this data mid-week, only to lead to increased bets that the Fed would be moved to action yet again. In my opinion, this backwards thought process, led to a rebound in the equity market as Fed Funds futures started to price in much higher probabilities of a rate cut as early as this month. I’ll have more on that below in the Government Bond section. Given the ISM numbers, market participants were braced for a terrible jobs number on Friday but that really didn’t come to pass. The US Non-Farm payroll report showed an increase of 136K jobs in September, a mere touch below consensus and favorable to the fears that had built up over the course of the week. How to interpret all of this? My take-away is that recessionary red flags continue to pile up and that investors should remain alert and more defensive in their posture towards the markets.
Speaking of recessionary flags, the US Treasury – German Bund spread did something very interesting this week. It broke out of the trading range that I had been outlining of +215bps to the downside and +235bps to the upside. Unfortunately, it broke through the bottom end of the range. Why unfortunately? Because a tightening of this spread has historically been a recession indicator. The chart below shows this downside break.
Looking forward, the biggest hurdles that the markets need to overcome are the US-China trade talks scheduled for this coming Thursday and Q3 earnings which should start in earnest over the next few weeks. Last week, I mentioned that 113 S&P 500 companies have issued EPS guidance for Q3 of which 82 have issued negative EPS guidance and 31 have issued positive EPS guidance. This is well above the 5-year average of 74 per Factset Insight and is particularly acute in the Technology and Health Care sectors. As is typical, analysts have been revising down their earnings estimates heading into the quarter. Again per Factset Insight, this quarter’s estimate decline of 3.6% is larger than both the five-year average and the 10-year average, but smaller than the 15-year average.
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 declined modestly this week to 2,952 or a little over 0.3%. The index was only able to achieve this result after recovering from a mid-week swoon which saw the index close below 2,900 on Wednesday. As discussed in the overview, the market swoon started with the release of the ISM manufacturing number on Tuesday, creating fears of recession. Those recessionary fears carried over into Wednesday trading before the market started to recover on the idea that the Fed was more likely to cut rates (yet again) at the upcoming October meeting. This combined with relief surrounding the September Non Farm payroll number allowed equities to recover most of their losses
Last week, I had said 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.” I guess that was a pretty good hunch. So now where do we sit? From a technical perspective, the S&P 500 index has breached both the 50 day and 100 day moving averages. The next areas of support, the 200 day moving average (2,841) and the 2,825 level, remain in tact for the moment. If those levels get breached, that would lead to a much greater technical breakdown in the index.
Consistent with the trading pattern in the S&P this week, there was a spike in the VIX which crescendoed on Wednesday in conjunction with the strongest part of the equity sell off. VIX levels rose as high as 21.46 on an intraday basis Wednesday before declining over the balance of the week to finish at 17.04. This resulted in a modest week over week increase. Notably, for a significant portion of the week, VIX levels were above the long-run average of 17.99 (since January 1990) using log normal data. Despite the increased volatility, VIX futures ended the week in contango (i.e. upward sloping) as the market continues to place a high level of faith in the Fed’s ability to fix the current economic problems. When the curve is in contango, it indicates that the market does not believe there will be meaningful near-term volatility. AS noted previously, that doesn’t mean, however, that the market will be correct in its assessment.
US Treasuries saw a massive rally this week with yields dropping precipitously across the curve. Remember, this rally started on September 13th when 10-year yields peaked at 1.90%. The intermediate part of the curve (2 year through 10 year) bore the brunt of the buying as 10 year Treasury yields fell 17bps from 1.69% to 1.52%. 2 year Treasury yields fell even more sharply, declining 23bps to finish the week at 1.40%. The rally was kicked off with the release of the ISM manufacturing report and was sustained for the balance of the week as expectations increased that the Fed would be forced to cut rates again.
This brings us to 3-month T-bills, the best barometer for Future Fed action. While T-bill yields fell a relatively uninteresting 9bps on the week, the absolute yield level fell from 1.80% to 1.71%. What’s significant about that? Well, with the Fed’s most recent target of 1.75% – 2.00%, a yield of 1.71% indicates that T-bills are predicting that a future rate cut is a certainty. This dovetails quite nicely with Fed Funds futures. As you know from last week, immediately following the Fed’s most recent rate cut announcement on September 18th, the market was assigning a 42% chance of an additional downward rate adjustment prior to year-end and by the end of last week, that probability had risen to 70%. This week, that probability rose further to over 90%, a near certainty. Even more interesting, the chance of that rate cut happening at the Fed’s meeting this October has gone up significantly from 50/50 one week ago to a greater than 75% chance as of today as seen in the chart below.
