Gold’s muted response speaks volumes

Contributors: Joe Foster, Portfolio Manager and Strategist, and Imaru Casanova, Deputy Portfolio Manager/Senior Analyst for the Gold Strategy

Gold faced selling pressure early in February despite normally positive conditions

In an environment that would typically be positive for gold, gold faced selling pressure as investors searched for liquidity to cover margin calls and redemptions. Gold declined in February as increased market volatility and a drop in equity and bond markets failed to support demand for gold as a safe haven. On 2 February, the labor market report in the US showed a strong rebound in average hourly earnings that was well above expectations. The US dollar rallied and gold declined. Equity markets dropped, with the Dow Jones Industrial Average down almost 9% by 8 February (ending February down 4%), US Treasury yields rose, and the US dollar, rather than gold, was the beneficiary.

Weaker US dollar, heightened inflation expectations helped gold reach month high

On 14 February, January's inflation report beat consensus, with headline inflation measured by the Consumer Price Index accelerating to 2.1% year-on-year. US Treasury yields continued their rise and the US dollar weakened. Meanwhile, the equity markets and gold bounced back. Gold reached its high for the month of US$1,353.70 per ounce on 15 February.

Gold rally loses momentum as US dollar strengthens on Fed comments

However, the gold rally was short lived, as the markets priced in hawkish expectations ahead of the release of Federal Open Market Committee (FOMC) minutes on 21 February. The Fed minutes themselves did not contain much new information, but confirmed the market's expectations for three rate hikes this year. In addition, the testimony by new Fed chairman Jerome Powell to the House of Representatives' Committee on Financial Services was viewed as optimistic, stating that he sees gradual rate hikes, and more importantly, an improved U.S. growth outlook. The US Dollar Index (DXY Index) was up 1.7% during the month. Commodities were lower during February, which is also negative for gold. Gold closed at US$1,318.38 per ounce on 28 February, down 2% or US$26.78 per ounce for the month.

Demand for gold ETPs up YTD helping bullion outperform gold stocks

Demand for gold bullion-backed exchange traded products (ETPs) declined in February, with holdings down about 0.3% for the month. This followed a 1.3% increase in holdings in January, resulting in a net 1.1% increase year to date as of 28 February. We track the flows into the gold bullion ETPs as we believe investments in those products typically represent longer-term, strategic investment demand for gold and, as such, provide an excellent proxy for the direction of the gold market.

Gold stocks underperformed gold, with the NYSE Arca Gold Miners Index (GDX Index) falling 9.91% in US dollar terms.

Gold stocks impacted by reaction to mixed Q4 reporting, not fundamentals

While many gold companies reported positive fourth quarter 2017 operating results, earnings/financial results were mixed and guidance for 2018, in some cases, seems to have surprised the markets. The negative sector headlines put significant selling pressure on the stocks. In many cases, these negative surprises have shorter-term effects, and do not change the companies' fundamental valuations. However, more recently, it appears that selling pressure might be intensified by headline-driven, algorithm-based trading where the longer-term fundamentals are ignored.

The end of the low interest rates era and the multi-decade bond bull market?

It looks like the post-crisis era of ultra-low, below-market interest rates and the multi-decade bond bull market both came to an end in February. In early February the simultaneous fall in both stocks and bonds caught the markets very off guard. Five- and 10-year US Treasury rates jumped up and out of a downtrend that goes back to 1985. The stock market sell-off was a taste of the unintended consequences of Fed policies that encourage investors to take on more risk, driving markets in one relentless direction for nine years. Funds designed to thrive in a low volatility environment were forced to sell in a reinforcing feedback loop, exposing new systemic risks.

Bitcoin crash another sign that easy money may be over

Another sign of the end of an era of easy money was the bitcoin crash. From its high of US$19,511 in December, bitcoin declined 70% to its US$5,922 low on 5 February. It has since recovered to around US$10,000. Bitcoin has already gone through one crash this year and the value of the emerging technology, while potentially disruptive, is still unproven.

Investor complacency remains despite volatility, rising debt, rising rates

Safe haven investments showed little reaction to the stock market selloff. Gold and the dollar essentially trended sideways, while US Treasuries headed lower. So far investors are treating the stock market volatility as an overdue correction, however we see it as the beginning of a secular shift in markets and investor psychology that brings more volatility and risk going forward. Perhaps the prelude to a bear market and economic downturn.

It looks like a higher interest rate regime is taking hold. It is not yet clear whether it is being driven by inflationary expectations, Fed rate increases, increasing fiscal deficits, or a combination of all three. Protectionist trade policies, wage pressures, and a weak dollar may cause core inflation to trend through the Fed's 2% target, which may bring more aggressive rate policies. Fiscal deficits projected to rise above US$1 trillion in a couple of years will cause the Treasury to issue huge quantities of debt at the same time the Fed is reducing its US$4 trillion hoard of U.S. Treasuries, mortgage-backed securities, and agency debt.  

A new era of higher interest rates brings added uncertainty. As these rates rise, equity risk premiums get squeezed, making stocks less desirable. According to Gluskin Sheff, a 50 basis point rise in rates costs the economy US$250 billion in debt service annually. We do not know how the new Fed management will respond to volatile markets and potentially weaker economic growth. Unwinding the Fed balance sheet (quantitative tightening) is an unprecedented financial experiment. Is the February volatility an indication of how a system dominated by passively managed funds, algorithms, and automation will behave?

We believe the muted response from gold and other safe haven investments suggests complacency continues to dominate the markets. In fact, the University of Michigan Consumer Sentiment Index's mid-month reading for February rose unexpectedly to nearly a 13-year high. As the year unfolds, we expect an erosion of complacency and confidence that benefits gold.

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