Market Update: Gold: Is the Bull Market Already Dead?

Up until a few weeks ago, 2016 was shaping up as the year that the precious metal market well and truly moved back into bull mode, with strong price gains that easily exceeded the returns generated in risk assets.
 
The implementation of negative rates in Japan, a Fed that backtracked from anticipated rate hikes at every opportunity, and a volatile stock market all contributed to the positive momentum for gold prices, which traded above USD $1,350oz at various points in July and August.
 
Since then though, gold has corrected by close to 15%, with a savage sell off in the last three weeks alone, despite the victory by Donald Trump in the US presidential election race, an outcome that most people thought would be gold bullish!
 
This decline, which can be seen neatly in the chart below, has led to a complete 180 in terms of the markets view on the future direction of gold prices.
 

Instead of the optimism that was evident prior to US election, perhaps best summed up by a HSBC note that suggested the gold price was to move meaningfully higher irrespective of who won the race for the White House; we now face a market that is overwhelmingly bearish.
We’ve seen headlines claiming that gold is “broken”, with fresh calls for the yellow metal to test its 2016 lows back around USD $1,050oz, if not break back down below the USD $1,000oz level in this washout.
 
What next for the yellow metal?
 
From a technical perspective, gold is looking well oversold on a short-term basis, and after touching important resistance just above USD $1,170oz, a bounce is to be expected. Our latest technical and market positioning report is calling for a move potentially as high as USD $1,231oz, though it first needs to break through important resistance at USD $1,202oz.
 
The likelihood of a bounce in the precious metal complex gains even further credence when one considers the fact that the rally in the USD and most global equity markets are now taking a breather, though it’s far too early to say that those moves are exhausted.
 
Despite the fact that we see a short-term bounce for the yellow metal, gold certainly faces no lack of headwinds at present, including the liquidation we are seeing in the ETF space, which for most of the year had been a strong source of support.
 
As at 23rd November, ETF holdings were down a few percent from the levels they were at during their peak earlier in the year, with almost relentless inflows in the first three quarters of 2016. ETF flows and the gold price during 2016 can be seen in the chart below from UBS.
 

 
The lack of support from Western investors via securitized products is just one headwind, with the strength of the dollar also likely to be a major factor, with the US Dollar Index on an almost unstoppable upward trajectory since Donald Trump won the race for the White House.
 
The circa 4% rally against a basket of currencies that we’ve seen in the greenback since early November has seen the US Dollar Index hit an almost 14 year high.
 
And with no shortage of political ‘risk events’ on the immediate horizon (especially the Italian referendum), most expect it to continue rising, especially considering the current yield differential between US 10 year bonds and those of their G10 counterparts.
 
The chart below plots the movements of the US Dollar Index alongside that of the yield differential on 10-year government bonds going back to the early 1990s, with a very clear correlation between a rising greenback and higher relative yields in the US.
 
 

 
Another factor driving the US Dollar higher this past few weeks is the obvious recalibration of interest rate expectations, with the market now 100% convinced that the Fed will deliver a rate hike next month, matching the one we saw in December 2015.
 
This recalibration of interest rate expectations by the market is not limited to next month either, with the following chart, which was from an article in Business Insider dated November 24th highlighting the much tighter policy that is now expected by the market, vs. expectations pre-election.
 
Interestingly enough, despite the relative hawkishness of market expectations today compared to three weeks ago, no one (outside of academia at least) is buying the Fed dot-plot three years from now, with market expectations still far lower than those indicated by the FOMC.
 
 

 
You can read the article that the above chart came from here.
 
Bloomberg also had a very good article on current market expectations re the future trajectory of US interest rates in an article which you can read here, which also touched on the carnage that has been unleased in bond markets in the past few weeks, which recorded their worst monthly loss in over three years.

A final factor that may has likely played into the gold market weakness we’ve seen over the past few weeks is the recent drama in India, with the frankly outrageous decision by the Indian government to ban higher denomination rupee notes.
 
Whilst we can sympathise with a policy that may in some way limit criminal activity, a move that effectively wipes out the value of 85% of the cash in circulation (see chart below) in an economy that is itself driven predominantly by cash was draconian at best, tyrannical at worst, especially when one considers the fact that hundreds of millions of citizens in India are without a bank account.
 

 
For a couple of interesting reads on the impact on the impact that this decision by the Indian government is having on the local economy, we’d recommend this read by Bloomberg here, and this read by Alasdair Mcleod of Gold Money!
  
Long-term, we can’t help but think that this move by the Indian government is gold bullish. After all, as Mcleod noted_; “the surprise money-grab by the Indian authorities intensifies the public’s perception of a corrupt, overly-bureaucratic, and ineffective government. The public’s suspicion that government paper money is ultimately worthless will have, in its collective mind at least, gained immeasurable credence.”_
 
In the short-term though, the ‘cash-ban’ in India has potentially contributed to the weakness we’ve seen in gold prices the past few weeks, as it has occurred alongside a persistent rumour of a potential ban on gold imports into India.
 
This has whipped certain sections of the financial media into a frenzy, perhaps best exhibited in the following headline from Marketwatch!
 

The article that bequeathed such a headline can be found here, and includes a suggestion that were a ban to take place, gold could see a 1 day drop of $200 per ounce.
  
Whilst this move is not currently on the cards according to various Indian government officials who’ve been interviewed about a potential ‘gold ban’, the rumour of it alone has no doubt damaged the gold price, adding to the list of ‘bearish factors’ that have seen ETF investors and managed money speculators run for the hills for most of November.
 
