ZIRP Über Alles
From the July 12, 2016 HRA Journal: Issue 254
Wall St’s doing the happy dance again. You’d think the SPX is well through a massive rally instead of just a couple of percent higher than it was 15 months ago. Never let facts get in the way of a good story.
Traders are pleased about June’s strong payroll numbers and even more pleased that there isn’t more obvious Brexit fallout. I don’t think the Brexit story is over yet. It may not harm markets further but that will depend on how messy the divorce between Britain and the EU ultimately turns out to be.
Gold prices continue to outperform just about everyone’s expectations. Other metals have also gotten some support from better general market sentiment though precious metals are clearly the star of the show. The past couple of trading sessions have marked the first significant pullback in the gold since the Brexit vote.
Still plenty of hand wringing by newly minted “gold experts” and expectations of major declines. I agree gold has become a crowded trade but bullish trades usually are. It’s worth remembering that gold prices basically went sideways from March until June. Those that describe the move as “purely speculative” and “parabolic” are advised to acquire a thesaurus and learn how to use it. The real holidays have started so volumes could be a little light but there are plenty of heavily watched exploration programs about to report. Do not adjust your set.
Read through the financial pages and you’ll see plenty of breathless references to the S&P hitting new highs. According to most of those press reports the new highs stem from high confidence in the US economy in the wake of last week’s huge beat in the June payrolls report.
That is a nice heartwarming story but not a completely accurate one. If you want to know what is driving markets, virtually ALL markets, look no further than the chart below.
The chart displays the price (not the yield) for the 20+ year US Treasury Bond ETF. It's an amazing chart and a good visualization of the waves of money that keep moving into the bond markets.
Equity traders are feeling pretty cocky now that the S&P is hitting new highs but that leading index has barely moved in the past year overall. Contrast that with the bond displayed below which has put up gains of almost 30% since the start of the year. Who said bonds were boring? No wonder its been so difficult to get bond traders to switch to equities even though bonds are trading at nosebleed levels.
The chart pattern displayed by the 20-year Treasury is repeated up and down the yield curve and across the bond markets of all advanced economies. In the case of most markets sky high bond prices are the result of direct intervention piled onto a prevailing deflationary view.
Central banks are buying up everything in sight in their continuing efforts to maintain liquidity and encourage investment. Where that’s not the case, notably the US, bond traders are buying to try and capture what meagre yield there is rather than being satisfied with the near zero, or negative, yields in their home market.
How long can this go on? I have no idea. Market strategists have been calling tops on the bond market for three or four years now and no one has gotten it right yet. Those weren’t foolish or irrational calls. It’s amazing anyone sees upside in bonds trading at current prices but the buying keeps coming. You’d think Bondholders would want some sort of return for taking on the risks of holding even government paper, at least in a normal market.
The true “risk free” interest rate is a slippery financial concept and one open to interpretation. For the past few decades the plug figure most analysts would use for the risk free rate was about three percent. I don’t think you’ll find an economic textbook that would suggest its natural level would be one with a negative sign in front of it. This is a very irrational market and there is no sign that logic and reason will return any time soon.
This is the market we find ourselves in however. Over 10 trillion in government bonds, mainly European and Japanese, carry negative yields, in some cases as much as 20 years out on the yield curve. How much of this is real demand and how much is artificial demand driven by various central bank QE programs?
Some bond markets, particularly Japan and some European countries, are operating under a deflationary backdrop. In those countries its at least conceivable buyers would be willing to accept negative nominal rates if they felt they were at least getting a small positive real interest rate after adjusting for deflation. Even so, I find it hard to believe they would move very far out the yield curve unless it’s just a short term trade. Who locks themselves into a trade that guaranteed to lose year after year?
The point I’m making is that its safe to assume central banks themselves are the buyer of last resort in both the EU and Japan. I don’t think the Fed is a major buyer anymore, notwithstanding the claims of a few conspiracy bugs.
What I DO think is that the ECB and Bank of Japan have crowded out potential buyers in their markets and driven them to the US in search of yield. Post Brexit, there’s a decent chance the Bank of England will join the party. The falling Pound creates potential inflation issues but the BoE is more concerned about containing economic fallout and potential for recession the Leave vote has created.
When England shocked the world with Brexit it generated yet another leg down in yields and rise in bond prices. Traders soon got over the shock—in most markets. Equities are at new highs in the US and have taken back their post Brexit losses and then some nearly everywhere else. The biggest exception continues to be bond markets.
