Market Report: Crosscurrents in financial markets

Jul 9, 2021·Alasdair Macleod

Gold continued to recover some ground this week to consolidate at the $1800 level. In European morning trade this morning, gold was $1805, up $16 from last Friday’s close, but still down about 5% on the year so far.

Silver underperformed gold, falling 55 cents on the week to $25.95, perhaps more in line with a consolidating commodity complex. Driving the wider commodity relationship has been a persistent rally in the dollar’s trade weighted index, which is our next chart.
The rally in the TWI is part of a broader confused scene. With rising consumer prices, one would have expected to see interest rates and bond yields rise. But the reverse has happened, as indicated by the yield on the 10-year US Treasury bond.

The fall in yield this week has been dramatic, returning the price to the 200-day moving average and is contra to the dollar’s TWI trend. Equity markets had a similar downdraft with the Dow Jones Index falling nearly 600 points before recovering half its fall in a shortened trading week (Monday was US Independence Day).

Driving markets appears to be the new 5 basis point payment on the Fed’s reverse repos, which has come at a time when the new Basel 3 net stable funding ratio discourages banks from taking short-term deposits. Without the Fed’s increase in the RRP rate, money market funds would have had nowhere to go without risking “breaking the buck”, which for a $4.5 trillion cash industry would have been potentially catastrophic. We can see the dramatic increase in reverse repos in the FRED chart below.

Reverse repos drain liquidity from the financial system. This has been necessary in recent months because the US Treasury spending down its balance on the General Account with the Fed and the Fed’s monthly QE of $120bn have combined to form too much liquidity for the banking system to cope.

But the combination of the Basel 3 NSFR and the Fed’s 5 basis point reward for reverse repos now threatens to make market liquidity constrained. Hence the gut reaction in equities this week. The move into US Treasuries appears to be consistent with a flight out of risk assets, on the fear liquidity tightening is being overdone.

With respect to gold and silver, the hedge funds appear to be marginal buyers of gold futures but not so keen on the more speculative silver contract.

This week also saw the publication of the last FOMC minutes, which showed that an early return to tapering was discussed. But if FOMC committee members think tapering is an option, they misunderstand the market role of QE. Equities and bond markets need QE to sustain current values and any reduction would risk bursting the equity bubble.

All this is short-term noise. Financial assets are in a bubble which will eventually deflate. It will create volatility for precious metals, but experienced hands will continue to use price dips to to drain physical metal from the market as it becomes available.

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