So is the Bull Market Over?
 
After the weakness of the past three weeks, many a precious metal analyst is asking if the bull market is over, with some saying the market is again ‘broken’. Precious metal bears have also piled in with a round of negative commentary.
 
One of the better articles I’ve read which covers the current state of play in a balanced way came from Rudi Filapek-Vandyck, Editor at FNArena, who hit the nail on the head with the observation that if; “a normalisation in US interest rates were to go hand-in-hand with a stronger US dollar plus an ongoing bull market for equities, I think gold investors should prepare for the worst”.
 
Note that referencing the above is not to say that those three things will happen (I for one don’t think any of those three trends can continue for too long without causing major economic damage), but the comment accurately captures the mood of the market, and three of the major headwinds for gold at present.
 
Rudi’s article, which you can read here, also included an excellent chart (see below), which is a look at the ratio between the S&P500 (currently near all time highs) and a troy ounce of gold.

 
The uptick in the ratio over the last few years looks like it may have a little more to play out, but if history in any way rhymes with the mid to late 1970s, then gold is going to be a big winner on a relative basis in the next few years.
 
Perhaps the better question to be asking in light of the recent correction in gold is if 2016 really did mark the beginning of a new bull market in gold (as many, myself included, stated), or if the bounce in the first several months of the year was just another dead-cat bounce, with gold still stuck in the cyclical bear market that began back in late 2011.
 
One analyst who subscribes to that theory is Jason Stevenson, who publishes Resource Speculator for the widely read Money Morning. Jason has been consistent in his call all year that gold hadn’t really entered a new bull market, pointing out that the weekly chart was still showing a primary downtrend for gold, evidenced by the blue lines you can see on the chart below. 
 

 
Jason (whose article you can read here), is far more positive on the outlook for precious metals, noting that gold is in a long-term bull market, but he sees the market potentially heading just below USD $950oz level before bottoming out.
  
We aren’t convinced gold is going to see quite that much downside in the short-term, particularly with sentiment already so overwhelmingly bearish. The graph below provides an illustration of that, looking at the pessimism towards gold miners. These are the kinds of readings one typically sees at or near a bottom!

 
Another sign that we are potentially due a short-term bounce can be seen in the options market, where the relative price of put protection (to cushion losses from gold price falls) has soared, to its highest level since July 2015.
 
This can be seen on the chart below, with gold putting in rallies of 16%, 11% and 21% the last three times we saw readings like the ones we are now.
 

 
You can read the article this graph came from here.
 
Despite what the options market and sentiment surveys are indicating, the weekly charts that Jason referenced don’t lie, and only a fool would ignore the recent weakness, and the damage it has inflicted on the gold market’s psyche.  
 
But even here it is worth pointing out that those weekly charts, and most gold price forecasts, are focused on the USD price, not the AUD price, which is the most important price for Australian investors, including the majority of ABC Bullion clients.
 
As such, one must factor in the impact of currency movements, and likely moves in the AUD FX rate versus the USD, a point that we covered in our book Gold for Australian Investors.
 
Our findings in that book, based on the analysis of monthly, quarterly and annual data over more than 40 years for the USD index, USD gold and AUD gold prices, highlighted two key points.

• The relationship between the USD index and USD gold is asymmetric, in that whilst a rising USD index was a headwind for USD gold, it was nowhere near as strong a factor as a declining USD index. Evidence of that is clear even in the last couple of weeks with many articles pointing out that the USD index is at 14-year highs. Gold, despite the weakness in November 2016, is some USD $850oz (circa 300%) higher than it was 14 years ago.

• For Australian dollar investors, a rising USD index in no way portended lower AUD gold prices, due to the impact of currency movements, with the AUD typically falling when the USD gold price fell, helping cushion losses for local investors.

As such, even in the gold price in USD does fall from here, we’re relatively certain the downside in AUD will be far more limited. The following table helps explain why, showing potential AUD and USD gold prices based on a range of FX rates, and the AUD loss in percentage terms that declines from current levels would translate too for local investors.
 
Note that in the table below we have used AUD $1,592 (the price when I was writing this report) as the calculation level from which the percentage losses in the final column is calculated.
 
Gold Price and FX Forecasts

 
As you can see from the above – the “worst case” loss for AUD gold investors (assuming USD gold falls all the way to USD $950oz), would be a decline of some 20%, with the AUD gold price trading at AUD $1,266oz, assuming the FX rate is unchanged at roughly $0.75.
 
We don’t think that's very likely though, for if the gold price really were to fall the better part of another USD $250oz from here, we think there would also be significant downside pressure on the local currency, which would take it to at least $0.70 (if not lower).
 
AUD Gold price declines from these levels, assuming the currency falls to $0.70 range from as little as 5.78% (with gold at USD $1,050oz) to slightly less than 15% (with gold all the way down at USD $950oz), though we think its fairly likely that the downside will be limited to 10% at the very worst from here.
 
Whilst that wouldn’t make for a Merry Christmas, it is hardly the kind of potential downside that should cause any great angst to long-term bullion investors, especially those accumulating the physical metal as a strategic holding to help them preserve wealth over the next few years.
 
 
Final Read of the Week!
 
Considering the chaos currently taking place in India, we thought we’d leave this market update with a link to a report from Deutsche Bank on “Cash, freedom and crime”.
 
You can read it 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.