Take another look at the chart on the first page. The red horizontal line on the chart marks the Brexit vote. Bonds surged after the votes were counted. Markets calmed after a few days. You would expect bonds - a “risk off” trade-to fall as equities gained but they continued to surge. There was a slight pause at month end and another on the release of a strong US payrolls number but that was it. Even with other markets signalling the all clear, the bids keep coming.
Now, look at the three charts on this page, six month charts of the US Dollar, Yen and Gold. Something unusual has been happening. The USD and Yen both surge on the Brexit vote release. Not too surprising as both are considered risk off trades. Gold surges too during the initial panic. Again, not too surprising—though not what many gold bugs expected. Many were concerned gold would get bulldozed as part of the rush to the $US in the wake of a “Leave” vote. It didn’t. Gold moved up with the USD for most of the period since Brexit. Gold hasn’t been reacting to moves in the USD the way its “supposed” to.
You’ll recall that I’ve written in the past that the negative correlation between gold/USD negative is not some unchanging iron rule. The strength and even the polarity of the correlation shift over time to a much greater degree than most traders realize. The USD is not the only thing driving the gold price. They can, and do, move together at times if they are being influenced by the same extraneous markets or events.
Now let’s look at this from a slightly different perspective. The three six month charts below display gold and the 20-year Treasury (TLT) again, plus the SPX for comparison.
Like all equity indices, the SPX got whacked when the Brexit vote was announced but the panic only lasted a couple of days. Sentiment soon reversed and the market traded back to pre-Brexit levels before vaulting higher again on the release of June’s 285,000 gain in payrolls in the US.
Look at the gold and the TLT again now that they are side by side. The correlation between them is quite strong, especially since the start of June. But the correlation with the SPX is also pretty strong lately, something else that doesn’t fit the classic gold bug narrative. No Virginia, the world does not have to be falling apart for gold prices to rise.
So what’s going on here and what’s changed? I think recent moves across markets are much more explainable if you view bonds, or rather yields, as a cause and a driver of the action rather than an effect.
Falling yields have gone a long way to support equity prices. Comfort that proactive central bankers will continue pumping liquidity into the system has kept stock traders bullish. Cynicism on the same topic, and maybe a darker worldview, seems to have bond traders just as bullish. Bonds keep getting bid and yields keep weakening.
Weak yields drive further buying in the stock market by the “TINA” (there is no alternative) crowd. I’m not sold on TINA but if enough of Wall St is convinced it won’t matter. Yields that stubbornly refuse to rise may be helping to cap the $US as well. It had a huge jump right after Brexit but has gone basically nowhere since. That is a good thing for the US economy.
Whether trader or central banker induced, low yields continue to draw money into the gold space. The situation has been highly confusing for traditional gold bugs who predicate their market view on the expectation of hyper inflation and/or currency collapse. Weak yields worldwide do help cap currencies but also imply the central banker confidence game is still alive and well. If you believe all fiat currencies are a chimera and that its all about to fall apart, you DON’T buy government bonds yielding 10 or zero or negative 50 basis points. That simply makes no sense.
What DOES make sense is that gold currently has a higher yield than $10 trillion worth of government bonds. That reduces the risks and opportunity cost of being long, even if you don’t believe in the metal’s strength as a store of value. It’s easier to convince yourself it makes sense to own a bit of bullion or some gold stocks if you’re not giving up yield elsewhere to do it.
That math continues to underpin the gold price and also explains a good amount of the speculative buying that is freaking out traditional gold traders. I find the level of speculative longs in the futures market unnerving too. But if those buyers are watching yields rather than expecting Armageddon it’s less concerning.
Traders hedging low or falling yields are likely to be far less skittish than those hedging a market crash. That helps explain why the gold price recovered so quickly after the strong payroll report. Gold traders expected a massive price drop after such a strong payroll report. They got one for about 15 minutes then traders noticed bonds weren't selling off as expected and got long gold again.
Does that mean its up, up and away forever for the gold market? Of course not. Nothing goes straight up and we should expect reversals and corrections as a normal part of a bull market. Personally, I wouldn’t mind seeing some over optimistic traders shaken out.
Gold equities indexes are up 100% or more this year and corrections have been pretty insignificant so far. Don’t discount the potential for a 10% down move but don’t let it scare you out of the best performing sector in the market.
Stronger markets make bargains harder to find but there are still some out there. This issue includes a new recommendation; a company with a large gold resource and high grade potential that is just getting back into bull market mode now. If all goes according to plan there will be another company added in the next issue as well. Happy Summer!
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