Why Gold May Finally Be Turning Higher
We came into last year with the idea that despite a historically low disposition at 3 percent, the 10-year yield had become In less than two years, yields had run up over 100% above the July 2012
cycle lows around 1.4 percent. Even in context of previous rate
tightening cycles, such as the one in 1994 that had caught the market
offsides - the move was massive. When expressed on a logarithmic scale,
the less than two year rip was the most extreme in over fifty years.
Click to enlarge images
Not
surprisingly, when viewed in this light, our expectations going into
last year were for 10-year yields to retrace a significant portion of
the move; hence, strategically we favored long-term Treasuries relative
to U.S equities, which by most conventional metrics as well as our own
variant methods - were also extended. To guide the arc of those
expectations, we referenced throughout the year the complete retracement
profile of the 1994/1995 rate tightening cycle - as well as an inverse
reflection of the secular peak in yields from 1981 that momentum was
loosely replicating on the backside of the cycle.
With
a year of daylight between that extreme, yields are still following
both retracement profiles - with 10-year yields just today feathering
the panic lows from last October. While
respective retracements in both Treasuries and equities may manifest
over the short-term, strategically speaking, we continue to favor
Treasuries - considering that the U.S. equity markets remained
relatively buoyant last year.
What
has been more difficult to handicap is the large differential in
performance between durations in the Treasury market, with shorter
durations greatly supported by expectations that a more conventional
tightening cycle would eventually transpire, as well as the influence of
ZIRP - which has muddled the waters from a comparative perspective.
Over the past few months we have noted the significant spread in
performance between 5 and 10 year yields, as a literal expectation gap
in the market has continued to grow.
Generally
speaking, this market mentality also maintained pressure on assets such
as precious metals and emerging markets throughout last year, as
traders waited for a second shoe to drop with further tightening
delineated by the Fed. Our general take has been that the lion share of
tightening - both through the posture and then completion of the taper,
has already been completed. From our perspective, pivoting on a policy
that actively and passively supported the markets to the tune of over 4
Trillion in net assets purchased, is the closest thing you will find to
materially "tightening" at this point in the cycle. Actions and
expectations are all relative, which is easily lost in this market -
especially with the Fed at ZIRP for over six years. We fleshed some of
these thoughts out in The World According to ZIRP last
October. If and when the Fed eventually gets a window to cut the ribbon
and take us off ZIRP, the move will likely be exceedingly modest and
ceremonial at best. That said, we continue to be far less confident that
even a modest rate hike arrives sooner rather than later and still
expect that the equity markets will continue to normalize with current
policy (i.e. QE free) - which for better or worst will broadly influence
expectations of future policy.
Needless
to say, market conditions are anything but conventional these days,
although we do believe that gold - a leading market, has made its peace
with policy first as well as digested the overshot from misguided
inflation expectations that slammed shut in 2011. Over the past year
we've posted a version of the chart below that showed gold relative to
10-year yields was at a level commensurate with significant lows in the
past. And while 10-year yields played the part last year, the large
expectation gap - that is captured below in red in the shorter end of
the Treasury market, held gold in place - until now. Gold appears to be
finally breaking out of its broad base as the extreme correlation drop
between durations that began with the taper in December 2013 exhausts.
As we pointed out last year, this same dynamic - to a lesser degree,
manifested with the previous tightening cycle that began in June 2004.
Once the policy shift was digested, gold broke out of its much smaller
consolidation range and correlations were reestablished in the Treasury
market.
Interestingly,
the two other occasions where the Treasury market dropped out of tune
with respect to durations and gold was during the 1970's bull market,
where the dynamic with the Fed was the polar opposite of how it reacts
with policy shifts today - as well as in the Treasury market. Back then,
when the Fed raised rates - gold rallied. When the Fed eased - gold
corrected. As such, gold trended with the relative performance between 5
and 10-year yields.
That
said, we continue to see the closest parallel with a broader cycle
continuation period - such as the mid-cycle retracement in the 1970's,
that shook the tree strongly before another set of branches completed
the larger move. While the saplings in this cycle have taken their sweet
time to germinate over the past year, we like the long-term prospects
for the sector - especially relative to the U.S. equity markets.
19:53
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