Gold on the Ropes and Why the US dollar is Gaining Strength

Gold versus paper money

US stocks were basically unchanged overnight as the selloff in the bond market continued. The yield on US 10-year bonds increased another seven basis points, to 2.22% — the highest level this year.

Still, it’s hardly panic stations, is it?

I mean, the 10-year bond yield is supposed to (but doesn’t always) track nominal GDP growth. Nominal GDP growth refers to real growth plus inflation. According to forecasts by the OECD, in 2017 the US economy will grow at a nominal rate of 4.3%.

So a 10-year bond yield sitting at 2.22% says the bond market either doesn’t believe in US economic growth prospects and inflation, or it’s wrong, and this selloff has some way to go.

Clearly, the election of Trump caught the bond market completely off guard. As the market digests his policies — and their expected impact on growth and inflation — more investors will reassess their positions.

But keep in mind that recent bond market pricing was hardly a natural outcome of market forces. Years of quantitative easing (QE) by the Federal Reserve, and ongoing QE by the Bank of Japan and the European Central Bank, led to massive artificial buying of bonds, which helped to suppress yields.

The market now sees the Trump presidency as the inflection point in the use of fiscal policy over monetary policy. The mob thinks this means higher growth and more inflation, and so bonds are losing their shine.

How long this perception lasts is anyone’s guess. The market, driven by groupthink, is always prepared to believe in the tooth fairy. In this case, the belief is that fiscal policy can do what years of monetary experiments couldn’t.

Maybe it can; I haven’t got a clue. But the premise is the same. That is, we’re being asked to believe that a government bureaucracy knows how to allocate scarce resources in the most efficient way possible.

On the surface, it shouldn’t be too hard. If Trump is serious about fixing America’s ageing infrastructure, projects should choose themselves, right?

But in the world of politics, it’s never that straightforward. Squeaky wheels get oiled, not necessarily broken ones. So there’s no guarantee that Trump’s supposed infrastructure spending will deliver the expected growth and efficiency gains.

A flow-on effect from the selloff in bond yields is the rout in the gold price. Every now and then the market focuses on certain correlations. And recently, the common-knowledge trade is that gold and bond yields move inversely to each other.

That is, when bond yields rise, gold prices fall. Longer term, there is no support for this relationship. For example, when bond yields hit all-time lows earlier this year, gold prices were well off their all-time highs.

The relationship is more about the level of real yields, rather than the nominal yields that market commentators refer to.

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So the recent sharp rise in bond yields — along with the lack of inflation — means that real yields are rising. And when real yields rise, gold comes under pressure.

That’s the market perception, anyway. It’s like a kneejerk response. When yields rise, gold sells off.

But if inflation is indeed set to rise, then real yields won’t necessarily rise, and the gold selloff would be overdone. Who is right? The gold seller or the buyer?

Let’s look at a chart to give us an idea. Technically, gold needs to find support around here. As you can see in the chart below, it just broke sharply through support, at US$1,250 an ounce. The line in the sand for gold is the May low at US$1,200 an ounce.

If prices sink below here, I’d have to say I’m wrong about the emerging gold bull market and that the bear is back. But while prices remain above US$1,200 an ounce, there is still life in the bull.


Source: Optuma
[Click to enlarge]

The other angle to this entire post-Trump market weirdness is the strength of the US dollar. This is probably the central figure in our story, and it explains everything else that is going on.

The consensus view (all of a sudden) is that a Trump presidency is good for both the economy and business. This means higher growth, higher inflation and higher interest rates.

This in turn means that the US will be the only major economy exhibiting decent growth over the next few years. As a result, capital is flowing into the country to get a piece of that growth.

This is why the dollar is strong. A currency is simply a price. When more capital flows into a country than is needed to fund the current account deficit, the ‘price’ of the currency rises.

So, despite the threat of an increase in the US Federal deficit (up from an already large US$600 billion annual deficit), the dearth of investment options in Europe and Japan sees global capital flowing into the US, which pushes up the greenback.

A stronger greenback means a weaker gold price. Everything is interrelated.

How it all plays out is anyone’s guess. But the market’s early verdict is that the bull market in stocks will continue, the bear market in bonds has just begun, and the bull market in gold is now either on hold or under threat.

Positively, copper had its best week for a long time last week. Other industrial metals are beginning to stir, too. That suggests the rise in commodity prices that got underway earlier this year could have much more room to run.

If you’re interested in some investment ideas in this space, go here.

Cheers,

Greg Canavan,
For Markets and Money

From the Desk of Managing Editor Bernd Struben: After a brief hiatus, Callum Newman is back in action with his podcast, The Newman Show. Tune in now to hear the latest on how you can ‘win the wealth game’ with entrepreneur Mark Robinson. Guests on The Newman Show include the biggest names in international finance. There’s hedge fund legend Jim Rogers, Currency Wars author Jim Rickards, and trend forecaster Gerald Celente. It’s all yours, for FREE. Check it out on iTunes here or Stitcher here.

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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