Gut Check

From the HRA Journal: Issue 289

Ugly, ugly, ugly. Yet more proof that trying to predict the gold market short term is a mug's game. The metals markets didn't do us any favours as June wore on but at least we got good news from several HRA list companies to cushion the blow.

I'm expecting more good news on several fronts soon, including most of the companies working on resource estimates and feasibility studies that were delayed. Note to self—Don't offer guesses on third-party study timing either.

Nevsun announced and Regulus announced an agreement on, quite impressive resources. I expect both to keep trading well. We also got somewhat delayed good news on the permitting front from Bear Creek and Excelsior. I expect MIN in particular to benefit.

Some of the best news this month was the takeover announcements from Arizona Mining and Dalradian. I don't expect an immediate impact on other companies, but I think those deals improve the odds for a better autumn. There are a lot of resource funds with no cash that will have some to play with again when those transactions close.

I held this for a couple of days because I don't like sending issues when it's a stat on one side of the 49th parallel or the other. It should be a slow news week, but I expect a lot of news volume next week. Happy Canada Day and Independence Day to you all.

Eric Coffin
June 30, 2018

Sigh. Well, I guess you could say that gold didn't "surprise" (in a negative, cynical way) but it certainly did disappoint through the second half of June. Right after I sent out an Alert noting my surprise that bullion was continuing to hold up, it took it on the chin. The beatdown has continued without much let up since.

As I feared and noted in the last Journal editorial, the trouble started with the central bank meetings. The Fed's dot plots indicated a fourth rate hike this year, but it was the ECB meeting, ironically, that seemed to do the most damage. Ironic because the Euro crashed after Mario Draghi backed off on a rate hike in the next few months ofwait for it10 basis points (0.10!).

Gold getting clobbered on the day of the ECB meeting started the draw down, but the fun hasn't ended there. Typically, the move is being blamed on "dollar strength". USD strength is in the eye of the beholder, in part because there are several competing USD Indexes. I've always used the USD index that trades on ICE. The updated chart on the next page shows you that, while USD had a good June, it could best be described as "sideways" price action. It's certainly not strong looking enough to account for the 5%+ decline in gold prices through June.

I do think some of the gold trade is due to "perceived" USD strength as some indexes, like that developed by Bloomberg, show a stronger uptrend.

We may also be seeing selling due to fears of further USD strength rather than just current strength. The USD Index has been turned back at 95 three times recently but there is still very broad consensus it's going a lot higher.

There continues to be a wide gulf between US economic metrics which have been strong (though weakening) and EU metrics that have broadly disappointed. It's one explanation for the selling in the gold market. Note, however, that the Citi "US Economic Surprise Index" that tallies positive and negative surprises on economic readings just went slightly negative. It was at a multi year high four months ago. I think the jury is still out on whether we see this growth differential narrow.

The other, related reason is simple "risk on" sentiment. Notwithstanding all that's going on in the world and the fact the SPX is still well below its January high, Wall St remains very calm. That's been helped by a slight dip in bond yields, even in the face of increased odds of a forth rate hike.

It's ironic that the drop in longer term rates also isn't generating any real concerns on Wall St. The yield curve has been flattening for months. The 30:2 yield spread (30–year yield minus the 2–year yield) has dropped from 2% in early 2017 to only 0.4% now.

That's not a disaster but it looks like a warning sign. The rate spread has been in a steepening downward trend for several months. Yield curve inversion, where short term rates exceed longer term rates, is one of the most reliable recession predictors there is. I don't think it's a cause for panic unless the rate differential gets very close to zero, but it's remarkable that traders are just shrugging.

USD, Risk On markets, and uncertain forward rates have all been weighing heavily on the gold price. Is the light at the end of the tunnel an oncoming freight train? It sure feels that way, but there are three reasons for at least mild optimism.

Firstly, seasonality. Gold has had a fairly dependable seasonal pattern for many years. May, and particularly June, tend to be weak months while the third quarter, on average, is the best part of the year. July itself is usually only slightly positive, with average month to month returns rising in both August and September. I stress that we're talking average returns, with wide year to year variation but, still, a good bounce would be a reasonable expectation after the recent pullback.

The second reason for optimism is, well, the lack of optimism. Sentiment and relative strength measures for the gold market are nothing short of horrible. The story is similar with futures positioning. It's been getting more bearish week by week, and the past few days of trading, yet unreported, surely continued the trend. Sentiment, like most things in the market, tends to be mean reverting.

