It’s On (For Gold, At Least)
From the HRA Journal: Issue 306
Did I mention gold?
No prizes for guessing the subject of the main editorial this issue. After so many false starts and failed breakouts in the last three years, it looks like we finally have the real thing.
I'm sure we'll see pullbacks in the gold price, sometimes large ones. Nothing goes straight up or down, but I think the die is cast. While I'm not sold on the bond market's current view that the Fed cuts rates four times in the next twelve months, I DO think they are going lower. Inflation is dead and the US economy is showing widespread signs of slowing. And the Tweeter In Chief still wants the Fed Chair's head on a platter. Trump isn't allowed to fire Powell, legally, but when has that stopped him?
If the gold price holds up, we'll start seeing money move down the food chain over the next few weeks. I expect to see a lot of financing announcements once management groups decide the gold price move is entrenched and traders will open their chequebooks. That, in turn, should lead to an increase in activity across the gold exploration space. There will be lots of dreck, but some deserving projects should get financing too. The odds of a price-driven rally, followed by a discovery-driven one, just went way up. Let's have some fun!
June 25, 2019
It’s On (For Gold, At Least)
If you don't feel like reading, you can just gaze at the chart below. It gets about 90% of the point across.
Ever since US Federal Reserve Chair Jerome Powell reversed the Fed's hawkish stance in December, markets, especially the bond market, have been pricing in an increasing number of rate cuts through the following 12 months.
The Fed's pivot to dovishness is the reason for the huge rally off the December bottom we've seen on Wall St. Indeed, Wall St is now convinced that it's calling the shots at the Fed. That if the bond market prices in future rate cuts and the equity strategists demand them to keep the bull market alive, they will materialize. Wall Street now has its own Field of Dreams with traders whispering, "cut rates and they will come".
The Fed hasn't cut rates – yet – but that hasn't stopped the bond market from pricing them in, especially after last month's mini-tariff war with Mexico and the continuing trade despite with China.
The bond market also recognized that the wor'd's other central bankers have become more dovish than the Fed as they dealt with sputtering economies in Japan and the EU. Falling yields elsewhere increases pressure on the Fed to act, especially as core inflation and inflation expectations measures were falling through the first half of this year. That increases the inflation-adjusted "real" Fed Discount Rate and makes further increases harder to justify.
An increasingly dovish bent to FOMC member comments kept a floor under the gold price and helped it grind higher through yearend 2018. Gold bulls got more hesitant as the US put up some good numbers for Q1 this year though there were a few skeptics (like me). That changed after Trump started his latest trade tiffs. US economic readings and inflation readings worsened and most of the yield curve inverted, arguably the most dependable sign that a recession is on the horizon.
All the above supported gold prices through late May but the real fireworks came this month. The US non-farm payroll report for May came in way under expectations and regional Fed economic activity measures also fell much harder than expected. Things were going the wrong way, fast. That led to a rapid drop in market yields, with the 10-year Treasury yield falling from almost 2.6% in early May to about 2.1% by the time of the Fed meeting last week.
While the Fed didn't cut rates this meeting, the wording of the announcement made it clear they would probably cut next month if things didn't improve quickly. And the "dot plots", projections of where individual members of the FOMC expect rates to be going forward, showed that half the voting committee expects to cut rates before year-end. The dot plots appear below.
Even though the message seemed a little mixed to me, the market didn't take it that way. Yields fell through the day of the Fed announcement, then fell HARD in overseas trading, with the 10-year yield dropping below the psychologically important 2% level in Asian trading.
This had a couple of immediate impacts, with the USD falling because it trades with yields and equity but, especially, gold futures moving higher because they trade against them. The move in gold was particularly shocking. You can see it on the right side of the first chart above. There was an explosive move from the $1350s to $1390s as "buy stops" put in place to limit losses by traders who were short were triggered forcing the price higher to the next buy stop level, triggering those pre-set trades, and so on and so on.
When a futures market spikes like this, you expect to see an immediate pullback as traders take profits and/or put on new short positions. That happened Wednesday night but, interestingly, traders couldn't seem to force the price back below $1380, even with very heavy trading volume.
The gold price not only held in North American trading, it moved back up to the highs seen on Wednesday night by the end of the US trading day. That evening, there was another short covering rally, this time taking the price to $1410. The price weakened in Europe and the US but, again, fought its way higher. Gold rallied to almost $1440, before pulling back on FOMC member speeches less dovish than I guess traders wanted.
