Since the beginning of the year, gold's price action defied the bears, enticing investors to become extremely complacent. However, this move brings the gold market (NYSEARCA:GLD) closer to an overbought situation, raising red flags to investors who would like to make a timely unloading of their gold positions. Such a danger zone for the precious metal is underpinned by an unfriendly global macro backdrop for gold and an overly bullish investor's sentiment, let alone the overbought technical dynamics. On the macro side, the drop of 10-year real interest rates to more than half of their 2016 highs was responsible for the bounce in gold. This move brought the gold and fixed income markets back to where they were a few days after the US elections. Still, the global business cycle is stubbornly accelerating. Under this light, sooner or later, the long-term real yields will have to align again with the improving global macro dynamics, by rebounding to new multi-month highs. This will most certainly weigh on gold, since a rise in real interest rates will follow, inducing investors to exchange zero-yielding gold for cash. Yet, investors do not expect such a volatile gold behavior, predicting one of the calmer price periods for the weeks to come. This means that gold bugs are increasingly likely to face an unexpected burst in volatility, amidst a new corrective move in prices. This corrective action might, in fact, be more egregious against the euro, since the proximity of Germany to an overheating cycle increases the chances for an unexpected hawkish shift in ECB's policy.
Global Macro Backdrop Is Not Gold-Friendly
The global macro backdrop is the single most important driving factor for the cyclical behavior of gold, through guiding long-term real interest rates. In this light, the current positioning of the global business cycle points to substantially higher real rates down the line, and a commensurately lower valuation for gold. This will become clear if we consider what caused this year's rebound in gold, in the first place.
The retracement of long-term nominal bond yields coupled with a slight increase in inflation expectations caused the drop in long-term real rates from 0.7% in late 2016 to 0.3%. The 10-year swap rate, i.e. the fixed interest rate a borrower pays in return for receiving floating interest rate, dropped from as high as 2.5% in late 2016 to 2.30% currently. At the same time, 10-year breakeven inflation, a market based gauge of inflation expectations over the next decade, rose from 1.85% to 2%. These moves made the 10-year real interest rates, i.e. the difference between 10-year swap rates and 10-year breakeven inflation rates, to drop and investment demand for gold to increase. This demand pushed gold above the $1.200 area.
Source: St. Louis Fed, ICE.
Why did long-term interest rates correct? Because investors' attention was overwhelmingly consumed by the latest Trump-related anti-globalization headlines, overlooking what the global economy achieved on its own. Nevertheless, the global business cycle is consistently showing signs of self-enforcing dynamics, making the long-term yields to divergence away from the macro backdrop as they go lower. Under this light, sooner or later, long-term nominal and real rates will have to move higher again to align with the real economic activity. In the process, real rates will rise because nominal rates will increase much faster than inflation expectations. Against this positively diverging macro backdrop, investors remain extremely complacent about gold's fate.
Sentiment and Technical Dynamics of Gold
Gold investors' sentiment, as reflected by the CBOE Gold ETF Volatility Index, a gauge of market expectations about the volatility in gold prices over the next 30 days, seems extremely optimistic. In particular, the index currently trades close to the lower bound of its trading range in the last five years. This shows that investors are too complacent about what to expect from the gold market in the near-term, despite the gold-unfriendly macro backdrop.
This highly optimistic investor sentiment comes in contrast with the technical dynamics of the market. Firstly, gold approaches the 38.2% Fibonacci retracement level of its previous down cycle at $1.220 an ounce, a potential resistance level. Secondly, the downward trendline (trendline A) of the last five months coincides with the 50% Fibonacci retracement level at $1.250 an ounce. The triangle area formed between the 38.2% Fibonacci retracement level and trendline A signifies the danger zone for gold. The market is already testing this area from the downside. Chances are that gold will meet heavy overhead resistance within that triangle zone and will most certainly lose its upward thrust.
Despite all these onerous indications, however, gold bugs argue that the risk of a potential exogenous deflationary shock to the global economy makes the precious metal more attractive than ever. They base their argument to the fact that investors will flock to the precious metal as soon as they witness the melting down of some part of the global economy, such as China's foreign exchange market for example.
What if The Global Reflationary Scenario Is Overturned?
Nevertheless, even during turbulent situations gold does not always benefit, as conventional wisdom holds. Should a global deflationary shock hit the world economy, gold will hardly benefit. On the contrary it will most certainly correct. This correction will be the result of an upward spike in long-term real rates, due to plummeting expected inflation. In situations of unexpected shocks to the economy which can create deflation, investor expectations about inflation adjust very quickly to the new dynamics by dropping like a stone, while long-term yields fall more slowly. This widens the gap between long-term yields and expected inflation, initially, increasing the long-term real rates. As real rates rise, investors exchange gold for the greenback (NYSEARCA:UUP) in order to secure the higher real yields which are on offer. This is exactly what caused the correction in gold in the first phase of the 2008-2009 Great Financial Crisis, and it can weigh on gold again.
Gold Versus Euro
Given the general overbought dynamics of gold and the unfriendly global macro environment, which is the best currency to short gold against? Oddly enough, it seems that it is not the US dollar, but the euro (NYSEARCA:FXE). The price of gold in euro terms has been trending steadily upwards since early 2014, while the price of gold in US dollars has been trending slightly downwards. Gold has been revaluing in euro terms assisted by the loss of investors' confidence in the common currency, due to disintegration fears.
However, currently with the German economy ready to start overheating again, under a historically tight jobs market and an expanding trade and current account surpluses, the ECB will soon begin to feel pressure to unwind its ultra-accommodative monetary policy. After all, the ECB was founded upon the model of the Buba, the German central bank, in order to be steadfast in its policy actions under its singular mandate; to preserve price stability. This makes the ECB prone to move pro-actively when inflationary pressures begin to emerge. Should these pressures happen, as is currently the case in Germany, rate normalization by the ECB will lift the euro. In fact, German mainstream media have started to call for an end to the devaluation of German citizens' savings, and to demand pre-emptive tightening action by the ECB. These pressures are expected to accentuate as more hints of inflationary data accumulate.
A gradually more hawkish ECB is definitely unfriendly for gold since it can push long-term real rates up in the Eurozone as well, and entice investors to exchange their gold holdings for euros. This is supported by the technical dynamics of gold denominated in euro. The recent gold bidding pushed gold in euro terms very close to the resistance of its five month downward trendline (trendline B), increasing the chances for a bearish reversal.
Overall, gold seems trapped between a rock and a hard place. Be it the base case scenario of global reflationary dynamics or an exogenous deflationary shock, the probabilities for a bumpy correction in gold increase by the day. Still, investors seem unprepared for such an increase in volatility, which is usually associated with downward moves in prices. Volatility might again come into play and not in favor of gold this time.
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