The third reason for at least some optimism is relative strength of gold miner shares, at least as tracked by the GDX ETF. The one-year chart for that appears on this page. The chart doesn't look great, but it also hasn't suffered the breakdown that gold price has yet. Granted, most of the strength is concentrated in a handful of stocks but it still could be meaningful. We often see bottoms when gold miner indices refuse to confirm drops in the gold price, for whatever reason.

None of the above guarantees anything, but the more bearish sentiment and market positioning is, the more likely it is that short term sellers are done. Let's hope so. No one disputes that the gold price is suddenly down to critical levels. If we're going to get a rally of large enough proportions to really make a difference it's going to have to start soon, even if it starts slow.

After a strong start to the year, we haven't been getting much help from base metals either. The overriding reason for that is clear to everyone. The start of tariffs that could still, and easily, turn into something wider ranging and nasty.

The chart below for copper, the base metal bell weather, shows how swift and deep the drop has been. Before we lay all the blame on trade, at least for copper, it's worth remembering what drove the late May spike.

Several of the world's largest copper mines are in the midst of labour negotiations. Most are still unsettled but we've yet to see serious strike action. A lot of the late May buying was probably hedge funds anticipating supply disruptions that haven't happened. A lot of the price fall in copper can be traced back to the lack of strikes.

Not all of it though. The rest of the blame can be laid squarely on Donald Trump's instigation of trade disputes. Trump has followed through with the first round of threatened tariffs, which were predictably met by counter tariffs in response.

We're in a short term pause which hopefully gets extended, but I'm not confident about that. Trump's tendency is to escalate when he doesn't get what he wants. He won't get what he wants from most trading partners. They aren't going to turn their backs on 60 years of trade liberalization. They have too much invested in it to do that even if US tariffs bite.

Sadly, the US President and his advisors seem to have only a weak and slippery grasp of macro economics (John Bolton? Larry Kudlow? Be serious.). The US has spent 70 years concentrating on making the US Dollar the world's reserve currency. The flip side of that is that the country that has the world's most in demand currency will usually have an overvalued currency. That's great for native consumers who want to buy cheap stuff (in USD terms) from everyone else. For US exporters though, not so much.

If we were dealing with any currency but the USD, you'd see the value eroding dramatically as currency traders price in 42 straight years of trade deficits.

Ironically, Trump's focus at the start of his term on the "too strong" Dollar is closer to the real culprit when it comes to US trade deficits. The deficits themselves aren't evil. They are a symptom. The US borrows widely and cheaply from countries with "excess" savingsincluding Chinabecause it can and spends those borrowed dollars on trinkets.

The trade and current account deficits are a direct result of the US living beyond its means. The world's reserve currency is what allows for that. If and when the USD is dislodged as the world's main reserve currency, capital markets will quickly start pricing in those deficits, and demanding higher returns. Just ask Britain. It went though that adjustment in the 1970s and it wasn't pleasant.

The US could "correct" this situation by forcing the USD down and allowing other currencies to share the mantle of the world's trade currency. This is going to happen over time anyway if China gets its wish.

A significantly weaker US Dollar would bring some jobs back to the US, but borrowing costs would move much higher as foreign lenders who underwrite Washington's deficit spending price in currency risk and demand higher real yields in return. This outcome would be great for commodity producers as the US denominated metal prices would move much higher, but Americans might not thank the administration once the bills came due. Almost all Americans, and definitely almost every politician in Washington, takes it for granted that the US can run ballooning federal deficits and borrow at 2% or 3% forever to cover them.

Americans in general and Wall St., in particular, are still assuming the trade disputes will blow over or the US will just get its way. The situation hasn't been painless for China. The Shanghai stock exchange is in bear market territory and China's currency has dropped 5% in the past two weeks. You can't help but wonder if the currency drop is due to capital flight and how Washington is going to react to it. China won't just roll over though. Count on that.

Trade war fears are directly impacting base metal prices, not surprising as China is the 800-pound gorilla when it comes to base metal demand. Remember though that most of China's copper, lead and zinc demand is for internal use, not re-export.

So far metals trading is more about fear than actual changes in demand. That could stall production decisions which would certainly solve the supply side of the problem.

So far, worries have centered on commodities and emerging markets. Wall St has taken it all in stride and QQQ and the SPX are priced to perfection. A shakeup on Wall St could actually help us. We'll get one if the Trump tantrums continue.

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