Gold: Equities Outperform But GLD Needs Some Love

Snipped from the January 11^th Maven Letter:

Gold has started out 2017 with a bang. The yellow metal is up 5.5% since Christmas. And gold equities are offering serious leverage: the GDX index of major gold miners is up 17.1% and its little sister, the GDXJ, is up 27%.

Base metal equities are also enjoying leverage: the TSX Global Base Metals Index is up 19% over the same timeframe, despite copper being up only 3.6% and zinc having gained only 4.5%.

Can it continue? That question breaks down into two parts: short term and long term.

In the short term, the gold run probably still has legs. Seasonality is still working for the yellow metal. We’re edging up on Chinese New Year and that always lifts gold demand in Asia notably. The US dollar hasn’t moved up in a month and it seems to me that, with inauguration day imminent, the market has reached the what-will-he-actually-do stage of the Trump honeymoon. Further dollar gains may well require reason, rather than sentiment. US stocks similarly have not made upward progress in a month and investors are probably wait-and-seeing for the same general reason.

However, there is one piece of evidence that suggests gold could turn back soon: ETF buying, or more precisely a lack thereof.

When the GLD ETF launched in 2004 it gave investors a way to have direct portfolio exposure to physical gold. Many other gold ETFs followed, creating a new and important player in the gold space. ETF flows correlate very closely with the price of gold; this is partly a function of how ETFs work (the fund buys and sells gold to keep the value of their gold holdings in line with the fund’s market value) and partly because ETF demand influences the gold price.

Chicken and egg? Yes. As the chart above shows, it is not clear which goes first: sometimes ETF gold holdings rise first because pro-gold sentiment pushes investors to buy into the fund, requiring the fund to buy gold, and sometimes the price of gold rises first because investor sentiment is elsewhere.

Right now we are seeing a divergence, as the chart shows (thanks to the Simple Digressions blog for putting it together). How this divergence reconciles will reveal whether mainstream investors are getting behind this gold move or not.

If they don’t, in the short term gold will stall and gold equities will fall, all the more for the upside leverage they have enjoyed of late. In other words, the gold price has to catch up a bit with equities for their divergence to be sustainable; for that to happen, ETF buying has to ramp up again, and fairly soon.

[January 15^th addendum: last week we saw gold flowing into GLD for the first time in two months.

It wasn’t a huge amount, but it was positive.]

Long term you all know that my gold outlook is grounded in negative real rates: provided inflation increases outpace interest rates, the real rate of interest in America will be negative and that is the most fundamental argument for gold. I have discussed this at length but today I wanted to show a nice chart on the topic that RBC produced.

RBC’s gold analysts ran a regression of the gold price versus real interest rates. As a proxy for real rates they subtracted the US 5-Year-5-Year inflation swap rate (basically the market’s expectation of the average level of inflation over 5 years 5 years from now) from the US 10-Year Treasury.

According to this proxy, real rates today are just a bit above zero (2.356% treasury yield minus 2.06% inflation equals 0.29%). The current gold price of US$1192 is pretty close to the regression average line.

For gold to perform this year, we need inflation to stay ahead of interest rates. I think that will be the case, as I’ve explained before, but this chart shows why real rates matter so much very clearly. Using the regression average, real rates declining to -1% means a gold price of US$1,540 per oz. while a real rate of +1% puts gold at just US$850 per oz.

At the end of the day, the question becomes: What will the Federal Reserve do? The minutes of the last Fed meeting, released just recently, showed a more divided committee than the mid-December rate hike and more aggressive dot plot suggested. And fair enough that they should be divided: the trajectory of the US economy under President Trump is hard to predict.

Will he be able to muster enough support from House Republicans to even pass half of his budget plans? And how long will it take for them to have impact? Can the US economy really grow when bond yields are rising and both corporate and consumer debt loads are so high? Will recent signs of economic strength in Europe persist? Is the dollar topped? (I saw a very interesting argument that sovereign sales of US Treasuries to fund government salaries and programs essentially converts US dollar demand into Euro demand, because so many of those salaries are spent buying European goods, and there is enough such Treasury selling that it represents a significant shift that pushes buying from the USD to the Euro. Check out the article here.)

I think the Fed will want to see Trump’s first 100 days and definitive platform before acting again. Meanwhile interest rates will continue to creep up. And a strengthening US economy that creates a race between interest rates and inflation (with inflation winning) would actually be the best case scenario for mining, as that would mean robust demand for base metals and support gold as a hedge against inflation.

Time will tell. For now, we can enjoy gold regaining a bit of luster and equities leveraging that shine for a time.