Precious Metals Market Commentary – December 2016

By Sam Broom



It’s been just shy of a month since our last “post-election” market update and given the recent developments across markets, it seems a pertinent time for an update regarding our thoughts on the precious metals market.

For those after the short version, the take home points are as follows:


·         Momentum is firmly to the downside in the gold price at present, but;

·         The gold miners have held up much better and have held support, for now. This kind of “bullish divergence” often hints at price action to come (bullish).
 

·         We believe the key forces influencing gold are a) real yields and b) the dollar, both of which broke out topside (bearish) following Trump's victory.
 

·         In the very near term, real yields as measured by 5 year TIPS, have rolled over following the Trump rally, whilst the dollar continues to move higher. This sets up a possible “tug of war” on the gold price.
 

·         Overall, there is a mix of bullish and bearish indicators in the gold space, making near term predictions difficult.
 

·         The Fed rate decision to hike just came out  - we're likely to see big swings directly post announcement.
 

·         For those looking to hedge their gold portfolio, the best bet right now looks to be in the currency markets, with a short on key dollar constituents.

 
For those after some more detailed reading, see below for a more detailed analysis of the current setup.

Overview

Contrary to the pre-election consensus, Trump's victory has been negative for gold, at least in the short term. Since his election on November the 8th, price has declined from a peak of $1,336 to where it’s currently trading at $1,170 a drop of $166 or 12.5%.

Since the election, gold has been trading in a strong down trend, slicing through key support levels at $1,250 and $1,200 with barely a pause. This is not typical of price action during a “bull market correction”, whereby we should be seeing buying support coming in around key support levels:

  

In my previous update I noted that we needed to be very cautious of a downside break of $1,200.

Given that this breakdown occurred, I believe investors should take a cautious approach regarding the near term direction in the gold price, as momentum is firmly to the downside at present.

However, there are many conflicting signals, the main one being the performance of the gold and silver mining stocks. Price action in the miners appears to have, momentarily at least, decoupled from the behavior of the underlying metals with which they produce. Take note the current strong, linear down trend outlined in gold chart above (downward red arrows) and compare that to the price action over the same time period in the GDX (upward green arrows) in the chart below:

 


The miners are currently trading at the same level as they were when gold was $50 higher at the $1,220 level - this is what technicians (chartists) refer to as “bullish divergence” and this can be (but is not always) a leading indicator regarding the price action to come in the near future.

In order to confirm this signal, we need to see a reversal of the downtrend in the gold price, with a break above $1,200 (hopefully with “gusto”) combined with a breakout upwards out of this sideways consolidation pattern we’re experiencing in the miners. This would be seen as a breakout above 22 in the GDX, with an eye to breaking the mid-term downtrend (i.e. the 22 to 23 level). Until we see this kind of confirmation, from a technical standpoint one should remain aware of the possibility that miners may  “capitulate” downwards and “catch up” with gold.


 

Precious Metals - Drivers

In my opinion, there are two key drivers of the gold price right now, both of which have “broken out” post-election; 1) real yields and 2) the strength of the U.S. dollar.

Real yields are best measured using 5 year TIPS, or Treasury Inflation Protected Securities.

Presently, the TIPS yield has the strongest (inverse) correlation to gold of any asset class that I’m aware of. This makes sense given golds primary “competition” as a safe haven store of value is US treasuries, the relative attractiveness of which varies depending on the degree to which inflation destroys it’s yield (it’s main perceived advantage over gold).

The chart below shows this strong inverse correlation between the two assets since the 2008 global financial crisis, with changes in trend almost directly correlating with the changing fortunes in the gold space:



The breakout in the real yields contributed to the smack down in gold through the key support level of $1,250 and it’s continued rise has been a big bearish headwind for the gold price. However, in the very near term (the past 2 weeks), TIPS yields have started to roll over, with no sign of support kicking in, yet (see chart below). If TIPS yields continue to correct, this should provide a positive backdrop for gold to move higher. The opposite is also true and if we see a strong support into a bounce, then this would likely add to further downward pressure in the gold space.

  

The Dollar - I believe the other major influencer of gold prices is the strength (or otherwise) of the U.S. dollar, best measured by the DXY index. As with real yields, the DXY recently broke out of its 18 month consolidation pattern when it moved above strong resistance at 100.5:


 


Increasing the resolution and looking at shorter (daily) timeframes, we can see that, unlike with real yields, the DXY has bounced strongly following a little pause and looks like it will test the recent high – a breakout to new highs looks likely (generally bearish for gold):

  

The reasons for the breakout are many, and deserve a discussion all on its own, but needless to say there are plenty of macro reasons to suggest the dollar may trend higher for some time.

Hedging Options for a Gold Portfolio

With uncertainty in the precious metals markets, it may be a good time to consider hedging a gold portfolio against further downside that may eventuate. Whilst we can’t discuss specifics here, with the dollar looking strong, some see the best bet being the currency market, i.e. shorting the major constituents of the Dollar index.

Summary

To sum things up, there are a host of conflicting forces acting on the gold market right now, making forward looking predictions extremely difficult. On the one hand, momentum in the gold price itself is firmly to the downside and we’ve yet to see any buying support during this selloff that followed Trump’s election. However, gold remains extremely oversold and mining stocks (often forward looking) have diverged in a bullish manner, giving hints that we may be nearing a bottom in this correction. In order for that signal to be confirmed, we need to see a convincing break for gold above $1,200, and a move above 22 to 23 in the GDX.

As far as the factors driving gold are concerned, we are again seeing conflicting patterns.

Both real yields and the dollar both broke out to the upside following Trump’s election, a negative  “double whammy” for the gold price. However, since breaking out, TIPS yields (arguably the most important influence) have looked weak in the very short term (bullish for gold). If these continue to move down, this should provide strong bullish tailwinds for the gold price. On the flip side, the DXY has looked much stronger, correcting only slightly before rebounding over the past few days.

Whilst we think real yields are likely to impact gold the most over the mid to long term, a rising dollar would likely provide negative headwinds for the gold price. If real yields and the dollar continue to move in opposite directions, we are likely to see a fascinating case of “tug of war” on the gold price.

With the Fed rate decision to hike today, Wednesday (14th of December) – we are likely to see some big swings in price immediately following this decision, and the price direction in the immediate aftermath.  Price action following the decision may confirm the short to mid-term direction.

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