Gold is a reactive market, not a leading one. It reacts to, among other things, the sentiment generated by the much larger debt market, currency market, and this month the stock market. The spike higher that occurred on October 11/18, was a 'fear-trade' resulting from the weakness in equities. Now that it is starting to look like "it was just a correction, not the end of capitalism", gold is going back to a more normal behavior. In this piece, we look at how gold is returning to its more usual correlations with the dollar, interest rates, and inflation expectations.
Long-term, gold has always had a strong negative correlation with the dollar. And as chart 1 highlights, the trading today in both the dollar and in gold is very similar to that of the 1998-2001 period. In the late-90s, the dollar had been trading in a range, and gold was carving out a wedge from which it broke lower as the dollar appreciated. The same is happening today with gold dropping out of a wedge as the dollar appreciates.
One thing that is different this time is that in 1999, as gold was dropping, the IMF suddenly restricted its gold sales which caused gold to shoot higher by nearly 30%, almost overnight. Gold immediately continued its fall, but from a much higher price. If the IMF had not done this, gold would likely have continued dropping at the same slope and ended up much lower. Since something like that is unlikely to occur today, we think gold will travel lower from here as the dollar continues to rise.
Rates (and the dollar)
Short-term, gold also has a negative correlation with the dollar, but is more volatile in nature than in the long-term (chart 2). The correlation of the dollar with rates (2-year Treasury), has been even more variable. Normally, the correlation is positive - as rates rise, so does the dollar - but since the start of this year, the average has been negative with only a brief foray into positive territory. This, of course, is because the dollar has not appreciated in proportion to the rise in rates since the start of the year. However, this negative correlation can work the other way as well, since correlation does not tell you direction, if rates slow their rise, then a negative correlation with the dollar would mean that the dollar is appreciating more than rates are. And a rising dollar tends to hurt the gold price.
The bias in rates is up, and even if they slow their ascent somewhat, gold will be pressured downward.
The iShares TIPS Bond ETF (TIP) is the ETF that holds Treasury Inflation-Protected securities which in turn move higher in price as inflation expectations increase. Inflation expectations normally correlate positively with the price of gold, but since the start of 2018, the correlation has been erratic. We have been here before. During the second half of 2016, gold fell $200 as the correlation with TIP returned to the normal positive. With inflation expectations falling as rates continue to rise, we expect the correlation of gold with TIP to return to the positive again this time, especially now that the fear-trade from equities has subsided (chart 3).
In conclusion, now that the fear-trade is over for gold (at least for now), we fully expect the normal correlations of gold to return.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.