Ben Bernanke’s announcement last week of Operation Twist, the strategy of selling short term treasury holdings and purchasing longer term treasuries in an effort to lower long rates, coincided with a sharp selloff in Gold. The US Dollar also strengthened last week, with UUP, the Powershares DB US Dollar Index Bullish ETF, finishing the week up 2.12% and up 5.61% the past month.
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Given the nature of Operation Twist, I began by asking what correlation, if any, does the dollar or US Treasury interest rate spreads have on Gold? One way to analyze the relationship between Gold and interest rate spreads is to look at the correlation between GLD and FLAT, the iPath US Treasury Flattener ETN, which I first featured earlier this month. FLAT seeks to replicate the inverse performance of the Barclays Capital US Treasury 2Y / 10Y Yield Curve Index. In other words, a flattening of the 2 year/ 10 year yield curve results in FLAT moving higher. This flattening occurs when either 2 year yields move higher or 10 year yields move lower, or a combination of both.
Since FLAT began trading in August 2010, we see that FLAT and Gold (via the ETF GLD) have had a wide correlation range and is currently near the high of its range:
Given that there has been no consistent correlation between the two assets, it is difficult to base a future investment decision in gold solely on a flat 2y/10y yield curve. However, long term interest rates still hold valuable information on the direction of gold.
As John Hussman detailed here, huge and sustained upward moves in gold are driven by worldwide inflation or a plunging US Dollar:
The price of an ounce of gold in U.S. dollars is measured as $/ounce of gold. In foreign countries, the price of an ounce of gold is measured as FC/ounce of gold (where FC denotes “foreign currency”). The exchange rate between the U.S. and foreign countries can be written as $/FC. That’s the price (in dollars) for 1 unit of foreign currency. Now, since gold is easily transportable, it obeys the “law of one price”. That is, the price in dollars is the same as the price in foreign currency, after currency translation:
$/ounce of gold = $/FC x FC/ounce of gold.
Stare at that equation for a minute. Any time you see the price of gold rise, one of two things must be true. Either the foreign price of gold (FC/ounce of gold) has increased, or the value of the dollar must have declined (i.e. foreign currencies have become more expensive, and $/FC has increased).
What have we seen since Quantitative Easing began? Global inflation, driven by accommodating monetary policy and rising agricultural prices, and a falling US Dollar, which has the circular effect of causing global inflation since most commodities are priced in Dollars.
Gold, via the ETF GLD, and a bullish US Dollar (via UUP) have, for the most part, had a negative correlation the past four years, although it has not been a perfect relationship:
When the dollar rallies, it can adversely impact the price of gold. A rally in the dollar can be caused by many things, but the primary driver (see Hussman article) is long-term real interest rates. He defines real rates as long-term interest rates minus long-term inflation expectations. When long-term real rates decline, the dollar typically declines. An increase in long-term real rates typically leads to an increase in the dollar. Thus, a decline in long-term real rates makes the dollar less attractive, increasing the likelihood of rising gold prices.
As we see below, TLT (iShares Barclay 20+ Year Treasury Bond ETF) has been in rally mode since August, meaning long term nominal rates have been falling (chart courtesy of Finviz):
As we saw this past week a rally in the dollar can also coincide with falling interest rates. Using Hussman’s definition of real long-term rates, if nominal long-term rates are falling and the dollar is rising, this implies long-term inflation expectations have decreased.
If investors expect a soft economy for sustained periods of time, and Operation Twist helps to reinforce this thesis, then inflation expectations are muted. Inflation expectations and the dollar may have also been impacted by Europe’s financial woes, which have accelerated in recent weeks as has the potential for a global economic shock. As Euro holders sell their Euros, they are exchanged for US dollars and other currencies. On Thursday we saw a large spike up in the dollar and long-term US Treasuries, which coincided with a huge decline in gold and GLD and preceded an even larger drop on Friday (chart courtesy of Finviz):
Where does this leave Gold investors or prospective investors? Investors need to decide if they are bullish or bearish on long-term treasuries & inflation expectations (real interest rates), the US economy, and the US Dollar, as these will be key drivers of gold prices. There will be many global fiscal and monetary announcements/initiatives/plans announced in the coming days, weeks, and months. This makes projecting long-term interest rates, inflation, and currency movements a Herculean task.
For investors wanting exposure to gold, GDX (Market Vectors Gold Miners ETF) or specific mining stocks may be a better option today. I have detailed numerous times on Scott’s Investments the relationship between gold prices and miners. In July I wrote that conditions were favorable for the miners, although not yet “optimal”. I have no personal desire to see a contracting economy, but the optimal setup for gold mining stocks would be for the Purchasing Managers Index (PMI) to have a reading below 50, indicating a contracting economy. The latest reading was 50.6.
The ratio of gold to the Gold &Silver Index (XAU) is at levels not seen since the crisis of 2008, a bullish sign for the miners in relation to the price of gold. In other words, when this ratio is overextended, I expect miners to outperform gold. Falling Treasury bond yields and rising inflation have also historically been bullish indicators for gold mining stocks.
The miners still have a high correlation to the price of gold, so it is useful to determine your stance on the underlying commodity and some technical entry points. As I already mentioned, predictions in a market littered with fiscal and monetary initiatives and interventions can be a frustrating task. Nevertheless, Dave Banister stated last week “The first area to watch is the re-test of $1702 spot pricing for a C wave low, but the evidence is for a further drop to $1643 before I would get too interested in trying to game Gold to the upside.“ He has been hitting his gold predictions fairly well this year and given that gold touched $1643 on Friday it is possible that we may be due for a bounce.
If spot gold cannot hold its low last week of $1632 then I think a retest of the $1555-$1575 level is likely (which corresponds to roughly $151-$153 on GLD):
The magnitude of the sell-off in gold and silver this past week was enormous. In the short-term anything is possible, but I think a long-term continuation of gold’s upward trend is still possible. If this upward trend resumes, the most profitable angle is gold mining stocks. I am happy to wait for confirmation of a reversal in gold and mining stocks rather than trying to “catch” the bottom. Given the nature of today’s world and the possibility of dramatic volatility in any asset class, investors and traders should always have risk management and capital preservation as their first priority.
Disclaimer: No current positions in stocks mentioned. Please note that Scott’s Investments is not a financial adviser. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of Scott’s Investments.