Imminent Move Downward In Gold

by: Michael Roat

The 10-year Treasury yield has again breached 3%. The Fed is projecting  around 5 more Federal Fund Rate (FFR) increases over the next 15 months.

The balance sheet unwind reaches max velocity of -$50 in securities per month in Q4. This factor and FFR increases will continue to push treasury yields higher.

Inflation expectations are likely to fall because of Federal Reserve tightening leading to a major depreciation in the Chinese yuan and continued declines in EM equities.

Long-end treasury yields do not automatically follow inflation expectations as there are other factors at play such as monetary policy, central bank balance sheet trends and the path of short end rates.

Higher nominal yields despite declining inflation expectations equates to a rising expected-real-yield, which is kryptonite to gold prices.

One of the best pieces of investing advice I've heard is from Soros and Druckenmiller after breaking the Bank of England on Black Wednesday. To paraphrase Druckenmiller, he explained successful investing is not about being right all the time. It's about having the experience and ability to know when you're right about something and to be max on when you are. I have never had higher conviction in a trade then the current short I have on metals prices and mining stocks. I own long dated put options on mining companies with one wave of options expiring in January 2019 and the second wave expiring in January 2020. After over a year of research I've reached a conclusion about the near-term direction of precious metals prices that I think any logical and intellectual conversation cannot refute. I believe now is the time to be max short metals and mining. I will attempt to convey the thesis in this article.

In the model, gold prices (GLD) are determined by inflation expectation adjusted treasury yields as well as a currency factor. This intuitively makes sense because gold is widely considered an inflation hedge asset and struggles to compete with rising yields or interest rates because it is a non-interest bearing asset. Also, the U.S. dollar has an inverse correlation with the metal. I will touch on both factors in depth.

The 10 year treasury yield has recently shown extreme resilience to break back above 3%. This is occurring even with the turmoil in emerging markets, trade tensions, and a global growth slowdown. I would attribute the rise in yields to a robust U.S. labor market, hot U.S. GDP growth, fiscal stimulus (with higher U.S. govt. deficits) and a hawkish Federal Reserve. U.S. economic growth is unlikely to slow significantly. I have little concerns about a near-term recession in the United States or major domestic slowdown. Globally, I think there are plenty of concerns, but I believe in the U.S. economy decoupling and continuing to lead the global economy as the strongest house in the world.

The ongoing U.S. credit expansion since the global financial crisis has room to run. Household debt to GDP has declined and debt service payments as a percent of disposable income have also declined. The labor market is healthy with low unemployment, robust job gains and rising wages (most recent print at 2.9%). Household net worth is at a record. Retail sales and consumer sentiment are on a strong trend. Tax cuts are positive for the consumer-driven U.S. economy as well. In conclusion the U.S. consumer and household is a good shape. This allows a continued expansion of credit into the economy thereby creating money and spending.

Total credit growth to the private sector signals a still healthy, mid-cycle U.S. economy. Many investment experts including Ray Dalio have said we're in the late stages of the credit cycle, but I find this incorrect. Every pre-recession peak in private sector credit growth was in the range of 10% to 15%. We are currently at approximately 5%. In the late stages of business and credit cycles, inflation hedge assets outperform. The last chart below shows we are not at that point yet.

In short, I don't see a driver that would push up bond prices or yields lower right now. One could cite global factors and a flight to safety of U.S. treasuries but as long as the Federal Reserve maintains on course, I wouldn't count on the safe-haven bid outweighing a tightening monetary policy and strong U.S. economy. Investors can look back to 2013 when Bernanke ignited a "taper tantrum". Despite the capital flight from emerging markets and declines in inflation expectations, U.S. yields still rose.

Federal Reserve tightening cycles have rarely gone without consequences in the global economy and historically led to some sort of financial crisis. I think what we are seeing now in emerging markets will only get worse as the Federal Reserve continues on it's current trajectory of unwinding the balance sheet and increasing the FFR. While investors and money managers can overlook Turkey and Argentina, they will not be able to overlook the EM turbulence when it significantly affects China and the yuan. I believe it is only a matter of time before there is a seven handle on the USD/CNY. This is very central to the short metals thesis. The USD/CNY has shown a strong inverse correlation with gold prices as shown below.

US Dollar to Chinese Yuan Exchange Rate data by YCharts

I think Chinese policy-makers have little choice, but letting the yuan fall. With the Federal Reserve tightening, U.S. treasury yields on the rise and the Chinese economy slowing, the interest rate differential between 10-year Chinese bonds and 10-year U.S. bonds is narrowing. Interest rate differentials drive foreign exchange rates. A 10-year Chinese government bond yields around 3.68% down from 4% earlier this year while the 10-year U.S. treasury is up from 2.4% to 3%. In essence, the spread or Chinese bond yield minus U.S. treasury yield has narrowed from 160 basis points to only 68 basis points. The yuan has fallen in tandem with this narrowing interest rate differential.

