gold may 2016 - macro blindspots

8/17/2019 Gold May 2016 - Macro BlindSpots

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The Macro Blind Spot

The rally in commodities over the last month has pushed inflation

expectations higher, prompting investors to buy gold. It appears that the

FED will allow inflation to overshoot its target before it acts. As long as the

FED continues to allow inflation to climb, investors will seek inflation

protection. Even if the FED acts sooner than anticipated and fuels a dollarrally that does not necessarily mean that gold will fall.

Contrary to popular belief, gold and the US dollar do not always trade

inversely. In fact, during times of rising inflation and a rate hiking cycle, spot

gold has produced returns as high as 88% over a three-year period.

Adding to the potential for a sustained breakout, gold producers continue

to hedge production. Despite apparent industry expertise, producers have

been notoriously bad a timing hedges.

Given the fundamental and technical setup for gold, I plan to buy the

breakout.

Where could I be wrong?

There are two developments that could prove me wrong. First, the FED

could surprise me by being more hawkish and not allowing inflation to run

above target. Second, a rising dollar/rising gold is a rare event and this

could prove to be one of those times they do not trade in tandem.

1. Inflation Target Not

Yet Met

2. Gold Dollar Myth

3. Producer Short

Squeeze

The Blind Spots

Gold

May 1, 2016


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2 The Blind Spot - May 2, 20

They say generals are always fighting the last war. I will leave it

to you to decide who “they” are and whether they are correct.

Like generals, traders and investors are often slow at dropping

old assumptions. This could be happening in the gold market,

and if so, could present an opportunity.

For the better part of the last 18 months the dominant theme in

the markets has been deflation. The narrative (which I

subscribed to) was that a strong dollar was the reason for oil

weakness and deflation. Once again “they” have a pithy

saying about deflation or “low prices” and its is, ‘the cure forlow prices is low prices.’ Lo and behold, this maxim has held

true for oil as it rallied over 48% in the last few months.

This rally in oil prices has not gone unnoticed by the bond

markets and interest sensitive stocks. Indeed market measuresof inflation expectations have been soaring along with oil. In

January 2016, the 5-year expected rate of inflation was less

than 1%; today it is approaching 2%. The mathematically

challenged, that is a 100% increase in inflation expectations.

Getting even deeper into the fixed income world we can look

at the FED’s preferred measure of inflation expectations, the 5-

yr, 5-yr Forward Inflation rate. This wonky financial market is

used to make bets on what the rate of inflation will be over a 5

year period beginning 5 years from now. I don’t know about

you, but I can hardly predict what gas is going to cost me next

week, let alone 10 years from now, but the FED seems to think

this number is special and as such it worth watching. No matterhow you slice it, the financial markets are expecting the prices

of ‘things’ to rise over the next 5 and 10-year horizon, aka

inflation.

I have always thought of gold as the global price index – that is

to say if the prices of ‘things’ are rising then the price of gold

tends to rise as well. The same holds true for when prices are

falling globally. There is an old saying that an ounce of gold willbuy you a nice suit in London. This relationship has held for

centuries and I am willing to make a bet that it will continue to

hold.

The bottom line is that as inflation expectations rise, investors

will look toward assets that can protect them; during times of

rising prices that asset is gold. Moreover, as the headline chart

indicates, the FED’s target for inflation is 2% and has yet to be

fully met. Barring a sudden epidemic of hawkishness, I wouldexpect the FED to let inflation run a little hotter than normal. In

turn this should be supportive of gold prices.

Blind Spot #1

Inflation

Target Not Met

FED Might Want to Overshoot 2% Target

5-Year Inflation Breakeven Rate

5-Year, 5-Year Forward Inflation Expectations


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There is a popular myth on Wall Street that gold and the US

Dollar trade inversely to one another. The logic is that sincegold is priced in dollars (the denominator), as the price of the

dollar falls then the price of gold should rise and vice versa. For

the most part this relationship holds, but as the top chartillustrates there are periods of time when both the US dollar and

gold rise together.

The top chart is the 3-year rolling correlation of gold and the US

Dollar; a positive number indicates gold and the dollar trading

in the same direction. What’s interesting is, while it’s rare, when

gold and the dollar become positively correlated it tends to last

for some time.

When Do Gold and the US Dollar Trade Together?

Yep, you guessed it, gold and the US dollar rise when the FED is

hiking interest rates and inflation is rising. This makes intuitive

sense as investors not only seek the inflation protection of gold,

but currency investors also find the higher interest rates more

appealing and begin to buy US dollars.

The table to right illustrates the periods when the FED was hiking

interest rates and there was a positive correlation between gold

and the dollar. There were five such periods and three

produced positive returns for gold while two produced negative

returns. The one period I would highlight is June 2004-

September 2007 – this is when oil was spiking to all time highs

and the FED hiked rates 425 bps. While oil is currentlydemonstrably depressed, it has had a tremendous price spike in

a short period of time. Will history rhyme?

While the sample size is small, the analysis is key because it

means I do not necessarily need a weak dollar for a longposition in gold to work. This means my odds of success during

this very rare period of time may be increased.

Breaking of the gold v dollar myth coupled with the view thatthe FED may let inflation climb above its target of 2% before it

acts, could mean that there is a window for gold to continue its

outperformance.

