I’ve been sporadically successful at shorting gold for years. From the end of 2018, through March 2020, and into H1 2022, I’ve encountered the unyielding resistance of the long gold crowd. These investors are as steadfast as they come, making them a tough group to sway. In this article, I will delve into the intricate tapestry of the global macroeconomic landscape and the myriad factors that bear upon the price of gold.
Firstly, I will explore the general portfolio theory of using a short gold position as an optimal market tail risk hedge. This can safeguard against a persistent surge in real yields, which exerts downward pressure on stocks, bonds, and inflation hedge assets such as commodities and TIPS. Consequently, this diminishes the efficacy of traditional 401K and risk parity portfolios. In short, the mechanism behind this tail risk is a bond hedge that operates in reverse.
Most strategies designed to shield portfolios during downturns involve diversification into a blend of equities, bonds, and inflation hedge assets like commodities. However, the predicament lies in the fact that higher real rates can exert downward pressure on all these asset classes, rendering this strategy imperfect in certain scenarios.
I advocate for a completely different approach. I propose holding a small portion of a portfolio in tail risk hedges that perform exceptionally well during catastrophic global economic events – events that have historically occurred time and time again. I view this as a perpetual insurance policy, akin to renewing it regularly. This could take the form of deep out-of-the-money options contracts, yielding thousands of percentage points in returns during extremely adverse global economic and financial market scenarios.
I believe this approach is significantly more effective than a diversified portfolio, as it allows a portfolio to take on concentrated risk in equities during favorable times. This can be done with the knowledge that the insurance policy of tail-risk hedging options will outperform if the majority of the portfolio, heavily skewed towards risk, takes a downturn. While many of these tail-risk hedges may expire if the markets flourish, in adverse scenarios such as financial crises, which many economists view as unpredictable, it provides much stronger protection compared to traditional forms of portfolio diversification. Furthermore, it avoids diluting returns through overly diversifying. For many passive investors, the approach I recommend should constitute a minuscule component of a larger portfolio, held consistently over time. This stands in stark contrast to diversifying risk (and return) through traditional portfolio theory, such as a 60/40 stock/bond portfolio.
It is worth noting that portfolio insurance hedges bear fruit only a small percentage of the time. John Paulson’s housing short in ’08 marked one of the most substantial returns in financial history. Many have likened it to buying flood insurance in a desert – or more aptly, what was perceived to be a desert. Consensus perceptions do not always mirror reality, and identifying these small windows is where alpha is generated. This philosophy has been the guiding force in my entire investment career.
The most reliable forward indicator of gold prices is the use of inflation-adjusted US T-bond yields as an inverse proxy for gold prices. When inflation-adjusted or real yields increase (indicating a decline in inflation or inflation expectations, and a rise in interest rates), gold correspondingly depreciates. This is intuitive, as gold is an asset that hedges against inflation, yet yields no interest, making it less competitive when rates climb and inflation stagnates or decreases.
We have recently witnessed a breakdown in this inverse correlation, with real yields surging over 200 basis points and gold smashing through all-time highs. How long can this anomaly persist? The answer eludes me, but it is inevitable that this cannot carry on indefinitely. Either real US Treasury yields and the USD will retreat, or gold will give way, as all the aforementioned factors have escalated to unprecedented levels.
I am holding firm to my $1100 gold price target, based on the extensive surge in real yields, without a commensurate decline in gold. The manner in which gold prices have defied the surge in real yields and a consistently robust USD indicates an expectation of the transient nature of higher anticipated real yields and restrictive monetary policy. Essentially, this assumes that real yields will recede as the Federal Reserve executes an anticipated (as reflected in the market) 100 to 150 basis points in Fed Fund rate cuts this year.
As illustrated below, there is a 95.4% market-implied likelihood of 100bp of rate cuts or more this year, a 78.8% probability of 125bp of cuts, and a 45.2% chance of 150bp or more cuts. The current target Fed Funds rate stands at 5.25%-5.50%.
