Gold: Time for Caution

The precious metal market has had a mixed week, with gold pushing up toward USD $1,263 per troy ounce, approaching the 200 day moving average, before pulling back toward its current level around USD $1,235.00 per troy ounce.
 
Silver has been under even more pressure, with the metal falling over 3.50% overnight, currently trading at USD $17.72 per ounce. The move happened rapidly too, with some USD $2 billion of notion silver exposure dumped unceremoniously onto the market.
 
Prices in Australian dollars have been supported by the fall in the local currency overnight, which fell a full cent. This helped limit the fall in precious metal prices for local investors, with the AUD gold and silver price sitting at $1,632 and $23.62 per troy ounce respectively.
 
This weakness in the AUD is no doubt due to the hawkishness of Fed officials, with the odds of a March rate hike soaring in the last week or so (see image below). 

That hawkishness has also obviously been a factor in the pullback in the USD gold price itself, with the dollar index hitting a level last seen in early January, with bond yields rising too.
 
As for what happens next to the gold price (in USD terms at least), we wouldn’t be surprised to see a consolidation and pullback phase here, with prices under some pressure.
 
ABC Bullion’s latest technical update suggesting the metal could ease back toward the USD $1,220 per troy ounce level, though it should first find some support around current levels.
 
You can read our latest report detailing the short-term outlook for all four precious metals, as well as oil, here, as well as this view from Greg McKenna (a trader whose view we respect), whose short blog is purely gold focused.

Our caution regarding the gold price is exacerbated by the fact that bullish bets towards the broader commodity complex are at levels not seen since the early 2000s.
 
This much is seen in the chart below, which shows average speculative futures positioning across a range of commodities (red line), with the Goldman Sachs light energy Commodities Index (black line) plotted as well.

No guarantees of course, for there was extreme bullishness back in 2002/2003 when commodities began a multi-year bull run, but the kind of positioning we’re seeing in commodities markets right now is at the very least suggesting a pullback, and the flushing out of this speculative excess, may well be due.
 
Were the broader commodity complex to go through a corrective phase, it would no doubt act as a headwind for the USD gold price, though we continue to think local investors in precious metals would be protected by weakness in the local currency.
 
From that perspective, we thought we’d also include the following chart, which shows the spread in bond yields between the United States and Australia for 2 year, 5 year and 10 year bonds, and how these have evolved since the middle of the 1990s.

As you can see, spreads have been declining for much of the last five years, which coincides with the peak in our terms of trade, and in the AUD vs. the USD. Spreads at the short end of the curve (2 years) are now just 0.50bps, a level they were last at back in 2001.
 
For reference, the AUD was trading at USD $0.51 back then, according to the article the chart above (which you can read here) came from.

Obviously currency weakness of that magnitude would be an enormous boost for AUD gold and silver prices. We aren’t predicting it, but we do think the Aussie will move in that direction, with a year end target closer to USD $0.65 not unreasonable.

Stock Market Looking Unstoppable!
 
Stocks have been on a near unstoppable tear since Trump won the White House, continuing on the historically impressive bull-run that dates back to early 2009. Since the start of 2017, they’ve continued to rally, with remarkably little volatility.
 
As a side note, that lack of volatility in risk assets is another reason we’ve been impressed with gold’s YTD performance, as it typically thrives in periods of higher volatility, and is more likely to struggle when volatility is low, as it is now.

Back to stocks, and whilst cyclically adjusted valuations might be closer to all time highs, as are market capitalization to GDP ratios, at this time, it is safe to say that none of that matters, with momentum well and truly on the side of stock market bulls.
 
RSI readings are flashing a clear warning signal (see chart below), with overbought readings that haven’t been seen since 2007, though even that is no slam dunk case for a correction, with little evidence of a technical top in place, according to this brief update on the Dow Jones by QMG Pty Ltd, via Livewire Markets.