As long as the Fed continues to move and the Chinese economy continues to slow, the yuan will have to depreciate further. That is, unless the PBOC raises their short term interest rates to prevent an excessively depreciating yuan and capital flight. The problem is, the Chinese authorities are trying to avoid a hard-landing, navigate an orderly slowing of the Chinese economy all while preventing a run on the currency. Chinese corporate leverage is very high and financial risk is elevated so there could be detrimental effects of raising rates on Chinese financial stability and economic growth. The authorities in China and at the PBOC will likely be more inclined to guide the yuan down than raise interest rates. According to Christopher Balding and Bloomberg:

More fundamentally, narrowing yield spreads suggest that China's growth model is at serious risk. With the Fed raising rates, the PBOC must follow suit to maintain the yuan's soft peg. Yet Chinese corporate debt stands at 156 percent of GDP, compared to 71 percent in the U.S. Raising rates under such conditions bears significant financial risks. The costs it would impose far outweigh any export benefits of a weaker currency.

More to the point, with debt approaching 300 percent of gross domestic product, any interest-rate increase would raise debt-servicing costs substantially and place enormous pressure on Chinese firms. This is exactly why the government is trying to keep rates down and maintain the peg. No country can depend on debt-financed investment to drive growth in an overleveraged economy if interest rates are rising.

This leaves China in a bind. If it wants to retain the soft peg to the dollar, it will need to accept a weaker yuan as spreads narrow, or raise interest rates.

Investors can look back to late 2015 and January 2016, when these concerns of China slowing and Federal Reserve tightening were at the forefront of the market. I believe they are starting to manifest again and will quickly become evident. As I said, investors bullish on inflation expectations may be able to overlook turmoil in smaller emerging market economies such as Turkey and Argentina, but China is far too significant.

Now I'm going to tie this all back into the all important gold price indicator, the expected-real-yield. The expected-real-yield is simply nominal treasury yields minus inflation expectations. When treasury yields rise and inflation expectations stay stable or decline the expected-real-yield rises. Oppositely, if treasury yields fall or stay the same and inflation expectations rise, the expected-real yield declines. A proxy for this is the 10-year inflation indexed security yield shown below. As one can see, it holds an inverse correlation with gold prices.

Essentially, I believe we are on the cusp of a currency crisis throughout emerging markets and China. This will push inflation expectations lower. Meanwhile, as the U.S. economy leads the global cycle, the Federal Reserve facing a strong U.S. economy with target rate inflation and fiscal stimulus will look through the turbulence and view it as transitory while continuing to tighten. I believe and also think the Federal Reserve will believe it to be more akin to 1997/1998 than 2008. As treasury yields continue to rise as a result of FOMC policy while inflation expectations decline because of emerging market currency and equity declines, the expected-real-yield (blue line above) will move higher.

As for the DXY or the U.S. dollar index which is more heavily weighted to developed markets such as Japan and Europe than emerging markets, I expect this index to move higher as well. U.S. yield premiums over Japan and Europe are at multi-year highs and this is very positive for the U.S. dollar and DXY index.

Net speculative positioning in the euro is still not drastically bearish with net positioning near zero. Previous net shorts were around -200k and net longs were around 150k. This type of positioning allows for further room for the EUR/USD to depreciate.

Source: CoT data, MarketsNow

The Federal Reserve is on pace to increase the FFR around ten times (since 2015), before the ECB or Bank of Japan move even once. Also, this is occurring while the Federal Reserve is reversing QE through unwinding it's balance sheet at a soon to be pace of -$50 billion per month. This process is also known as quantitative tightening. The ECB and Bank of Japan are still buying bonds and securities thereby increasing their balance sheets. QE is still fully in effect in Japan. In Europe, it will be phased out by year-end, but the ECB has not even discussed reversing QE or engaging in a quantitative tightening process. The first rate increase from the ECB has also been pushed back through Summer 2019.

It can also be argued the stock of assets on a central banks balance sheet is more important than the flow. This makes sense because many thought tapering QE in the United States would lead to a rise in yields, yet this proved untrue. Yields actually fell throughout the tapering process, mainly because, in my view, the Federal Reserve was continuing to hold a large stock of assets on it's balance sheet despite new QE inflows being tapered. Interestingly, only when the Federal Reserve began quantitative tightening or reversing QE did monetary policy begin having a significant upside effect on yields. I expect a similar situation in Europe.

In conclusion, I think gold is far from oversold and this is only the beginning of a bearish speculative wave against gold that could last around 18-24 months. I am not permanently bearish on gold, but until the factors outlined in the article happen or change, I see little reason to be long right now. I believe the eventual bull market in gold will be a result of overheating economies and rising inflation expectations, but I don't anticipate this in the short run and in fact I am preparing for almost precisely the opposite.

Disclosure: I am/we are short GG, ABX, WPM, RGLD, FCX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.