The market has already completely priced in a 25-basis point cut by the June FOMC meeting at a 99.4% expected probability, and the likelihood of two cuts by September has been pegged at 99.7%. The anticipated outcome regarding a 25bp cut in March is evenly split. These probabilities are depicted below.
Are these expectations extravagant? The market evidently thinks otherwise, but I remain more skeptical. I anticipate that core inflation in the United States will not comply – in other words, it will not decelerate below two percent annually. This would preclude the Fed from embarking on a sizable policy easing cycle.
A Deeper Dive into the Surprising US Economic Landscape
The US economy is, to borrow a phrase, one tough cookie. Challenged by lingering inflation fears, contrasting views on the bond market, and speculation around the Federal Reserve’s rate cuts, the convoluted nature of the current economic landscape has left investors in a state of flux. Let’s unpack the intricacies and delve into the surprising trends shaping the future of the US economy.
Lingering Inflation Concerns
Economist, Larry Summers, and renowned bond investor Bill Gross have weighed in on their concerns about inflation, with Summers warning about potential market underestimations and Gross deeming the 10Y UST overvalued at a 4% yield. These cautionary notes underscore the palpable unease around inflation levels and its impact on the Federal Reserve’s policy decisions.
The Resilient Yield Curve
Despite the turbulence in the bond market, recent indicators point to a potential bearish-steepening of the yield curve. An invigorated appeal for front-end yields, combined with market dynamics, presents a compelling case for a steeper yield curve, indicative of a resilient US economy and a recession-resistant outlook.
Stable Labor Market and Consumer Confidence
While concerns loom over personal savings and its impact on GDP growth, reassurances from industry leaders like Brian Moynihan, CEO of Bank of America, paint a different picture. Moynihan’s statements about the robust financial state of US consumers, supported by personal savings, retail sales growth, and disposable income growth, lend credence to the resilience of the US consumer and the consumption-driven economy.
Deciphering the Fed’s Stance on Rate Cuts
The Federal Reserve’s stance on potential rate cuts has been a topic of contention, with varying opinions from officials like Christopher Waller, Raphael Bostic, and Loretta Mester. Their cautious approaches and varying timelines for rate cuts underscore the nuanced nature of policy decisions in the current economic climate.
Financial Analysis: The Complexities of Gold Pricing and International Economics
Preemptive Pricing and the Gold Market
The recent approach of preemptive pricing in the wake of large cuts has instilled optimism among investors. With the Federal Reserve showing limited concession, the long gold crowd faces uncertainty. The possibility of pricing in seven cuts is being dampened by the Fed’s conservative approach, potentially averting a recession. Thereby, the road ahead seems promising for the procrastination of realizing the effects of the recent tightening, bolstering a bearish view on gold.
Challenges in the Global Economy
The post-pandemic rise of the neutral interest rate, known as R*, underscores the challenges facing the US economy. While a soft landing may be conceivable, it does not bode well for risk assets, financial markets, and emerging market economies and FX rates. These dynamics have the potential to significantly impact inflation expectations, metals prices, and commodity demand.
Market Front-Running and Its Implications
The front-running of rate cuts in financial markets further complicates the situation, increasing the unlikelihood of the anticipated cuts. The combination of accelerating core inflation and decelerating headline CPI poses a significant threat to risk assets and stocks, underscoring the challenges faced in today’s market environment.
Impact on Asset Classes
The pervasive anticipation of Fed fund cuts, with prices factoring in reductions of 100-150 basis points, reverberates through various asset classes, including bonds, equities, FX rates, corporate credit, and emerging markets. The persistent strength of the USD, despite the expected cuts, hints at a robust fundamental demand for the currency.
China’s Economic Position
The slowdown in China’s explosive growth post-2018 has introduced deflationary pressures, affecting global inflation expectations and metals demand. With the Chinese banking system facing over-leverage and a slowing domestic economy, the People’s Bank of China (PBOC) finds itself in a challenging position.
Challenges for Chinese Banking System
The mismatch between Chinese banking assets and economic growth points to a potential NPL and capital shortfall problem. The surge in interbank rates signals a domestic shortage of the RMB, illustrating the difficult choices confronting the PBOC in managing the country’s economic trajectory.
