Let’s start this week with a few simple observations. Then, I’d like to spend some time explaining (and in some cases re-explaining) why we are looking at certain market data to help inform a view on gold. In my mind, the goal of examining the gold money relationship in detail is to develop better entry and exit points for both long-term holders of gold as an investment as well as those investors temporarily looking to benefit from using precious metal as a hedge or as a means to benefit from its price movement. To be clear, when I use the term gold money relationship, I mean the price relationship between gold and fiat currency (primarily the US dollar). Despite this week’s stock market rally, we continue to advocate investor alert as most other markets movements reinforced our increasingly bearish view.
Leading off, yield alternatives continue to gain attractiveness as the decline in global bond yields marches on. While I wouldn’t have put my money on hitting the levels we saw this week in Germany, 10-year bund yields continue to make new lows.
How about that US Treasury – German Bund spread? On a week on week basis using a Friday May 31st close of +239 basis points (“bps”), the spread with US Treasuries shrank a bit further despite recovering somewhat from Mondays sub +230bp spread. Note that the chart I included in last week’s report ran through Sunday, June 2nd. On that basis, this past Friday’s closing spread was essentially unchanged at +235bps. I’ve been highlighting this directional change in spread since last November’s cycle peak and will spend more time on why I think this trend is important in a moment.
So where else have we seen rates and/or rate expectations decline? My last mention of the Fed Funds futures was in the Precious Metal Market Update – 20 May 2019. The observed change in expectations since then has been dramatic. At that time (as implied by the futures prices), there was a 74% chance of a single 25bp rate cut and a 32% chance of two or more 25bp rate cuts by the December 2019 Fed meeting. These expectations were just beginning to reflect the new reality of US-China trade and the implementation of additional tariffs. Today, according to the CME Group’s FedWatch tool, a 25bp rate cut by the December meeting is a near certainty. In addition, the chance of two or more rate cuts has increased to 86% (from the 32% mentioned above) and now there is a 54% chance that there will be three or more rate cuts – 75bps of cumulative easing! Given all of the above, you can see why earning a yield on gold with Precious Yield, while always attractive for long-term holders, looks increasingly attractive in this environment.
Finally, on the observation front, I’d like to add a new piece of data to the mix – copper prices. Copper prices are a very good indicator of global demand and recent trends don’t look pretty. I’m no expert chartist, but a break below $2.60 would seem to whisper something about the global economy while a meaningful break below $2.50 would seem more like shouting. Check out the weekly candle chart of front month copper futures contract.
Now for a bit about the why I look at this data. Just as inversions of the US yield curve have been a reliable forewarning of market tops/impending recessions, US Treasury – German Bund spreads have had a similar predictive power. Peak spreads in May 1999 as well as October 2005/June 2006 support this conclusion. But what else can we glean? A shrinking spread means the market believes that the US economy is becoming relatively less attractive in comparison to the Eurozone. This could in turn lead to higher domestic stock market volatility and a weaker dollar, both of which are supportive of higher gold prices. Where could this spread conceivably go? Most market watchers observe the history of this spread back to the fall of the Berlin Wall in November 1989. My analysis of the data suggests that the average spread is approximately 53bps. Where would 10-year US Treasuries be if spreads reverted to the mean with German bunds trading at a yield of NEGATIVE 25bps? It should come as no surprise then, when JP Morgan lowered their forecast for US 10-year Treasury yields below 2%.
Beyond market volatility (or lack thereof) and dollar weakness (or strength), interest rates are the final major pillar in determining likely investor demand for precious metals. A shrinking US Treasury – German Bund spread does not automatically mean that global interest rates are in decline. It just so happens that right now, global bond yields are falling while that spread is shrinking. Why are falling global bond yields important to gold? Because it reduces the opportunity cost associated with foregoing positive bond yields in order to use that same capital for gold as an investment. 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. As discussed last week, the gold yield is negative in most other holding forms outside of Precious Yield – see our white paper entitled “The Alternatives Available for Precious Metals Investors” from March 24, 2018.
With that, let’s have a look at each of the drivers individually.
