Basic rule: always call their bluff,
- James Bond
Over the past five years pet rock (spot gold) has traded with a resistance level just above $2000 USD. However, on March 1 spot gold made an impulsive break to a new high. The unusual element of the breakout and recent price action in this episode, is the divergence with real yields. Recall that gold has a cost of storage (cost of carry) therefore the competing asset for gold is the real Treasury yield (chart 1).
Chart 1
The related divergence is the correlated performance of gold and risk assets (equities and credit). Gold has typically performed better in phases of risk aversion rather than risk loving sentiment. Curiously, gold ETFs remain net sellers and CME positions are not particularly high in a historical context. However Chinese retail demand for gold is +24% year on year. Moreover, emerging market central banks (who are starting from an underweight position as a proportion of reserves) have been material net buyers of gold. The buying is likely related to geopolitical conflict and an attempt to diversify foreign exchange reserves (chart 2).
Chart 2
Gold is also perceived to be a hedge against monetary inflation and the next (future) move by global central banks back into an easing cycle (both lower interest rates and a taper of Quantitative Tightening of the balance sheets). Of course, our quarrel with price is the prospect that core services inflation (ex-shelter) has started to reaccelerate above 4%. Our pipeline inflation pressure index also suggests that the risk of a second wave has risen over the past few months. There is evidence to suggest that inflation may be structurally higher. The implication for gold is potential for structurally higher US dollar interest rates or an elevated level for the competing asset. From our perch, the only hope of renewed monetary accommodation is a rapid deterioration in labour market conditions over the next few months.
The good news for gold mining equities is that they have not priced higher spot gold over the past year (chart 3). Gold miners trade at a 53% discount to world equities, the largest since 2015 (70%). Although costs for producers have accelerated, revenues and margins are elevated with spot over $US 2000 and even higher for Australian and Canadian miners (who have costs in local currency).
Chart 3
Our key reticence on the miners is 1) persistence of higher-for-longer USD rates; and 2) the potential convergence of spot gold with real yields. However, gold producers are inexpensive if one extends the time horizon to the next phase of monetary inflation and relative to world equities. Miners have often provided diversification to an equity portfolio as well. We are also reticent when traditional correlations or macro relationships breakdown. It can be a warning of something more sinister in a macro or cross asset volatility sense.
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