PBOC’s Dilemma and Potential Outcomes
The PBOC faces the dilemma of balancing economic stimulation and currency devaluation, with potential ramifications for USD-denominated debtors. The choices made in this regard are poised to have a profound impact on the global economic landscape, particularly in emerging markets.
Implications for Global Capital Movement
The divergence between US and Chinese yields is attracting global capital, leading to a weakening of emerging market currencies and a reduction in USD funding. As emerging market economies grapple with significant debt maturities, the dynamics of global capital movement are poised to undergo a transformation with far-reaching implications.
Challenges of USD-Denominated Debt
The prevalence of USD-denominated debt in emerging markets creates a vulnerability to USD appreciation and acute dollar shortages. This situation not only amplifies debt burdens but also triggers a cycle of forced selling of US Treasury bonds, leading to a compounding USD shortage.
Insightful Analysis into EUR/USD, Gold, and the Federal Reserve
Economic indicators are showing a marked downturn in Germany, fueling speculation of a recession, while such dire forecasts in the United States remain mere conjectures. The potential recession in Germany is expected to exert downward pressure on EUR/USD and gold. As the euro is historically viewed as a risk-on pro-cyclical global growth currency, it seems prudent for the ECB to pivot sooner rather than later. A pivot that aligns with their best interests would involve more aggressive and quicker rate cuts compared to the Federal Reserve.
The ECB’s Strategic Pivot
Should the ECB opt for a proactive approach to lower rates ahead of the Fed, it could drive the DXY to 120.00 without impeding nominal Euro area GDP growth. This move could also subdue commodity and input price inflation, enhancing net export competitiveness through a weakened euro. Furthermore, lower policy rates are anticipated to bolster domestic aggregate demand, leading to a stronger real Euro area GDP. Such a strategic shift could have substantial implications for the global currency markets.
Understanding the Federal Reserve’s Reverse-Repurchase Facility
The Federal Reserve’s reverse-repurchase facility, commonly known as the RRP market, has been a subject of intense discussion and frequent misunderstanding. The drawdown in RRP can be attributed to two primary factors, neither of which bodes well for gold prices. Firstly, there is a growing willingness to accept duration risk due to the widespread anticipation of rate cuts. In addition, the US banking system is witnessing an increased scarcity of USD reserves and UST bonds, both of which serve as counter assets. Amid declining liquidity, the preference for USD reserve assets over temporary placements in RRP is becoming more pronounced, contributing to a significant decrease in RRP balances.
The Fed’s Conundrum and Quantitative Tightening
The evolving landscape in the RRP market is intricately linked to the Federal Reserve’s impending decision on tapering its quantitative tightening program. The reduction of USD liquidity within the US banking system is leading to a noticeable tightening of overnight USD liquidity. This situation echoes the circumstances at the close of 2019, evoking memories of a looming USD shortage. The challenge for the Fed lies in determining the optimal level of reserves within the banking system, a delicate balance where there are enough reserves without an excess. The looming shortage of USDs and its potential impact on inflation and economic stability presents the Fed with a complex puzzle to solve.
The Uncertain Path Ahead
We find ourselves in a position resembling the year-end of 2019, with the specter of a shortage of USD reserves looming large, reminiscent of the pre-pandemic era. The looming quandary for the Fed revolves around identifying the appropriate level of reserves and addressing any emergent stress in the overnight bank funding markets. The uncharted territory introduces an air of uncertainty, reminiscent of the Fed’s response in 2019. With inflation proving to be more responsive and no economic shutdown in sight, the playbook for addressing a potential scarcity of USDs remains a subject of conjecture.
In Conclusion
As our journey draws to a close, it is vital to recognize the value in shorting gold as a prudent measure to shield portfolios from prevailing optimism that hinges on real US rates declining. This is an opportune moment to analyze market dynamics and position investment portfolios to weather the storm stemming from the ripple effects of Federal Reserve’s policy decisions.
