Yes, a last gasp rally is possible, but a bear market awaits silver and gold
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LAST WEEK a friend of mine, an astute investor, pointed me to gold and silver price graphs and it is evident that both metals are at major points of resolve. His question was what major move lies ahead – up or down?
As a mining analyst many moons ago and investment strategist and fund manager later on, I focused on supply and demand in forecasting metal prices, especially gold.
Although I got a somewhat better idea than some economists whose numbers are just thumbsuck, I continued to be perplexed about the relationship between the supply/demand equation and the gold price in terms of US dollars.
I experienced a lightbulb moment a few months ago when I discovered that gold was nothing else than a 10-year US Treasury Inflation-linked Security or bond, also known as Tips. Tips are government bonds whose face value rises with inflation.
The gold price in terms of US dollars is highly correlated to the US 10-year Tips yield (R squared = 0.86).
According to the US Treasury, the 10-year Tips yield is based on the closing market real bid yields on actively traded Tips in the over-the-counter market and are calculated from composites of quotations obtained by the Federal Reserve Bank of New York.
In the absence of ready access to a price index for the US 10-year Tips, I used the historical net asset values of the iShares Tips Bond ETF fund and adjusted them for income distributions to get an idea of a clean price index for the 10-year Tips.
The gold price in terms of US dollar is also highly correlated to the clean price index for the 10-year Tips based on the iShares Tips Bond ETF fund (R squared = 0.81).
What it means is that Mr Market arbitrages between gold and Tips – selling the one and buying the other when prices move out of line.
The overall gold supply/demand situation therefore has little to do with the movements in the gold price except in the case of gold-backed exchange-traded funds or ETFs.
The overall gold-backed ETF universe tends to experience fund inflows when TIP yields fall and, vice versa, fund outflows or slowdowns in inflows when TIP yields rise.
The outlook for the gold price in terms of US dollar therefore depends on the outlook for the US 10-year Tips.
But why is the 10-year Tips yield negative? The Tips yield falls into negative territory when the yield on US 10-year government bonds trades below what market participants expect inflation to be in the next 10 years, on average.
The expected inflation rate, also known as the breakeven inflation rate, is calculated by subtracting the 10-year Tips rate from the US 10-year government bond yield.
Since mid-2008 the breakeven inflation rate was range bound between 1.5 and 2.5 percent and only briefly dropped below 1.5 percent during the 2008/09 Global Financial Crisis and at the height of the coronavirus crisis last year. The breakeven rate is currently 2.27 percent after touching a high of 2.47 percent in July.
According to the US Federal Reserve’s July meeting minutes, it indicated a willingness to start reducing its bond-buying programme before year-end, yes, tapering. The current outbreak of the Delta variant of the coronavirus in China and across the globe may lead to slower economic activity worldwide into the fourth quarter.
While that would postpone tapering by the Fed a few months, the unemployment rate in the US is lower than when tapering started in 2013.
Although the US house market is cooling after a staggering rise in prices, it is evident that US 15-year mortgage rates are bottoming. Tips yields and mortgage rates move in tandem while the latter tends to lead 10-year government bond yields by a month or so.
Over the past 13 years the gold price tumbled when mortgage rates rose significantly.
Barring any Black Swan event which may cause the opposite, I am of the opinion that the gold price has already started to rollover, but may have a last gasp from last Friday’s close of $1 782 and even test $1 900 per ounce.
In light of the historical relationship, an increase of 50 basis points in the US Tips yield could see gold down to about $1 650 per ounce and $1 500 in the case of a 100 basis point increase in the Tips yield. It can overshoot on the downside, though.
Silver is already struggling. Silver’s correlation to the Tips yield is relatively weak (R squared = 0.61 since 2013). Despite this and given the historical relationship, an increase of 50 basis points in the US Tips yield could see silver down to $22 per ounce and $20 in the case of a 100 basis point increase in the Tips yield.
Yes, a last-gasp rally is possible but a bear market awaits silver and gold.
Ryk de Klerk is analyst-at-large. Contact [email protected] He is not a registered financial adviser and his views expressed above are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.
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