Blind Spot #2

The Gold and

Dollar Myth3-Year Rolling Correlation Gold vs. Dollar

Time Period Fed Funds

Increase

Spot Gold

Return

May 1983-Oct 1984 225 bps -17.37%

Feb 1988-June 1999 312 bps -18.56%

April 1993-July 1995 300 bps +8.03%

July 1999-Dec 2000 175 bps +6.37%

June 2004-Sep 2007 425 bps +88.61%

Gold Performance During Rate Hikes


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The nearly 20% rally in gold year-to-date was fueled not only by a slightly

weaker dollar but also by a short squeeze. According to CME’s

Commitment of Traders Report, Managed money (aka hedge funds) had

a net short position in gold futures at the beginning of 2016. In the last

few months, hedge funds have covered those short positions and are

now net long gold futures. One might be tempted to think that the short

squeeze is over, but there is another group in the gold market that is still

net short…. the gold producers themselves.

The headline chart on this page shows that as gold rallied 20%, producers

have been hedging and now have a net short position. It’s this short

position that may provide the fuel for the next leg of the gold rally.

Don’t be fooled by the apparent expertise that producers’ posses, they

are historically terrible at timing hedges. For

example, from November 2012 to January 2014

gold producers went from a net short position to

a net long position. During this time gold fell from

$1753 to $1236 an ounce, or -41%. It pays tofade, not follow the producers.

I want to point out one serious flaw in the

Commitments of Traders (COT) report, it does not

account for OTC transactions. If a hedge fund or

producer enters into an over the counter (OTC)

hedge transaction it will not necessarily show up

in the COT report. Dealers and brokers may use

futures to hedge these OTC transactions, but the

“real” position of market participants is still

unclear.

That being said, the COT report does give a high

level view of investor and producer sentiment. More specifically, I findthe change in positions to be the most informative. In the current situation

the increase in producer net short positions coupled with historic bad

hedging decisions, should be supportive of gold prices.

Blind Spot #3

Producer Short

Squeeze


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The one chart that I have seen passed around the most over

the last few weeks is the one presented above. It is the daily

chart of spot gold prices that appears to be forming a

pennant. BK does not fancy himself a “classical” chartist, but

he does like to use this type of technical analysis to identify

consolidation zones. Even more important, I use these support

and resistance areas as entry and exit signals. This clearlydefined daily pennant formation gives me a very clear entry

upon a breakout and I can set my stop loss just below the

bottom of the formation.

The second piece of price action that encourages me is thebreakout from the pennant is not just happening at the daily

time frame. When we look at the weekly chart, the price

action clearly shows a weekly closing price breakout. I have

found patterns that break on multiple time frames to be the

most reliable trade signals.

Turning to the trend indicators, aka-moving averages, it

seems that the 50-day moving average has been serving as

support. It’s interesting to note that the 50 day movingaverage also correspond closely with the bottom of the

pennant. When multiple technical indicators suggest the

same level of support I take notice. Since traders andinvestors use different types of indicators I prefer to have

multiple indicators supporting the same price action. The

thesis is that multiple confirming indicators could mean that

buyers from various disciplines are likely to enter the market.

The last group of buyers I want to capture is the

momentum/quantitative investors. Given the similarity in

strategies this type of investor exhibits powerful herd behavior,

especially in commodities. One of the biggest determinants

for momentum investors to enter a market is that the current

price must be above the price from one year ago. In fact, this

is how many trend following and quantitative investors define

momentum.

In the case of gold, the current price has been above the

year ago price for the better part of 2016. Add in the fact

that the 50-day moving average is above the 200-daymoving average and we have a very nice setup for

momentum investors.

The bottom line is that gold not only sets up positively from a

price perspective, but the pattern presents a well-definedrange that can be used for risk management.

Price Analysis

Breakout

Spot Gold Daily Bar Chart

Spot Gold Weekly Chart – Close Only

Spot Gold Daily – 50 and 200 DMA

Spot Gold Daily – w Year Ago Price Line


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The Reversion

byline

Lorem Ipsum

When considering a trade entry my most important

factor is risk to reward. My target risk reward is over

4:1. Using this risk-reward ratio I can be correct on

timing only 40% of the time and still make money

over the longer run. This gives me a comfortable

margin for error.

Based on this risk-reward requirements here is how I

am trading this breakout in gold.

The Trade

Buying GLD: $121.20

Stop Loss: $118.00

Total Risk: $3.20

Potential Targets:

Determined by measuring the Dec 2015-Mar 2016

move and adding to the bottom of pennant.

Target #1: $136

Potential Profit: $14.80

Risk/Reward: 4.6 to 1

Target #2: $149

Potential Profit: $27.80

Risk/Reward: 8.68 to 1

The Trade

Buying GLD

I have been long gold since December 2015 and remain constructive based on the underlying fundamental drivers and

the potential for a large technical breakout. The current price pattern provides an excellent opportunity to get long

gold via the SPDR Gold ETF (GLD) with a clearly defined stop. The entry, stop-loss and target levels indicate that the risk-

reward ratio could be as much at 8:1.

gold may 2016 - macro blindspots

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