Market Report: Bond rout undermines PMs

Nov 18, 2016·Alasdair Macleod

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Gold and silver prices moved lower this week, while bond yields around the world rose sharply. There can be little doubt now that the bond bubble is deflating, inflicting enormous strains on portfolios, banks and even central banks which have initiated QE programmes. The gold price fell from $1228 at last Friday’s close to $1205 in early European trade this morning. On the same time-scale, silver fell from $17.37 to $16.61.

Behind continuing weakness for precious metals is a very strong dollar against other currencies. The JPY rate has moved from 101.36 at its lowest on 9 November to 110.81 this morning, a move of 9%. On the same time-scale, the euro went from 1.1284 to 1.0600, a move of nearly 6%, to which can be added losses of about 6% on 10-year German bunds. With yield curves steepening everywhere, suddenly there are concerns that interest rates will soon rise in the US, followed by rises in the Eurozone.

The strength of the dollar coupled with a moderate decline in the dollar price of gold means that gold has held up reasonably well in euros and yen, though it has taken a hit in sterling. This is shown in out next chart.

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The change in sentiment facing financial markets arises from indications that the Trump administration will cut taxes and spend up to $1 trillion on infrastructure. It will require substantial bond issuance to fund this stimulation, driving rates higher along the yield curve. Equities meanwhile ignored the bond rout and raced to new highs.

Gold and silver are becoming oversold, and today’s action is reminiscent of the temporary dollar strength after the Lehman collapse. The effect on gold at that time is the subject of the next chart.

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During October 2008, a stampede into the dollar developed, which drove down the price of gold, shown by the down-arrow. It was obvious that the Fed would have to reflate to stop the financial system imploding, and the Fed made unlimited funds available to the banking system. The result was the banking system survived, and the price of gold began rising to discount the massive monetary dilution engineered by the Fed.

Today we face a mini-version of the same situation. The surprise election of Donald Trump to the presidency has generated a flight into the dollar. We know the outcome will be inflationary, the principal difference being a rise in the general level of prices will be driven by deficits rather than monetary policy.

Therefore, gold is in a similar dip phase. We know that the general price level will start increasing next year, fuelled by infrastructure spending in both the US and China, as well as a growing US deficit, all of which will be good for gold prices. For the moment, there is a shortage of dollars, and it is inconceivable that it will be allowed to persist. This being the case, the outlook for the gold price becomes more positive, and should eventually rise, rather like it did post-October 2008.

The trick for traders is judging when sentiment changes. For longer-term investors, and those seeking to protect purchasing power by owning gold bullion, their bet is central banks and governments will continue to inflate come what may.

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