Rate Cut Makes Gold Even More Attractive
- Latest Fed interest rate cut is music to the ears of gold investors.
- Gold's competitive advantage with sovereign bonds has improved.
- Global recession fears will keep gold price buoyant in the coming months.
The emergency cut of the Federal Reserve's benchmark rate has given gold yet another new lease on life. After last week's price plunge, the yellow metal came roaring back to life this week as economic uncertainties relating to the COVID-19 virus returned to Wall Street. In this report, I'll make the case that gold's "fear factor" can maintain the metal's rising trend even after the coronavirus threat ends.
If there was ever any doubt that gold's primary function is as a safety hedge against geopolitical and economic uncertainty, the events of the last two weeks should satisfy even the most stubborn skeptic. The recent 5% pullback in the gold price was likely a result of a technically overheated market condition, coupled with heavy profit-taking after the precious metal hit a multi-year high.
But now that market participants have had a chance to weigh the latest developments pertaining to the coronavirus - as well as the all-important interest rate outlook - it's clear that the bulls still have control over gold's intermediate-term (3-6 month) trend. The fact that the gold price stopped short of violating the widely watched (and psychologically significant) 50-day moving average is also another piece of supporting evidence suggesting the bulls won't surrender their control of gold's intermediate trend anytime soon.
While the dust still hasn't settled from Wall Street's coronavirus panic, now would be a good time to assess the widespread damage and the most likely outcome for gold as it pertains to this panic. Let's start with a market overview which underscores gold's relative strength versus its leading competitors. It should be noted that gold is the best-performing asset of 2020 to date and the only one with a net gain. The extent to which gold is outperforming other major asset categories is shown in the following chart.
Source: World Gold Council
As this chart also shows, crude oil is the hands-down loser so far this year, having surrendered over 25% of its value and recently entering a bear market. Normally, gold's intermediate-term prospects are closely tied with that of the oil price. But with deflation (or disinflation) threatening the global economy in the coronavirus's wake, gold is being propelled higher strictly on flight-to-safety concerns. In other words, gold is fulfilling its major purpose of being a hedge against economic uncertainty, and this more than anything else explains gold's disconnect with the crude oil price.
Another factor which has helped to push gold prices higher is the fact that bonds are offering practically no competition with the yellow metal right now. The U.S. 10-year Treasury yield has fallen to 1% as of this writing, an all-time low. More importantly, it's an indication of how incredibly frightened investors have become over the coronavirus and its potential to wreak havoc on the global economy.
For gold investors, however, plunging bond yields are good news in that the opportunity cost of holding bullion vis-à-vis sovereign bonds has fallen drastically. Because bonds no longer offer a significant yield advantage over gold, investors are feeling greater confidence to park their cash in gold until all threat of a global recession has disappeared.
Another near-term support for the gold price is the lingering uncertainty over the U.S. financial market outlook. This is closely related to the interest rate outlook, and on March 3 the Federal Reserve made an emergency cut to its benchmark rate of 50 basis points - the largest rate cut since the 2008 credit crisis.
While Wall Street had expected the Fed to cut rates at its March 18 policy meeting, the extent of the surprise cut may have made traders nervous since it implied the Fed sees potential danger ahead for the economy. But another explanation is that perhaps the market wanted even more in the way of stimulus from the Fed. According to an MSN news report:
Traders had already priced in a rate cut of 50 basis points by this month's policy meeting. Fed Chairman Jerome Powell noted the central bank was not prepared to use any additional tools to stimulate the economy aside from rate cuts. This may have disappointed some on Wall Street who were expecting something more from the central bank.
While equity traders were alarmed by the emergency rate cut, it was music to the ears of gold investors. For the stock market's negative reaction to the Fed's policy action was affirmation that abnormal financial market volatility remains a serious risk going forward, and this should provide an additional boost to gold's safe-haven demand.
Further underscoring the extent to which gold is likely to profit from the ultra-low rate environment is the following graph, which shows the progression of the 5-year Treasury Inflation-Protected Securities (TIPS) yield. As you can see, the TIPS yield has become decisively negative since January in reflection of the disinflationary environment we're now in.
Source: Treasury Department
The fact that so-called "real" yields are negative also shows that investors remain scared over the possibility that the global economy could go into a recession. On a relative strength basis, gold is quite attractive when compared against the falling TIPS yield, as gold prices tend to move in the opposite direction to the TIPS yield.
Even if there is an abatement of the coronavirus's destructive force in the coming weeks, the benefit to gold's intermediate-term trend conferred by a low interest-rate environment is of incalculable value. Because rates are so low and aren't likely to witness a major rebound anytime soon, gold safety-related demand is likely to remain high - even after the virus ceases to be a major threat. For this reason, investors are justified in maintaining a bullish intermediate-term posture toward the yellow metal.
On a strategic note, I was briefly stopped out of the iShares Gold Trust (IAU), my favorite gold-tracking fund, on Feb. 28 when the 15.00 level was violated on an intraday basis. Based on the technical rules of my trading discipline, however, the ETF will confirm another immediate-term (1-4 week) buy signal if it closes above the 15.62 level anytime this week. This would amount to a 2-day higher close above the 15-day moving average, thus reactivating IAU's immediate upward trend. Assuming the new immediate-term buy signal is confirmed in the coming days, I'm planning to use the 14.93 level (the Feb. 28 pivotal low) as the initial stop-loss on an intraday basis for the trading position.
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