How important is the move for resource traders? Very. I'm excited to see gold at $1400 but, for me, the important near-term level is $1380. To see why, look at the seven-year gold chart below. As I said last month, while I was happy with how the gold market was shaping up, it was the $1370-1380 level I was focused on. This is the range where rallies in 2016 through 2018 repeatedly failed. Moves below that level might excite gold bugs, but technical and generalist traders wouldn't care. They, correctly, would not view a move as a potential long-term uptrend until the gold price broke through $1380. And what I think many really want to see is a monthly close above that level. We're a few days from that still.
After so many failed rallies, its understandable that resource stock traders are hesitant and worried about every pullback in price. I do think this time is different though, and not just because pf the price action we've seen so far this month. I'm not a technical analyst, but you don't need to be to see the breakout on that seven-year gold chart. It's pretty obvious. The more important thing now is whether the rally holds and continues and why.
I think it will for the same reason I originally started to get more bullish. I think the US economy continues to slow and the convergence between US growth rates and those in other currency blocks will keep yields low and weaken the US Dollar both.
The following chart, from WSJ, shows purchasing managers indexes ("PMI") for Japan, the EU and the US. Not surprisingly, the US reading is strongest but its converging fast with the lower Japanese and EU readings. We've seen readings for the regional Fed activity indices for June, which are good predictors of the ISM number. All three were much weaker than expected, and part of the reason bonds and gold rose this week.
I expect the convergence to continue, with the US weakening further. The chart below is a long-term chart of ISM readings and economic growth. ISM readings are a leading/coincident indicator for growth rates. You can see how steep the dive is in ISM readings on the right side of the chart. So far, the growth rate hasn't shifted down to match the ISM readings, but I think it will.
If things continue to unfold the way I expect, we may see some divergence between equities and gold and bonds. So far, it's been "pass the punchbowl" for almost all asset classes.
You can get gold prices and equities moving together. It's not unusual. The two largest gold rallies in the past 20 years occurred when equites were both rallying. The first rally (up to 2008) was all about a falling US Dollar while the second (2009-2012) was about zero interest rates and monetary expansion. Both were positive for equities too. If the bond market is right about where interest rates are headed, we could have bonds, stocks and gold moving in tandem.
Where things could diverge again would be equities, that is Wall St, moving lower. So far this month, we're in one of those "bad news is good news" periods. After bouncing at the start of the month when the US-Mexico "dispute" was settled, Wall St has reacted favorably to a litany of poor economic stats. The effect on yields has been strong enough to drive equities higher as yields dropped.
The next chart shows the TNX, the 10-year yield index for the past year. The drop in yields is remarkable, especially when you consider that the Fed still hasn't cut rates yet. The bond market is way ahead of the Fed.
Bond traders are pricing in four rate cuts in the next 12 months, starting in July. The only way that makes sense to me is if the US enters recession during that period. The Fed doesn't expect that and has tried to temper the bond market -a little-which is the main reason for the recent pullback in gold. If the bond market is right though, we're in for growth slow enough to roll over Wall St. I'm still siding with the bond market.
The biggest near-term risk to the gold market is a China-US trade deal reached on the sidelines of the G-20 meeting this weekend. A deal would help US sentiment and Wall St and could generate some gold selling. No deal announcement, especially if accompanied by Trump rage tweets, could generate another Wall St selloff. That muddies the picture but isn't necessarily gold negative. A "fake news" deal with China that doesn't address issues would only have a short-term positive impact. It needs to be a substantive deal.
Gold and in gold miner indices have been crazy strong all month. Look at the GDX chart on this page. That is some rally. It's easy to argue both are "overbought". Some corrective action or at least sideways movement should be expected, no matter how strong the rally ultimately is.
We're already seeing inflows to specialist gold funds and gold ETFs, though I suspect most of that came from "true believers." Larger generalist pools of money haven't arrived yet and won't until they see gold hold $1380 through month end and hopefully move higher again.
Money flows downhill when a sector rallies. Gold producers are moving already and developers with resources with economic studies are seeing early buying now. If the rally continues, we'll see money move down the food chain to late-stage then early stage explorers.
There are very few open financings in the junior gold space right now, but that will change if the rally continues. We could see activity levels, and share prices, starting to rapidly expand over the next month if gold prices stay up, even though it's the "quiet" part of the financing calendar.
It's been a brutal couple of years in the junior gold sector. Traders and insiders are still cautious and skeptical, with good reason.
We've been burned before. That said, even though this breakout is only a few days old, it feels different than the last few. For a lot of reasons that I've discussed above and earlier in the year, I think the rally is real this time. It looks like resource traders are going to have a fun summer. Let's enjoy it.
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