The past week on financial markets saw U.S. yields surge to levels not seen since 2011. As long-term Treasury yields broke well past recent ranges, it would seem that improved growth prospects, rather than an acceleration in inflation, propelled the move. We have had no inflation data points since the August PCE, reported last week, came in at a benign 2.2% y/y. Signs that the U.S. economy remains robust were reflected in this week’s macroeconomic data (see below). We believe the biggest factor to watch into year-end is not Trump’s charades nor even next quarter’s earnings announcement, but rather the path of yields and the potential inversion of the Treasury yield curve. For the moment, the market is not pricing into interest rates the inflation that we are expecting. The chart below shows the 10-Year T-Note yield (orange line) vs. the 10-Year Break-Even rate (white line) on TIPS securities (a market-based gauge of the annual U.S. inflation rate for the next decade). The 10-year breakeven rate has risen to about 2.17%, yet remains below a four-year high reached in May. It suggests investors don’t see inflation exceeding Fed officials’ 2% target on average over the next decade. They are wrong.
The first week of the month brings the key U.S. macroeconomic data. We did not see anything alarming in the numbers to suggest that the economy is already starting to slow into recession. The ISM PMI for Manufacturing came in at a stellar 59.8 reading in September, though down from 61.3% the prior month. Prices paid ticked down to 66.9 in September from 72.1 in August, a drop exceeding economists’ expectations. Perhaps this explains why the Break-Even yields did not jump with nominal yields this week? The ISM Non-Manufacturing index rose to 61.6 from 58.5 in August. This was a positive surprise. Monthly factory orders bounced back in August, +2.3% after slipping -0.5% in July. Finally, the closely-followed Non-Farm Payrolls number missed expectations for 185k job creations, coming in at 134k (but with strong upward revisions for August, the overall jobs report was good). The unemployment rate ticked down to 3.7% — the lowest level since 1969! Hourly earnings are rising at +2.8% y/y. The Fed should rethink its gradual rate hike path.
Inflation, Rates, and Gold
If you don’t believe that years of money printing and near-zero interest rates won’t end in an inflationary spike, then you should not be investing in gold. We believe that inappropriate Federal Reserve policy over the past several years will have negative consequences on the economy and financial markets. We just need to look back to the 2000’s. Greenspan dropped rates too low in the Tech Bubble recession. Following the lagging PCE price index, the Fed remained behind the curve, leaving Fed Funds below the market equilibrium level. Low rates fueled a speculative housing boom. The rest is history.
Don’t believe that the Fed members today are more enlightened. They are making the same mistake. In the push for a strong economy, and reliance on lagging inflation measures, the good-willed FOMC is once again trading short-term gains for long-term pain. The gold bull market from 2003 to 2011, seeing a gain of +500% in the yellow metal, can be directly attributed to Fed policy errors. Past is prologue.
Yes, Gold does best in periods of high inflation, as the yellow metal is a stable store of value. However Gold and inflation actually don’t move in lock-step, at least recently. The chart below shows the 10-Year Break- Even inflation rate and Gold. Investors have used chosen to use equities, which adjust for rising prices, as an inflation hedge. It is in stagflationary markets that Gold out-performs (low/no economic growth, high inflation). During the famous tagflation of the 1970s, the Gold price rose +450%!
Before enumerating the positives for Gold today, a word of caution to calm the ardors of perma-bull Gold readers. While Gold may see a tradable rally on inflation fears, risk-off events or a weaker dollar in the coming weeks/months, until the economy rolls over and growth slows, we cannot expect to see Gold to get back to 2011 highs at $1900/oz. Gold will only outperform if it becomes a better inflation hedge than the S&P 500.
The Stars Are Aligning For Another Gold Rally
Since Gold spike to its record in 2011, owning Gold over stocks has been an exercise in frustration. Relative to stocks, Gold has fallen to Financial Crisis levels.
As mentioned above, to have a sustainable gold bull market, we need an environment in which Gold becomes a more attractive hedge against inflation than stocks. However, as all bull markets are bred from pessimism, we see an opportunity to get into Gold before the markets begin to worry about inflation as economic growth passes its peak.
The precious metal logged its sixth straight month of declines, its longest losing streak since 1989. Signs of pessimism and capitulation are very present. Below we cite several signs that suggest it may be so bad for Gold that it is good for buyers.
Speculators in Gold Futures Are Net Sellers. We follow closely the Commitment of Traders Report released by the Commodity Futures Trading Commission (CFTC) every Friday. The report reflects the commitments of traders within the futures contract markets in the United States.
There are two groups of traders in the futures markets. Commercial Traders (Hedgers) are producers, industries, or farmers who use/sell the underlying commodity in their business, and rely on the futures market to offset business risk (ie the risk that their commodity price moves against them). As we would expect, the largest positions are held by Commercial Traders that actually provide a commodity or instrument to the market, or have bought a contract to take delivery of it. Non-Commercial Traders are large speculators. Speculators are market participants that are not able to deliver on a contract or that have no need for the underlying commodity or instrument. They are buying or selling only to speculate that they will exit their position at a profit, and plan to close their “short” or “long” position before the contract becomes due. The CFTC also reports a category of “Non-Reportables” which are small speculators and can be lumped in with Non-Commercial Traders.
As a rule of thumb, when a commodity price gets to an extreme, or turning point, Speculators are massively in the market on the wrong side. Conversely, Hedgers tend to be on the right side of the market at turning points in the commodity price.
Looking at this week’s CFTC data for Gold futures, we see that Speculators are NET SHORT Gold contracts. Our chart denotes major peaks and troughs in the Gold price over the past 20 years.
We took a shorter date range of Large Speculators Gold positions and overlaid the Gold price. Clearly, if you plan to take a position trade in Gold, wait until Speculators net position falls below 50,000 contracts …. as we currently see in the market.
If you look at Commercials or Hedgers, it is best to wait until their Net Long positions (which are almost always negative, therefore making them Net Short, thus the hedge) are minimized. Today Commercials are holding very few Gold contracts. They are unhedged. The chart below shows that this is the time to get into Gold.
Precious Metal Fund Closures. Another contrarian indicator favorable for Gold is the closure of metals mutual funds for lack of performance. Vanguard just restructured its precious metals mutual fund, slashing its exposure to the industry from 80 percent to only 25 percent. This means the world’s largest fund company will no longer offer its investors a way to participate in a potential rally in metals and mining stocks.
The last time Vanguard made a change like this, it coincided with a huge run-up in metal prices. In 2001, gold was just as unloved as it is now, prompting Vanguard to drop the word “Gold” from what was then the Gold and Precious Metals Fund. Bad move—the precious metal went from under $300 an ounce to as high as $1,900 in September 2011.
Industry Consolidation. Yet another positive sign that Gold may rise from the ashes is company mergers/take-overs within the industry. Mining giants Barrick Gold and Randgold Resources announced an $18 billion merger that, once complete, will create the world’s largest gold producer. Historically, this is a telltale sign that an industry has found a bottom and is in consolidation. A recent example of a wave of mergers and takeovers was in the then- truggling airline industry following the financial crisis. From 2009 to 2018 the U.S. Global Airlines Index has risen a cool +1,100%.
Conclusion
Gold has been a horrible trade since 2011. Investing in physical gold, a non-yielding asset, has left permagold bulls with nothing but a hole in their portfolio. However, we are seeing signs of light at the end of the tunnel. It is not a far stretch to imagine the macro environment becoming more favorable for gold investors within the next few quarters as Fed rate hikes choke off economic growth but inflation continues to run higher. In the near-term, Gold is unloved and unwanted – the typical characteristics of an asset near a major price bottom.