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Gold, confidence, rates, and seasonality

Before discussing the latest news, let’s set the stage by going through the key forces on gold right how.

  1. Confidence. From Trump to market overvaluation, from diverging hard and soft data to dollar declines, there are many factors feeding concerns about confidence at the moment. An actual failure of confidence has the potential to end the bull market, erode the dollar, and shoot gold up. Ongoing confidence concerns are less dramatic, but would still generate sustained support for gold.
  2. Interest rates. A month ago the market had almost completely priced in a mid-June rate hike. Two weeks ago those odds had fallen to only 60%. Today they’re back above 80%. This matters: gold will decline into an expected rate hike and then rise out of it. If the hike does not happen, my take is that gold will still do well (the Fed not hiking means economic confidence is low, which supports gold via point #1) but the reaction would not be as immediate.
  3. Seasonality. Gold declines in the summer, especially early in the summer season. Gold equities lever this decline. A mid-June rate hike would cut the summer doldrums short.

Confidence is the least tangible but most present force at the moment. Two weeks ago, US confidence was faltering. Trump’s firing of Comey and his intel slip with the Russians came hot on the heels of North Korean missile tests and the US airstrike in Syria, all of which left the world highly unsure what to expect from the US president.

That matters.

Last week was the first time the idea of Trump not finishing his first term was totally open for discussion. I’m not saying that is likely – it takes a majority of the House to impeach as well as 67 Senators and Trump hasn’t done anything so egregious to turn a third of his party against him. But he has angered a good number of sitting Republicans. And it is only month four.

This letter is not about politics. But it is about the markets and in that context impeachment proceedings would matter. That’s the kind of confidence sinkhole that ends a bull market. As Jared Kelly wrote in his free letter The 10th Man last week:

“If you are a global investor, and you have the ability to pick and choose asset classes around the world, then why on earth would you pick the same 500 overpriced US stocks that everyone is piling into?

“Put a little thought into what it means when you send off that check to the S&P 500 index fund. Stocks are not expensive in Europe or Asia or in emerging-land. Go somewhere else.

“Maybe somewhere that is not threatening to have a major constitutional crisis?”


Sorry to quote Jared twice in two months, but he is good at capturing an idea.
That major political upheaval would hurt the markets was broadly evident on May 17th, when US markets fell almost 2% after Trump’s conversation with the Russians. Gold gained $22 in response, but to me what is notable is that the yellow metal has basically held those gains since, despite stocks rebounding.

That’s the uncertainty factor in effect. Investors sure want the bull market to continue. Why wouldn’t they? But at the same time they cannot ignore all the warning signs – weak economic data, Trump, overvaluations, the duration of the bull, weakening inflation, and the like – that suggest the run could end. And they can’t ignore the possibility of something calamitous. Against both possibilities, gold is insurance.


Moving on to point #2: interest rates

Three weeks ago, when the Federal Reserve last met to talk interest rates, the members of the Open Market Committee were apparently a touch concerned about signs of a slowing economy and cooling inflation. They wanted confirmation that such setbacks were temporary before committing to raising rates in mid-June.

Indeed signs had been slow, headlined by GDP growth in the first quarter that came in at a measly 0.7%.

At the same time they discussed how they might start shrinking the Fed’s massive balance sheet, which holds $4.5 trillion worth of Treasuries and mortgage-backed securities bought during the economic crisis. When holdings have matured the Fed has reinvested the proceeds; the first step in cutting back the balance sheet would be to not reinvest everything. The minutes outlined an initial plan for doing that, specifically decreasing reinvestments every third month to reduce holdings in a predictable fashion.

So it was mixed messaging, saying both that they needed to see better numbers before raising rates but that they might start tightening by reducing reinvestments.

The market reaction was just as mixed.

Stocks jumped, based on the basic message that a June rate hike is not guaranteed. That was no surprise to me, as Wall Street has shown an incredible ability to only see the pro-stocks side of the news for some time now. Any bit of news with the potential to support the ongoing bull market, such as the suggestion that a tiny expected rate hike might not happen, is taken as reason to buy.

The bond market, however, took a different message from the minutes. Yields fell as bond traders baked in two kinds of tightening – a rate hike in a few weeks and reduced Fed reinvestments. And indeed, those betting on whether a hike will happen have shifted back to the Yes side of late. Expectations of a June rate hike increased to 83% today, up a few points in recent days and up almost 20% over the week.

The dollar lost ground and gold gained, though neither move was huge.

It’s worth, though, looking at gold and the dollar from a bit farther back. The dollar index peaked in late December at 103. Since then it has slid 5.7% to 97.1. Over the same period, gold has gained 10.96%.

Gold moving against the dollar makes sense. The negative correlation actually begs the question: is gold strengthening at all, or is it just reacting to currency moves? Looking at other prices helps to answer. In euros, for example, gold is up only 3.2% since late December but the euro is up 7.7%, creating a positive currency correlation.

In yen, the price of gold has gained 5.1% since late December. The Japanese currency, meanwhile, is up 4.7%.

Gold is moving against the US dollar but outperforming it, while gaining in other currencies despite those currencies gaining ground. In other words, the yellow metal is making headway despite it all.

The “all” trying to spite gold comprises two main things: persistent conviction from politicians, Wall Street, and investors bent on an everlasting bull market that the US economy is heating up and seasonality, which works against gold at this time of year.

The positive headway despite it all stems from that very first point I raised: uncertainty. Were the uncertainty only related to geopolitics, I would have less confidence in it as a sustainable pro-gold force. But it is far from limited to geopolitics – half of the uncertainty driving markets today is investors worried the market is going to turn down, because valuations are way ahead of real growth, and leave them holding the bag.

That kind of economic uncertainty is precisely why gold is gaining despite it all.

That is essentially my message right now: gold is set up to do well whatever happens. If growth truly appears, inflation will be right there with it and the Fed will hike rates, keeping real rates low. If growth does not appear, there will be neither inflation nor rate hikes and thus real rates will again stay low. And amidst it all, Trump and Brexit and North Korea and Manchester and the army of unpredictables keeping everyone on their toes will keep churning out surprises.

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