Investors are obviously optimistic on the ability of the Trump administration’s ability to pass substantial corporate tax reform, and implement an infrastructure spending boost, which combined should boost earnings, and the share of those earnings that investors get to keep for themselves.
 
As such, fund managers are busy redeploying cash into markets, fuelling further gains, whilst an unprecedented surge in small business optimism in the United States also portends higher stock prices, based on historical readings and the subsequent movement in markets.
 
There is also the fact that whilst this bull market in equities is exceptionally long in the tooth, it also remains unloved. Further evidence of that was seen this week in this blog by Daniel Muller of Forager Funds, who noted that yesterday’s Australian Financial Review contained bearish articles and headlines on both Australian and global stocks, as well as Australian bonds. 
 
As the author notes; “Market peaks are accompanied by euphoria, not gloom and doom. And there are no bears to be found. As a fund manager, I know the top is near when I get asked for hot tips at barbecues. I’ve rarely been asked for a hot tip since 2007.”
 
There might not be a lot of value left in the market, but you can certainly understand why people are so bullish, with the potential for a euphoric blow off top in stocks ahead of us.
 
For as long as this momentum in risk assets lasts, it will act as a headwind to the precious metal market, limiting demand for defensive assets.
 
Note this is not to say gold can’t hold its own from a performance perspective, as it has for calendar year 2017 so far, but just an acknowledgement of a relevant factor that impacts the precious metal market.

Inflation – Making an “Official” Comeback
 
Regular readings of ABC Bullion market updates will know that I have at best limited faith in the ‘accuracy’ of official inflation readings. When I say ‘accuracy’, I’m not disputing that the mathematical calculations are performed correctly, or that the numbers are fudged per se.
 
Instead I’m referring to the fact that they don’t seem to appropriately measure the cost of living pressures that many in society are feeling, evidenced by the fact that the latest Australian official CPI readings came in at just 1.50% for the year, whilst a Roy Morgan ANZ survey of actual Australians in January suggested that inflation expectations were sitting at 4.3%, a rate nearly three times the official reading. 
 
We are not surprised with the discrepancy, as prices for essentials (health care, child care, utilities, housing costs, etc.), which take up close to 70% of every AUD $100 consumers in this country spend, have been rising at a far faster rate than headline CPI increases for years, and will likely continue to do so.
Nevertheless – markets do tend to place more emphasis on official readings, which is one of the reasons why gold prices (in USD terms especially) struggled between 2012 and 2015, as official CPI readings in the United States declined meaningfully.
 
This trend has well and truly reversed though, with core CPI and sticky inflation in the United States all moving meaningfully higher of late, with some inflation readings hitting highs last seen several years ago.

Even over in Europe, inflation readings got a jolt (see chart below), with the increased pressure on prices no doubt one of the reasons that the precious metal market has had a solid run for calendar year 2017 as a whole.

Obviously the outlook for inflation will have a meaningful impact on precious metal prices in years to come, with it being our view that more and more investors will rotate a portion of their negative real yielding cash investments and term deposits into gold, which will help support prices.
 
It will also be interesting to see how this plays out in the bond market, with the chart below showing the relative performance between the iShares TIPS Bond ETF (TIP) with the iShares 20+ Year Treasury Bond ETF (TLT). TLT holds long-term government bonds whilst the TIP ETF holds treasury inflation-protected securities.
 
When the ratio in the chart is falling (as it was between 2011 and 2015) it signifies the outperformance of TLT. When it is rising, it means TIP is outperforming, indicating the desire of investors to hold assets deemed more likely to preserve wealth in the face of higher inflation.
 
If you look at the chart between 2009 and 2011, you can see that TIP outperformed strongly. Not surprisingly, this coincided with a period of strong performance for gold. If the recent upward move in this ratio lasts, it bodes well for the precious metal complex. 

You can read more about this chart, as well as the latest thoughts on gold from hedge fund legend Stanley Druckenmiller here.

Until next time,
Jordan Eliseo
 

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.