Linking real yields, the dollar and gold

Sentiment in financial markets understandably remains caught between renewed outbreaks of Covid-19 (India, Hong Kong and Spain, parts of the US and Latin America) that restrict economic activity, but which also heighten expectations of further stimulus.

This trade-off between economic pain and policy relief only intensifies recent market trends with the focus firmly on the US. These take the form of even lower real bond yields — adjusted for inflation — extended pressure on the dollar and a boon for commodities, particularly gold.

The haven metal certainly glistens and has climbed above its 2011 nominal peak to $1,945.26 a troy ounce on Monday. Traders expect a test of $2,000 and there are signs of that positioning. Demand for gold also has an ally in the shape of frosty relations between the US and China, a dynamic that is likely to enter cold storage once the presidential contest picks up the pace.

Line chart of $/ounce showing Gold shines as investor confidence wanes

Saxo Bank’s Steen Jakobsen reckons:

“With this latest price action, the next obvious psychological focus is on the $2,000 level for gold, while the $25 per ounce level is the next psychological marker for silver, still over 50 per cent below the 2011 high.

It’s not hard to see why gold has scope for pushing higher given how prevailing economic uncertainly should keep central banks and governments firmly in easing mode, led by the US — see Quick Hits — and all-time lows for a 10-year Treasury real yield around minus 0.9 per cent. The 10-year real yield began the year at plus 0.15 per cent, when gold was around $1,520.

BNY Mellon’s John Velis says:

“The story of real yields is the story of the rally in gold. As its nearest substitute, real interest rates on risk-free assets track gold prices very closely. The combination of expected inflation and expected real returns priced into real yields has driven the yellow metal higher.”

Falling real yields — driven by Federal Reserve policy — have been sapping the dollar for a while and the week has begun with the reserve currency registering broader losses.

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TD Securities reckons “this US dollar move has become self-fulfilling” and that market sentiment is pushing for a test of $1.18 in the euro — shown below — before any snapback arrives.

It has not gone unnoticed in foreign exchange circles, that beyond a charging euro, other currencies now have an opportunity to catch up with a ropey looking US dollar, notably the Japanese yen.

Brad Bechtel at Jefferies notes that an Aussie dollar above 71 cents versus the reserve currency shows US weakness “is broad based” while he notes the Swedish krona is outperforming both the euro and the dollar.

All these moves are coming as the White House and Congress spar over a new round of spending measures. For all the near-term political jousting, the longer-term budgetary message does not look good for the US dollar. This chart from Citi suggests the dollar is heading a lot lower in value over an extended period as Washington keeps the spending spigot open:

From a policy standpoint, a depreciating dollar helps to offset a weaker US economy and the recent slide in the reserve currency reflects the surge in Covid-19 cases and renewed lockdowns in parts of the country.

Economic activity hobbled by restrictions and the open-ended prospect of fresh lockdowns hardly entails a vigorous recovery and perhaps does indicate that worries about another recessionary dip are warranted.

Ultimately a health crisis requires a treatment that enables a full restoration of economic activity. In the interim, government spending measures underwritten by central bank policies fill the gap.

For now, a midsummer reversal from the latest global Covid-19 spikes is hopefully the story, but for all the promise surrounding vaccines and treatments, there remains a risk of a deeper economic malaise.

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Neil Shearing at Capital Economics notes:

“The question for the US, and indeed other economies, is whether any new outbreaks sit at the relatively benign end of the spectrum or whether they take a more malign form”, an outcome that would entail “the risk of wider and stricter restrictions — and thus a double-dip recession”.

Quick Hits — What’s on the markets radar?

The Federal Reserve two-day meeting that wraps up on Wednesday is expected to lean very dovishly and that means maintaining downward pressure on real yields. This serves the purpose of pushing up market expectations of inflation and should sustain appetite for risk assets. But the fall in real yields does not bode well for the economy’s longer-term growth expectations and worryingly suggests a stagflationary outcome.

Market sentiment will take its cue from Jay Powell, the Fed chairman, during his press conference and expect no resistance to the idea that negative real yields are here to stay.

Lou Crandall at Wrightson Icap does not rule out a hint of more support from the US central bank ahead of wrapping up its policy framework review:

“Chair Powell is always careful not to prejudge [Federal Open Market] Committee decisions, so we expect him to limit himself to generalities again at this week’s press conference. That said, we would not rule out the possibility that the Fed might be ready to hint that it will tilt its [quantitative easing] purchases toward longer maturities once the framework review is completed in the fall.” 

Such a signal likely prompts lower real yields and a flatter nominal yield curve, represented by the difference between five-year Treasury notes and the 30-year bond. The gap between five and 30-year yields has now dropped below 100 basis points and from here a test of April’s low of 80bp and perhaps the flattening nadir of 52bp in March are possible outcomes.

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Gold mining stocks are enjoying quite a ride with the likes of Newmont Mining and Barrick Gold up more than 50 per cent this year. Still, AJ Bell reckons they are lagging and note that the NYSE Arca Gold Bugs index — up 41 per cent year to date — “still stands at just 0.18 times the value of gold, compared to a lifetime (post-1997) average of 0.31x and an all-time high of 0.62x times in 2003”.

It adds:

“Gold producers offer huge leverage into changes in the gold price (up or down) as their costs are largely pretty fixed, so a minor change in price can lead to huge changes in profits, cash flow and therefore ultimately dividends.”

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