The Death of Volatility

It’s been another soft week for precious metal prices, with gold currently trading just below USD $1,220oz. Silver is currently sitting just above USD $16oz, a more than 13% fall from its mid April 2017 high, when it briefly pushed beyond the USD $18.50oz mark.
 
There have been no shortage of headwinds for the sector of late, including the continued rise of the USD, relative geopolitical calm, rising USD bond rates and stock markets, and the greater likelihood of a June rate hike from the Fed, all of which temper demand for safe haven assets.
 
The other factor at play right now is the complete dearth of volatility, with the VIX index falling to its lowest levels in decades.
 
To help visualize just how low implied volatility is, consider the chart below, which I came across in a recent update from the team at Mauldin Economics.
 
It shows the VIX index for the last 27 years. To put in perspective how low the VIX is right now, consider the fact that of the circa 7,000 trading days that are captured in the chart below, the VIX has only been this low on 10 of them.
 
Expressed another way, it means implied volatility has only been this low 0.22% of the time. It’s as good as dead right now, though like inflation, we suspect it’s only a matter of time before it makes a comeback. 

Obviously gold tends to perform best when volatility is higher and rising, as investors seek refuge from risk assets.
 
As such, the weakness that we see in precious metal prices right now is understandable, given the complete lack of said volatility, coupled with the other headwinds we briefly touched on earlier.
 
Technically, this puts gold at an interesting point, with a potential downside move as low as USD $1,190oz-USD$1,200oz, as per the chart below, which was included in a great update on gold from trader Greg McKenna, which you can find here. 

At the very least we’d expect gold to bounce from those levels (indeed we were expecting more of a bounce this week already), though the charts do suggest this period of price weakness could continue a little longer.
 
ETF flows supportive
 
Despite the poor price action over the last month, ETFs did experience inflows for the month of April. Total holdings rose to 2,277.5 tonnes according to the World Gold Council, up 24.5 tonnes from end March, driven by an increase in North American gold ETFs.
 
Speculative long interest in the metals has obviously declined meaningfully in the past month, though it had been very overextended (particularly in silver).
 
On the physical side, demand from India and China appears to be returning, with a 10th May article in Bloomberg suggesting gold imports into India gained more than four-fold from the corresponding period a year ago, predominantly driven by jeweller re-stocking.
 
Despite the soft-tone in the metals market right now, and the decline in prices over the past month, there are still a few banks out there with a positive outlook on the metals.
 
Chief amongst these is Credit Suisse, who see gold trading at USD $1,400oz by year end, driven by their expectation that ‘real’ interest rates in the United States will surprise to the downside, relative to market expectations.
 
Other factors they see as being supportive of higher gold prices are a waning rally in the USD, continued physical demand out of China, and the potential for a disruptive geopolitical event.
 
Investors in the sector may also be interested in a recent note from Goldman Sachs, who think the broader commodities complex could be set to outperform, based on market returns in previous rate hiking cycles.
 
As you can see from the image below, commodities tend to perform best, and substantially outperform stocks and bonds in rate hiking cycles. 

Of course this research looked at a basket of commodities, rather than gold and silver specifically, but it is interesting nonetheless for anyone interested in markets, and commodity investments specifically.
 
You can read more about that the Goldman research here.

Gold:Silver Ratio Extended
 
Another point worth making on the precious metals sector this week is the gold:silver ratio (GSR), which is sitting close to 76:1 today, having risen from just below 70:1 just a month ago.
 
Short-term, we could see the ratio go higher, and even retest 80:1, though as per the chart below, which shows the GSR over 10 years, silver is looking very cheap today, relative to gold. 

It was this ratio that encouraged me personally to top up my ABC Bullion Gold Saver recently, picking up some more silver alongside my regular weekly purchase.
 
In the coming years I still expect precious metals as a whole to rise meaningfully, with the GSR indicating it will be silver that will lead the way performance wise.

Federal Budget Update
 
Before finishing this update I wanted to share a couple of quick thoughts on the just released Australian Federal Budget. As you may have seen, there were a raft of policies tinkering with the housing market, superannuation and of course the major headline grabber, the new levy on bank liabilities that will hit CBA, ANZ, Westpac and NAB, plus Macquarie Bank.
 
The whole Australian news media has spilled countless amounts of ink going over all of this, so I won’t re-hash it, but I just wanted to share one chart and one table with you.
 
The first, which is the table below, comes from the Budget, and highlights arguably its most laughable forecast, that of a near doubling in the annual rate of wage growth in the next four years, from just 2% to nearly 4% per annum. 

To put into context how unlikely that is, consider the chart below, which comes from the RBA, and shows the wage price index forecasts from the RBA over the last 7 years, and what has actually happened. 

Every year, they predict it will get better, and every year it gets worse, with Australians experiencing negative wage growth in real terms.
 
In budgetary terms, the likelihood that wage growth won’t be anywhere near as high as forecast means there is in reality little chance of recording a surplus within 4 years.
 
This is because the projected surplus is reliant of income tax receipts that are forecast to grow by 8.5% in 2019-20, and 7.5% the following year.
 
In our opinion, that won’t come close to happening, with the end result being yet another delay in a return to a balanced budget, and the eventual stripping of Australia’s AAA credit rating.
 
In terms of everyday Australians, the reality of negative real wage growth was evident in the latest Australian retail sales data, and the overall trend for consumption growth, which is incredibly weak, something we touched on here.

As we discussed in that short update, the tepid economic environment in Australia will continue to pressure the RBA to cut interest rates, with our forecast unchanged that they’ll ultimately settle below 1%.
 
That has obvious downside implications for the Australian dollar, which will prove a boost to gold and silver prices for local investors.
 
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.