Charlie Morris, Chief Investment Officer at Newscape Group and editor of the Fleet Street Letter and Atlas Pulse, explains to Glint what the gold breakout means.
In this issue…
- Breakout – a six year high for gold
- Thank the Fed – but don’t ignore Iran
- Positioning – light compared to the almighty asset bubble
- Equity bubble – gold has taken the lead
Source Bloomberg: Gold in US dollars with a 12 (blue) and 6 (purple) month moving average – past decade
I promised you an update on the state of this gold bull market when the breakout came. It happened on Thursday night, first on the back of the Federal Reserve’s commitment to ease monetary policy, and then had another jolt as tensions rose in Iran. This is a big deal, as gold has just made a six-year high. In this piece I will examine the sustainability of this move.
Moreover, the US dollar has been the strongest currency of them all. That gold in now flying in dollar terms, is a sign of strength. The next chart puts that into perspective by showing gold in a range of currencies since the market peak in 2011. Dollar gold is shown in thick red at the bottom. Second worst performing gold price comes in Thai Baht, closely followed by gold in Renminbi. Has Thailand been overlooked as a hub for sound money?
No currency on earth is stronger than gold
(and don’t say Bitcoin because it’s not a currency)
Source Bloomberg: Gold in a range of currencies since August 2011 rebased to 100 log scale
Gold has been weakest in US dollars (-24%), Thai Baht (-22%) and Chinese Renminbi (-18%). In contrast, cold has been strongest in Turkish Lira (157%), Russian Ruble (66%) and South African Rand (57%); not to mention Venezuela, Argentina and so on. Gold has made all-time highs in Japanese Yen, Canadian Dollars, Aussie dollars, Mexican Pesos and is just 3% away in British Pounds and Euros. Eight years since the peak in 2011, and it won’t be too long before gold has made new highs across the board. The gold market has breadth.
Thank the Fed
US interest rates turned the corner in 2013, starting with the rhetoric. They halted stimulus, then said they would hike rates, then kept reiterating that point until they finally did it in late 2015. That first rate hike coincided with gold’s low at $1,050. Then by late 2018, we saw the ninth hike and the stockmarket didn’t like it. The Fed reversed course. They said they’d slow, then they’d hold, then they’d ease etc. Presumably they’ll soon cut. It’s a reminder that words can have more impact than actions when it comes to central banking.
All about rates
Source Bloomberg: US ten-year bond yield RHS (blue), ten year inflation expectation (red), Fed funds (black), real rate (green) and gold in USD LHS (gold) since 2012
Much of the gold story can be explained by interest rates and inflation. The important line is the green one, real rates. That is the ten year yield less the expected future rate of inflation. When real rates are falling, bond yields are falling relative to inflation (or inflation is rising relative to bond yields. The bottom line is that gold benefits from falling real interest rates and vice versa. They have been falling aggressively since December, shortly before the last hike. And with President Trump in the White House, are likely to keep on falling. Property magnates love easy money.
Using magic, I have turned the green line above into a fair value for gold.
Gold has good reason to rally
Source Bloomberg: Gold in USD and the Atlas Pulse Gold fair value model derived from US 20-year bond prices since 1998
The model essentially mimics a hypothetical, zero-coupon, US 20 year inflation linked Treasury bond. It fits like a glove and gold has been closely following this thesis for a decade. If gold is way above the model, it is trading at a premium, and below, at a discount. Gold is currently slightly ahead of events, but mot materially. Below is the same chart again, but zoomed in over the past five years.
The breakout is justified, but slightly ahead of events
Source Bloomberg: Gold in USD and the Atlas Pulse Gold fair value model derived from US 20-year bond prices since 2014
Major price breakouts are important technical events. Typically, a price flirts with a major level, in this case around $1,370, several times before finally breaking through. Many traders will have various options strategies at that level, and market mayhem kicks in when the price finally passes. Breakouts are rarely quiet affairs, particularly when dealing with a level that has been tested five times over six years. Gold could ease back, but the odds are that it won’t. What was resistance, becomes support. And given the Fed is now committed to easing, gold has the wind behind it.
Iran and the Strait of Hormuz
Gold has a history of being a safe haven asset, particularly during times of geopolitical stress. I would hate to profit on the back of human suffering, but it is important to understand what is going on. The breakout on Thursday night came in three moves. The first was due to the Fed which drove gold to $1,360. Then during Asian trading hours, gold surged again on the news of the attack on the US drone, followed by the threat of retaliatory air strikes.