Looking at the moves in the 10-year and 3-month in conjunction with one another, the persistent curve inversion that we have been experiencing worsened to -19bps versus -11bps last week but is still well inside the deepest inverted levels (~ -45bps). Why persistent? The chart below shows that this part of the curve has been consistently inverted since May with one brief exception towards the end of July.
10 Year versus 2 Year Treasuries, on the other hand, continue to steepen further from the late August inversion and are now 12bps apart versus 6bps at the end of last week. A few months ago, I wrote about how some consider a re-steepening of the treasury curve, once it has inverted, as the “final recessionary shoe”. You can read more about this argument via this link.
At the beginning of this section, I mentioned that 2-Year Treasury yields ended the week at 1.40%. Precious Yield continues to offer 2-year physical gold term deposit rates of 2%. As a result, the US Treasury – Precious Yield spread* is still in Precious Yield’s favor at week’s end. The spread increased from -.37% last week to -.60% given the fall in 2-Year Treasury note yields. This is the largest disparity between the two since we began tracking the data. 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 dollar index (Ticker: DXY) fell 0.3% this week to finish at 98.81, but not before it reached new cycle highs since the early 2018 lows. Mid-week, the index was within spitting distance of 100 and remember, the last peak in the dollar index was 103.3 in December 2016. As for the major index components, the Euro and the Pound (57.6% and 11.9% index weight respectively) were both 0.4% stronger against the dollar while the Yen (13.6% index weight) was the star of the group, gaining 0.9% versus the greenback. I believe the outperformance of the Yen was dual-fold this week. First, the Yen has historically acted as a safe haven currency despite Japan being the most indebted country in the world. This is because its citizens own most of the debt and therefore there is little pressure from foreign holders. Second, a little talked about (at least here domestically) news story broke at the beginning of the week indicating that the Bank of Japan may slash bond purchases in October and that the Government Pension Investment Fund is pivoting toward buying more foreign debt (as opposed to domestic Japanese government debt). Both of these, if put into action, would have the impact of increasing yields in Japan and therefore make the Yen more attractive.
As for the yuan, there’s nothing to report given that the Chinese markets were closed most of the week in observance of the country’s 70th anniversary. The US and China are still scheduled to have talks in mid-October in an effort to make progress on resolving the trade dispute. As we’ve discussed for some time, the USD/CNY fx pair has been impacted greatly by this friction. That said, the currency exchange rate currently remains comfortably inside the highs set just prior to the September 5th announcement that the US and China were renewing attempts to resolve their differences. In my opinion, if any progress gets made in the trade talks towards an actual trade deal, it should be a positive for risk-on markets and conversely, the gold price per ounce would likely suffer.
With falling equity prices, increased volatility, lower Treasury yields and a weaker dollar, gold had lots of foundational support to rise in price this week. Remember though, that most of those trends happened AFTER the release of the US ISM manufacturing data on Tuesday morning. Before that release, during the early part of the week, gold broke through the second of my key support levels, the 50 day moving average ($1,492/oz.). In fact, gold dropped as low as $1,466/oz on an intraday basis. This leaves me with a lone near-term downside price target zone of $1,400-$1,425/oz. But then the US ISM manufacturing data came out and instead of gold continuing its descent, the ensuing negative market psychology caused the gold per ounce price to reverse and finish the week in the green. Consequently, as measured by the LBMA afternoon fix (11:00AM EST), gold increased 0.6% for the week to end at $1,499/oz.
Checking in on gold volatility, the “Gold VIX” increased slightly to 15.26 from 14.96 the prior week. This remains well below the average reading of 17.91 since June 2008 using log normal data. Looking at both the AM & PM LBMA fixes over the course of the week, the gold price per ounce fluctuated in a $51/oz. price band or 3.5% overall as measured against this week’s low of $1,466/oz. I believe we can use these price bands to better understand the movements in the “Gold VIX” (Ticker – GVZ ) levels from above. That said, 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. To remind our readers, 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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