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Why this risk rally won’t stop gold

Sean MacLean
Research Strategist
Jun 11, 2020
Gold traded below the 1700 level last week as a good dose of FOMO drove investors out of gold and into the risk rally which saw the S&P 500 (US500) erase all 2020 losses and the Tech 100 index (US100) trade to record highs.

Don’t think it’s over for gold though: the precious metal has since regained much of those losses in defence of that important 1700 handle. Here’s why the case for gold remains as bullish as ever.

Chart source data: Metaquotes MT5

Let’s start with some technicals

Gold has moved sideways since early April, which is the market telling us it’s happy for the metal to hold around the 1700 handle and is awaiting conviction for the next leg higher. The 1700 handle itself is an impressive feat. Until 2020, gold hadn’t traded at 1700 USD since December 2012.

1745 remains a level to beat: I want to see a break above here on a daily closing basis to indicate the next move higher. From there, I have my eye on 1790 - the tried and tested resistance level from 2011-12 that I know gold bulls are closely watching. A daily close above here will cause excitement and possibly a FOMO trade. It could be a nice one to ride higher.

Also note that the 50-day EMA (purple) seems to be supporting price fairly well. Gold traded only briefly below this level late March and early June before promptly bouncing back. So I’m watching the 50-day EMA as an opportunity to buy pullbacks.

So will gold break to record highs in the coming years?

You might have read previously the research team here at Pepperstone saying again and again that the case for gold is as bullish ever. Gold (XAUUSD) traded to its highest ever price in September 2011 - a massive 1920 USD. Here’s why I see gold making new all time highs over the next couple of years.

Gold loves our low-yield world

Gold reacts to movements in the US Treasury market, displaying an inverse relationship with treasury yields. Gold has no yield, so the lower nominal and importantly ‘real’ (inflation-adjusted) treasury yields go, the better the precious metal performs.

Source: Tradingview

So why are yields so low? Treasury yields have historically represented the risk-free rate and have fallen alongside the US Federal funds rate as it has once again approached the zero-lower bound. Add to this globally low interest rates and a safe haven flight to Treasuries amid crisis, and yields have moved closer and closer to zero.

As of 10 June 2020, the shorter end of the curve has one-month Treasury yields at 0.13%; the long end has 30-year yields at 1.53%. I’ve used the 10-year yield in these charts as a middle ground benchmark, but you see a similar trend comparing yields for other maturities.

Now let’s add inflation to the mix

So nominal yields are offering very little expected return, but real yields are even lower, with markets pricing the expected level of inflation higher than the yield on offer. US real Treasury yields are trading at negatives all across the curve, with only the longest maturity of 30 years briefly breaking above zero to breathe in early June.

The real yield is the nominal yield minus inflation expectations.

Although current inflation expectations are modest, they’re enough to move real yields into negatives. And if inflation expectations rise at a faster pace than nominal yields, real yields go deeper into negatives. All the while central bank QE programs ensure demand for government debt, keeping the nominal yields low. This is an environment that gold loves. Gold might offer no yield, but at least it’s not a negative yield.

5-year, 5-year forward inflation expectations. Source: Saint Louis Fed

You can see that gold has traded as a zero-coupon bond when you compare its price movements to Treasury Inflation-Protected Securities (TIPS), which are indexed to inflation, offering a “real yield”. On the chart below, you can see that as the value of TIPS (white) has changed according to inflation, gold has followed alongside quite nicely.

US 10-year TIPS (white) vs gold (XAUUSD - orange) from January - June 2020. Source: Bloomberg

Inflation expectations pose other troubles if they risk too quickly. We have recently seen a substantial expansion of the money supply available to the public with QE programs ramped up around the world. Although the Fed has downplayed inflation expectations, when the demand side of the economy kicks in again, we do run the risk of inflationary pressures.

The public can tolerate a modest amount of inflation but will panic if they expect too much in the future, especially if it comes with low growth - stagflation. This is when investors start actively looking for alternatives to cash - and gold is an obvious beneficiary here too.

The Fed as dovish as ever

The US Federal Reserve maintained its dovish stance after the June meeting, with Chair Jerome Powell insisting the central bank will not consider hiking rates again until 2022, even if economic data starts to come in better than expected. Historically easy policy is here for the long-run as the Fed cannot see its targets of 2% inflation and 3.5 - 4.7% unemployment being met in the next two years.

Forward guidance being the key tactic here, Powell has set clear expectations and stamped out any concern of policy tightening before 2022.

Fragile economics

Remember, global economics were already fragile before the pandemic. The global economy closed out 2019 in a vulnerable position: global trade was slowing, global growth was sluggish (especially japan and the eurozone), consumer confidence wasn’t flash, not to mention the lingering US-China trade war. The ominous yield-curve inversion in August last year, whereby shorter-term treasuries temporarily yielded higher than longer-term treasuries, was widely regarded as a recession warning sign.

So perhaps markets were ready for a recession but were awaiting a trigger: the pandemic happening to be a very dramatic trigger that did the trick.

And to combat the recession, nations are issuing record amounts of debt and pursuing arguably the easiest monetary policy ever seen. This is a huge amount of uncertainty, and offers an environment where gold can thrive.

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