My point is that the Fed’s move saw gold’s fair value shift higher and the price move was justified by fundamentals. The geopolitical troubles could escalate but will only drive the price to a premium, rather than shift fair value itself; notwithstanding an oil shock. But when tensions ease, that premium will evaporate. Investors should understand why they are buying gold. If is the war premium, then inside information from the command bunker would be extremely useful. But if it’s monetary policy, better to have spies at the Fed. Unfortunately, I have no spies, just publicly available data.
It’s worth outlining a few scenarios for gold under different rate regimes
- Current situation. 2.25% 20 year bond yield and a 1.75% 20 year inflation expectation gives a fair value of $1,307
- If the bond yield went to zero on current inflation, expect a $2,000 fair value
- Japan scenario, zero yield, 0.2% inflation then a bit over $1,021
- German scenario, yield 0.1%, inflation 1.2%, circa $1,700
- Stagflation, yield at 2%, inflation at 4%, $3,350
- Modern monetary theory? Who knows, but it would be very bullish
Source: Atlas Pulse predicted fair value for gold under different interest rate scenarios. Current rates in grey.
Looking how investors are positioned is important. Normally we look at the futures market and record the longs and the shorts. We also look at the size of the exchange traded funds (ETFs). Putting this together gives us a sense of whether investors are already heavily invested in gold or have yet to make their move.
But how useful is this information?
In the next table, I show the relationship between positioning from the futures and ETFs against price. The data has been calculated using five years of weekly data.
|Investor type||Correlation to the gold price|
|Net futures (long less shorts)||67%|
Source Atlas Pulse
The futures are quite good with the longs explaining 61% of price in a correlated manner. The shorts, less so but still 50% negatively correlated isn’t bad. The net position is a healthier 67%, but the ETFs are better still at 69%. Now for the exciting bit. The complete picture from the financial investors, which combines net futures and ETF flows shows a whopping 84% correlation. Investors should take note.
Flows drive the gold price
Source Bloomberg: Gold in USD and the COMEX net futures position (long minus shorts) plus gold held in exchange traded funds in million troy ounces since 2014
It is one hell of a tight fit, with a 48% R squared over the past five years, jumping to 67% over the past three. It implies that for each million ounces (moz) of gold that investors buy, that adds approximately $6.50 onto the gold price. In other words, to see gold at $1,500 you’d want to attract another 15 Moz into the market. Is that possible? Of course.
Looking at this another way, investors have held an average of 80 moz over the past ten years, which is now 92 moz. You could say they own too much, but then the total ETF market was far smaller a decade ago than it is today. To the best of my knowledge, the ETF market has grown six fold. That means the 72 moz held in ETFs (20 moz is held via futures) is much lower on an adjusted basis than the 53 moz held in 2009, oe even the 82 moz held at the peak. To put it another way, investors have bought 30 million ounces since last autumn which cost them around $40bn. But when you consider how large financial markets have become, that might not be very much at all.
I illustrate this point in the next chart which shows the ETF holdings in dollar terms, as a percentage of the US total equity market value (market cap).
Gold is 0.3% of US equities
Source Bloomberg: Gold held in ETFs a percentage of US total market capitalisation since 2009
Gold ETF holdings used to represent 1% of US equity market cap in 2011, a number which has dropped to 0.3%. That is gold used to be equivalend weight as Exxon, a global giant, has now dropped to Starbucks. Gold doesn’t seem like a crowded trade to me.
The stockmarket bubble and demand for alternative assets
Which brings me onto the last point; the stockmarket bubble. Who knows how much further it has to run. Lot’s probably, given the support from the Fed. But my last chart shows the relationship between gold and the S&P 500. The trend now favours gold. High time too.
Gold is now leading the stockmarket
Source Bloomberg: Gold relative to the S&P 500 with 50 and 200 day mov averages past two years
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I am not paid by Glint, nor an investor or an adviser. They manage the production and distribution of Atlas Pulse, and I just write it. Thanks to the team for their help.
I promised you an update on the great breakout and I have delivered on my word. That begs the question what the next big target is. $1,600 is where the next point of major resistance is, but it may take a while. Or not. I’ll write one then, if not before if something interesting happens or there is a change to the thermometer. And don’t forget, even if you hate gold, its strength is saying something. When gold is falling, we know that the central bankers are doing a great job. When it’s rising… Mmmm.
A move from 0.32% of gold ETF holdings back to the 2011 bubble high of 1% of equity market cap, would imply investors would need to buy 150 million ounces of gold. If a million ounces shifts the price by $6.5, a bubble today would see a price closer to $2,400. Food for thought.
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