By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
Many gold bulls are frustrated that during last year’s U.S. dollar decline, the precious metal didn’t rally more strongly. After all, the U.S. dollar had a terrible 2017.
One might assume that this would have been an ideal environment for gold. I have even heard the argument that since gold couldn’t rally more strongly during this period, when the U.S. dollar eventually stops declining, gold will be vulnerable to a big sell off. The logic being that if that’s the best gold can do in a U.S. dollar bear market, it will get crushed in a U.S. dollar bull market.
I like to think about this scenario a little differently.
While most gold bulls are disappointed by the inability of gold to break out, I am heartened by the fact that even with the massive increase in real yields, gold managed to eke out some decent gains.
Most market pundits believe the U.S. dollar is the most important determinant when it comes the gold price. It’s easy to see why. Take a gander at this chart of gold versus the inverted U.S. dollar index:
It sure appears as if gold is merely the inverse of the US dollar index.
Yet I beg to differ. Let’s back up the time frame and look at this chart from a longer term perspective.
Although over the past few years gold has been negatively correlated to the US dollar, during the 2013-14 period, gold plunged $500 while the US dollar was also declining.
Well, you are probably saying to yourself, “it might not be perfect, but it sure seems to track the majority of time – and especially lately.” Yup – can’t say I disagree.
But what if I told you there was an even better asset that explained gold’s movement better? One that even stayed correlated to gold during the 2013-14 plunge?
Have a look at the price of gold versus the inverted US 5-year TIPS yield (the real yield):
This makes intuitive sense. Gold is an asset that is no one’s liability, but has no yield. In an environment of minuscule real yields, the opportunity cost of holding gold is low, so it is bid up. When central bankers increase the real rate of interest, this cost increases, and gold is replaced with income-earning fiat.
But the sharp-eyed reader will notice something ominous about that chart. Over the past half-year, US 5-year real yields have spiked to new highs (new lows on the chart).
Here is the same chart with a shorter time frame:
So that begs the question – what is driving gold more at this point of the cycle? Is it the US dollar, or real yields? Has gold disappointedly not risen as high as the bulls would like given the US dollar weakness? Or has gold not declined nearly as much as the bears would have expected given the run-up in real yields?
I am not sure. Given the massive one-sided nature of sentiment against fixed-income (everyone is short), it wouldn’t surprise me to get a vicious trading rally in bonds in the near future. Yet will that cause gold to rally? Or will that just bring yields back in line with the fact that gold has not declined as much as would be expected? And what will the US dollar do in this environment? Logic would dictate it should decline (lower yields), but the higher yields of the past half-year has not stopped a brutal US dollar bear market, so maybe the US dollar is not trading on interest rate differentials at all.
It is an interesting time for gold, the US dollar, and rates.
I don’t have many answers, only observations about some of the relationships that are breaking down.
And in another one-of-these-things-is-not-like-the-others moment, the chart of the copper/gold ratio versus the yield on the US 10-year treasury note has also diverged.
Gun-to-my-head it feels like the back-up in yields has gotten ahead of itself, but there are certainly plenty of interesting divergences.
But most of all be careful with the idea that gold is performing poorly given the US dollar decline. I am much more partial to the theory it is performing extraordinarily well given the rise in yields.