The price of gold and the 10-year note have been trading in a highly correlated fashion as of late (click to enlarge images):
You could make the argument that the recent rise in each was due to a flight to safety in the wake of the equity and commodity correction in August or you can make the argument that each has traded up on investor expectations of the Federal Reserve initiating another round of bond-buying and something known as QE3.
The first argument rests on the assumption that US debt, despite S&P’s downgrade in August, is thought of as a traditional safe-haven asset in times of uncertainty with there being little consideration that the US would ever default on its debt obligations and that gold is also seen as a safe-haven asset with the precious metal viewed as a physical and transferrable store of value that cannot be undermined by the flaws of a fiat currency tied to debt.
Considering the tremendous uncertainty and fear connected with a reappearance of the sovereign debt crisis this summer and some signs of a possible double dip recession, it would make sense, then, that investors would flock to these safe-haven assets in July and August and particularly when it seemed possible that there was going to be an all-out stock market crash.
The second argument rests on the fact that gold is up more than 200% over the last five years with the bulk of these gains having been made after the Federal Reserve lowered the fed funds rate to near-zero in December 2008, launched a $1.3+ trillion round of bond buying in March 2009 and then started a $600 trillion round of bond buying last November. The overall goal of those monetary policy moves was to flood the financial system with liquidity to keep it dynamic in the wake of the financial crisis in 2008 by keeping interest rates as low as possible in order to encourage lending and borrowing activities.
However, a major result of keeping rates on the floor and of having a large and sustained buyer in the marketplace to keep rates low was to drive up the price of Treasurys with price moving inverse to yield.
Another consequence of keeping rates at ultra-low levels and of monetizing the debt is a debasement of the currency tied to the debt as has occurred with the dollar index down as much as 20% over the last five years.
It is this consequence that has fueled gold’s tremendous rise over the same time period as investors have sought to protect themselves against a weakening dollar due to the increasing debt load tied to it with gold, again, being a physical and transferrable store of value that is independent of a fiat currency or debt load with its value being determined solely, and somewhat arbitrarily, by the marketplace itself.
And this brings us closer to the crux of the second argument.
QE2, or the Fed’s $600 trillion round of bond-buying came to an end at the end of June and with it a major and sustained buyer in the marketplace disappeared and something that caused Treasury prices to fall and yields to rise with the two moving inversely to each other. Such a dynamic raised the question for investors about whether or not the economic recovery could be sustained if rates were allowed to move too high and something that might inhibit normal credit market activities.
This question has been the source of major speculation among investors over the last several months and before QE2 even ended with many believing it is inevitable that the Fed will have to step back in to prop up the economy by keeping rates as low as possible to prevent some sort of deflationary situation or liquidity trap situation as is the case in Japan.
If the QE3 proponents were right, it would mean that the price of Treasurys would go up, as rates were depressed, and gold, too, would rise as investors sought a hedge against a currency tied to even more debt inherent to another round of bond buying.
Strong investor anticipation of a third round of bond-buying by the Fed, then, is another reason to think that investors flocked to gold and Treasurys simultaneously in July and August driving up the price of each.
Now clearly the safe-haven argument is simpler than the QE3 argument and the truth is probably somewhere in-between, but I would argue that it rests more with the latter or with strong investor expectations that the Fed would announce another round of bond-buying in looking at the chart of gold and the 10-year note together.
As is shown above by the red arrows, gold and the 10-year traded up into the three possible announcement dates of QE3 at the August 10 FOMC policy meeting, Fed Chairman Ben Bernanke’s Jackson Hole speech on August 26 and Mr. Bernanke’s September 8 speech to bankers in Minneapolis. Each of those spikes up was followed by a spike down after no mention of QE3 was made.
The timing of those spikes up and spikes down in gold and the 10-year are too close to dismiss each as a happenstance particularly since the same “coincidence” happened three times in less than a month.
In fact, not only was QE3 not announced on any of those dates, but the Fed has made it all but clear most recently that QE3 is unlikely to be announced in this Wednesday’s policy statement as it may favor a smaller “step” of reducing or removing the interest paid to banks on excess reserves held with the Fed or something called “Operation Twist” that would shift the Fed’s portfolio toward a longer duration to keep borrowing rates artificially low.
Not surprisingly, the likelihood of the Fed favoring a small policy step over the big step of QE3 is showing up in the charts of gold and the 10-year beyond the correlation of both trading down with each showing bearish technical patterns.
Specifically, gold’s near-term uptrend is officially reversed as it shows a series of lower highs that comprise the right side of a bearish diamond top formation with a target of $1,600 per ounce while the 10-year is showing a bearish and flat-bottomed broadening formation that perhaps finds some support around a possible “Operation Twist”.
In turn, if these bearish technical aspects prove to be correct with gold moving toward $1,600 per ounce and the 10-year trading down as well, it will seem that the second argument around the particularly strong correlation between gold and the 10-year as of late will prove correct and it will mean that the Fed will have not announced another round of bond buying, or QE3, this Wednesday that would prop up gold on a weak dollar and Treasurys on an old/new big buyer.