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Gold Taking its Cues from Risk Trends, Inflation Expectations

Gold Taking its Cues from Risk Trends, Inflation Expectations

2011-05-07 07:33:00
Ilya Spivak, Sr. Currency Strategist
Share:
Gold_Taking_its_Cues_from_Risk_Trends_Inflation_Expectations_body_Picture_3.png, Gold Taking its Cues from Risk Trends, Inflation Expectations

Fundamental Forecast for Gold: Bearish

Gold is once again becoming anchored to risk sentiment trends, with the correlation between the yellow metal and the S&P 500 benchmark stock index rising to the highest in five months last week. Furthermore, gold continues to show a strong link to the one-year breakeven rate, a gauge of investors’ near-term inflation expectations derived from Treasury bond yields. On balance, both relationships point the way lower, albeit not without some false starts.

The spectrum of risky assets tumbled last week. Stocks, key commodities, and high-yielding currencies all came under intense selling pressure while the US Dollar rose 2.7 percent, marking the largest five-day rally in 10 months. The catalyst between the aggressive reversals was almost certainly April’s Federal Reserve monetary policy announcement, where the rate-setting FOMC pledged in no uncertain terms to end quantitative easing (QE) as the controversial program’s second round expires in June. With the Fed thereby in neutral, the direction US yields would be once again left to the markets.

Simply put, the Fed’s action amounted to telling investors that had capitalized on QE to borrow Dollars on the cheap and use them to invest in higher-yielding assets, “From this point forward, you are on your own, and if yields rise then so be it.” Needless to say, the size of the US budget deficit and the amount of new bond issuance that it implies – not to mention the recent S&P downgrade of the US credit outlook – suggests borrowing costs will indeed move higher as bond prices decline once Ben Bernanke and company take to the sidelines.

Presented with such stark reality, investors began to book profits on their Dollar-funded exposure, sending all of the assets that had benefited from the status quo – with gold among them – broadly lower while the greenback enjoyed a robust recovery. More of the same is likely ahead as the QE expiry deadline looms ever-closer, although the move will see some fits and starts as bouts of weakness bring buyers eager to capture attractive entry points into what will appear to still be well-established trends. A fundamental shift seems nonetheless underway however, and the environment it is likely to produce is one in which gold finds itself retracing much of its recent strength.

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