Taking stock of what has happened.
The last week has seen dramatic moves in commodities and none more so than in Gold.
There is lots of speculation as to what has caused this selling of commodities but the simple matter of fact is that there were more sellers than buyers at the levels of last week. Now it is to be seen whether there are more buyers than sellers at the prices we are at today.
First of all lets clear up a few things. Gold has been touted as a financial hedge against the risk of inflation or the debasement of the US$ since the Fed first implemented QE in 2008. Gold has never been a meaningful hedge for inflation, but when the US had previously encountered periods of higher inflation then the US$ had weakened and that meant that Gold prices rose- so in effect a hedge against US$ weakness brought on by inflation. Recent weeks have seen many members of the FOMC discuss what would happen if the US economy strengthened in the second half of 2013 to such a level that the FOMC could reduce the amount of QE. It meant that some investors had begun to price in a reduction in QE.
A reduction in QE would have taken away one of the key supports to owning Gold, that is the perceived if incorrect notion, of a weakening US$ and a higher inflation risk.
So Goldman Sachs, one of the strongest proponents of a strong 2H Global economic recovery, released a research piece suggesting that Gold was now overpriced and should indeed be shorted, they targeted $1390 t/oz as the 12mth forecast.
Then the EU leaked a report suggesting that Cyprus would be selling some of its Gold Reserves to provide additional funds for the bailout. Whilst this is only a suggestion the market reported this as a done deal and also as a template for other countries that may be required to have an increase in their bailout or indeed a new bailout, i.e Portugal, Spain and Italy. I have a big issue with this as it would seem very risky for a country that is facing severe austerity and a risk that it may need to have its own currency again in the future to sell its Gold Reserves that would be needed to back any new currency.
And certainly Italy would face huge domestic political pressure to hold its Gold Reserves.
So it seems to me that the stories surrounding the selling of Gold by European Central Banks is a non-starter and used by the bears to scaremonger a fall in the Gold price.
However the below expectation Chinese Q1 GDP released yesterday morning would be a concern for the base metals and energy commodities. And as can be seen from this chart of the Gold to Copper Futures Ratio from yesterday, Copper cheaper than Gold, it was Copper that led the weakness first and it wasn’t until the US opened fully that we saw Gold weaken more than Copper.
The price action to me looks very much a Hedge Fund trade where the price action in commodities led some Hedge Funds to join the trade and shorting Gold is one of the easiest trades to do that in having a liquid ETF and futures market. So there will be new shorts in the Gold ETF and Futures market now.
The Price action in Gold looks very overdone– whilst some investors may be comforted that the financial risks are reduced- Gold is fundamentally a safe haven and retail investors are still unsure as to how their wealth can be protected. In Europe Gold looks to have moved into cheap levels in comparison to the credit spreads of the European financials. European Financial Credit Spreads are on the way up again and yet EuroGold is now below €1100/toz. Given the political deadlock in Italy it is very possible that we see European Financial Spreads, as measured by the iTraxx 5yr CDS index, above 200bp and that would support a EuroGold valuation back to €1150/toz at minimum.
But the bigger concern for the markets should be the Deflation risks that are increasing. US Inflation breakevens are finally moving down in line with the performance of commodities so far this year. I have often said that 5yr US Inflation breakevens are way to high given the commodity price action and yesterday we saw a 7bp decline and that is a cumulative 32bp decline since the middle of last month. They should still fall a lot further and that will drag US Treasury yields lower.
And it questions the FOMC’s actions.
Last month’s Phili Fed survey showed that the Current Prices Paid component remained in negative territory for the second consecutive month. Yesterday’s Empire Manufacturing Survey showed only a slight increase in the current price components of the survey , but declines in the future price components. Thursday sees the release of the Phili fed survey for April. If the current price received component remains in negative territory for the third consecutive month then I would think that the FOMC will have to start talking about increasing QE and not as they have done recently in tapering it. Because the one thing the Federal Reserve has to fight is deflationary pressures. Previous extensive periods of price deflation seen in the Fed Surveys have indeed led to QE extensions or new programs.
Put together this continues to suggest that 10yr US Treasury yields will trend towards the bottom of the trading range in the next few days to1.60%.