Gold and Bonds Getting Back to Normal

Andy Waldock |

Gold, interest rates and the stock market have a very interesting relationship. Normally, declining interest rates are good for business and bad for gold. Post 9/11 and housing bubble, zero interest rate policies (ZIRP) created an artificial situation that fractured this relationship rendering it virtually useless over the last decade. This began to change last summer when the Federal Reserve Board stated that they would begin slowing the stimulus they’ve provided to the economy thus allowing interest rates to gradually rise. These relationships have begun to sort themselves out over the last three quarters and may actually be telling us something about the current pricing in the gold market.

The Fed’s actions have caused the Long Bond yield to rally by more than 33% since last May. Meanwhile, the 10-year Treasury Note has seen its yield climb by more than 55%. The climb in yields signals inflationary expectations, which corresponds to lower bond prices. Typically, this would lead to a rally in gold since gold is a classic inflation hedge. However, as markets are wont to do, the gold market got ahead of itself on its way past $1,800 an ounce attempting to surpass the 20011 highs near $2,000. Due to the overbought nature of the market, it fell of its own weight. The money that was pulled from bond and gold funds rotated into the stock market. Stocks screamed throughout 2013.

We feel that many of the manipulated gyrations of these related markets have sorted themselves out over the last several months. This is evidenced by the current situation, which shows the gold and bond markets at opposite ends of their spectrum while the stock market has continued to climb. This is as it should be and ties into the classic relationship among these markets. However, there are notable internal dynamics taking place among the major trading groups at these levels that lead us to believe that we are nearing inflexion points on a macro scale that traders and investors should be aware of going forward for the perhaps, the rest of 2014.

The bond market has stabilized since last summer leaving a broad pattern of consolidation at the bottom of a multi-year low in price (high in yields). Technical analysis teaches us that consolidation leads to continuation. Therefore, the recent rebound in prices which has led to the classic pattern of declining rates and a rising stock market is being sold hard by commercial traders as we trade near the upper boundary of the range bonds have established. For example, commercial traders were net long nearly 30k Long Bond contracts last October when the market was near its current level. Now, commercial traders are net short more than 20k contracts at the same price.

Transferring this analysis to the gold market, we can see that the big losers have been the index traders. These are the money managers who must peg their investment vehicle like GLD, the gold ETF to the current market price of gold itself. Therefore, as the market climbs, they’re forced to buy more to maintain proportionate physical holdings to meet investor demand. Conversely, as the market declines they’re forced to sell, both to maintain the proper weighting as well as meet investors’ redemptions. Currently, Index traders are selling gold, which is being bought hand over fist by commercial traders who are seeking to guarantee the price of future acquisitions. This has led to commercial traders’ momentum turning positive for the first time since mid-January and only the second time since last August.

Finally, the market gyrations that have been artificially manipulated by the Federal Reserve Board appear to be getting back in sync. Professional traders are eying the resistance levels in the bond market as they look for places to sell in expectation of higher interest rates. Commercial traders are buying into the gold decline as they did last June. The next key will be to see if they’re buying eclipses their buying totals from last July and December. If this is the case, and the pattern suggests that it is, we may find ourselves shifting to the inflationary environment that retail investors were sure would push gold past $2,000 per ounce in 2011. Obviously, this time we’ll see the rally led by commercial trader accumulation followed by renewed retail interest once the market gets moving and finally accelerated by index managers forced to rebalance their portfolios yet again. 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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