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Gold Breakdown Comes as US Treasury Yields, Real Rates Rise

Gold Breakdown Comes as US Treasury Yields, Real Rates Rise

2016-11-28 04:55:00
Christopher Vecchio, CFA, Sr. Currency Strategist
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Gold Breakdown Comes as US Treasury Yields, Real Rates Rise

Fundamental Forecast for Gold:Neutral

- Gold falls back under $1200/oz on weekly closing basis for first time since February.

- Metal prices have been in a freefall since November 8 – when the wave Republican election boosted hopes for fiscal stimulus and the end of gridlock in Washington DC.

- Rising US real yields – US Treasury yields minus inflation – have been rising steadily since mid-August, undercutting demand for assets on the bottom of the yield totem pole.

Gold finished down for the third week in a row, driven by the same set of factors since the November 8 US Presidential election: a strong US Dollar, underpinned by rising interest rates globally but mainly out of the United States. In plain terms, Gold is being driven by a classic fundamental underpinning: how US real yields are evolving.

Real yields are inflation-adjusted yields: in this case, the US Treasury 10-year yield minus the core inflation rate. Why does this matter? Investing is all about asset allocation and risk-adjusted returns. On the risk-adjusted side, for example: if asset X has an expected return of 10% with a standard deviation of 8%, and asset Y has an expected return of 12% with a standard deviation of 15%, asset X is the superior choice given the risk trade-off. On the asset allocation side, it’s about achieving required returns given the investor’s wants and needs. If inflation expectations are rapidly increasing, you would expect to see fixed income underperform: why would you want to have a fixed return when prices are increasing? On a real basis, your returns would be lower than otherwise intended.

The early part of 2016, when Gold and Silver were rising rapidly, was characterized by an environment in which US real yields were falling: inflation was steady and soft, and US Treasury rates were falling. Falling US real yields means that the spread between Treasury yields and inflation rates are decreasing, decreasing the penalty for holding a low yielding asset. If Gold yields nothing, has an estimated cost of carry of -2.4%, and only can return capital appreciation, it would best suited to rally when US real yields fell.

Accordingly, Gold is not a desirable asset in a rising real yield environment, which is what we’ve been seeing develop over the past several weeks, but in particular in November. The US 10-year real yield (Treasury yield minus core inflation) rose from -0.83% on July 6 to -0.32% on October 31. Heading into the coming week, the 10-year real yield had risen to +0.23%.

While the prospect of US yields continuing to run higher and Gold lower persists, particularly if the market continues to pull forward expectations for rate hikes beyond December, the coming days don’t seem likely to provide the fodder necessary to keep the recent trend in place. Rising political risk out of the Euro-Zone and some reignited tensions over the US Presidential election results may yet boost demand for precious metals as a hedge against American and European policymakers’ incompetence, at a minimum. –CV

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