Stocks posted major gains this week with the S&P climbing 4.4% and the VIX falling to 16.3 despite last Friday’s sell-off on the back of Trump’s announced Mexican tariffs bleeding into Monday’s market action. Of note, Monday’s stock market decline coincided with the nadir in US bond yields this past week. We view this week’s rally as 1) an oversold bounce as opposed to a brightening in fundamentals and 2) increasing market conviction in a rescue from the Fed. Here’s a couple of points in support of those views. First, the S&P finished higher than its level immediately preceding the Mexican tariff threat which now appears to be fully resolved. Consequently, we don’t view this favorable resolution as the reason for the rally. Second, economic data (particularly the jobs numbers) were a disappointment. Please see how Atlanta Fed GDPNow continues to track below consensus estimate for Q2 GDP. Finally, the timing of Fed easing got pulled significantly forward this week as indicated by the Fed Funds futures market. At the end of last week, there was a 53% chance of a July rate cut. Now there is an 87% chance. In terms of key technical levels, while nearly achieved on Friday, we view an S&P close above 2876 as important towards building momentum back towards the highs. This level represents the closing S&P level on the day prior to the new Chinese tariffs going into effect (May 16).
US 10-year treasury yields fell from 2.14% last week to 2.09%. These are the lowest US 10-year treasury yields and tightest spreads to the yield on gold since August/September 2017. Of note, the US yield curve remained inverted by 19bps between 3-month T-bills and 10-year Treasuries as the shorter-end of the curve began to be impacted by the increasing probability of a near-term rate cut by the Fed. While the inversion did not steepen further, its persistence continues to be a cause of concern (see repeat of last week’s FRED chart below). Weak inflation data out of the Eurozone (core inflation sub 1% YoY) paired with continued weak global manufacturing data and a big miss on US jobs, led the global bond yield declines. With Precious Yield’s gold yield remaining steady, US Treasury – Precious Yield spreads continue to shrink. 2-Year Treasury notes finished the week at 1.85% while Precious Yield continues to offer 2-year gold term deposits of 2%.
As expected, the US dollar was unable to hold its prior week gains in the face of a shrinking US Treasury-German Bund spread. Making matters worse for the dollar, the increasingly aggressive Fed rate cut expectations being built into the market provided an additional headwind. The dollar index lost 1.2% comprised primarily of a 1.4% decline against the Euro and a 0.8% decline against the pound. With a lack of further appreciation in the dollar vs. the Chinese yuan, the yen was relatively stable in its current role as a safe haven in the US- China trade war. We continue to monitor the USD/CNY FX pair for clues about the status of trade negotiations. In our view, additional weakness in the dollar will be more difficult to come by given the amount and timing of monetary policy easing built into expectations. Continued dollar weakness will be dependent on a further deterioration in domestic economic data and a further compression in the US Treasury – German bund spread.
As measured by the LBMA afternoon fix, gold prices had a spectacular week, finishing with a gain of 3.5%. Gold price volatility picked up significantly from levels that as little as two weeks ago were two standard deviations away from the mean (using data going back to October 2011). Even with this uptick, gold price volatility remains below average. The cadence of this week’s price gains was fairly consistent throughout the week as expectations of a Fed rate cut fueled by Powell’s dovish trade war pivot continued to grind higher. Gold clearly responded to bond yields (both current and future expected) as well as the weaker dollar while choosing to assign little validity to the rebound in stocks and decline in stock market volatility.
Last week, we reminded investors to consider a host of factors when deciding to invest in precious metals including but not limited to market volatility, global bond yields, and dollar strength/weakness. Over the last several months, we have highlighted the tug of war between the receding need for flight to safety assets offset by the shrinking future perceived yield differential between US Treasuries and the precious metal. We may be entering a period where the receding need for flight to safety assets dynamic is changing while the shrinking future perceived yield differential is not. This would be supportive of gold in our opinion.
While an investment in gold has historically been associated with negative carry, Precious Yield offers investors the opportunity to earn a yield on gold. If you are a long-term holder, turning gold as an asset for diversification purposes into an alternative investment with Precious Yield allows for some cushion against gold price movements via the gold yield. To learn more, please browse our website or contact us for more information. See you next week!
Gold 1-Month Price Chart
Silver 1-Month Price Chart
Platinum 1-Month Price Chart
Palladium 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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