The only rationale for gold to rise along with Treasury yields is when inflation expectations are growing (all things being equal, real yields fall and then the opportunity cost of holding gold is lower). The recent rebound in gold prices reflects the increase inflation expectations embedded in long-term rates (proxied by inflation breakeven). As can be seen in the chart below, they edged up from their late spring lows (a move mainly driven by the 10% rise in oil prices). Given my target for oil prices at year-end ($108 per barrel), the inflation-linked rise in gold prices should quickly run out of steam.
Click to enlarge images.
The renewed weakness of the USD also helped the yellow metal on the upside. As can be seen in the second chart below, the correlation regime between gold and the USD seems to have converged toward its "normal" bound after six months of de-correlation in positive territory.
According to my gold model, which is based on the USD, inflation expectations and real U.S. yields, the recent move (assessed over 13 weeks) seems close to overdue.
Is there any risk, though, that gold could spike further in the short run? The answer is yes. The recent move in gold prices took place at a time when the correlation between the USD and the S&P 500 reaches new highs, which has historically been an early signal of a forthcoming rise in risk aversion.
At this stage, we have higher gold prices driven by higher inflation premium (the move is probably over) and, above all, a weaker dollar. A positive correlation between USD and U.S. stocks, which means that the potential for U.S. stocks to head lower is not insignificant.
1. On a relative value basis (Fed model), the short-term outperformance of stocks to U.S. bonds seems slightly overdue. This would call for lower U.S. stock prices ahead as Treasury yields seem to be heading toward 3%.
2. The recent divergence of ADXY (basket of Asian Currencies to the USD) and the relative performance of the S&P 500 to Asian stocks ex-Japan is another important signal. If the currency market is a leading indicator of risk perception in the EM world, a lower ADXY would mean a forthcoming outperformance of U.S. to EM stocks.
This combination of a cyclical richness of U.S. stock prices and a potential outperformance of U.S. to EM markets generally characterizes a stock market correction. What are the implications for gold? As I have shown in a previous article, the gap between the S&P 500 and EM stocks is wide and inconsistent with the current level of gold/copper. I wrote that given the improvement of the economic environment, copper had further to rise until year-end, pushing both ratios to the downside.
However, in the short run, the messages sent by the Fed model and the ADXY would probably lead to a stable S&P 500/EM ratio, pointing to a significant upward potential for gold prices.