10-Year Treasury yields rally, Dollar surges

Ten-year Treasury yields tested support at 4.25% yesterday before rallying to 4.35%. Breakout above 4.35% would suggest a stronger move to test 4.50%.

10-Year Treasury Yield

The Dollar index surged in response and is likely to test resistance at 103.

Dollar Index

Gold weakened slightly, to $2040 per ounce.

Spot Gold

Long-term View

Jim Bianco thinks we are headed for 5.5% yield on 10-Year Treasuries by mid-2024. He says that the 10-year yield should match nominal GDP growth:

  • No recession next year
  • Inflation bottoms around 3%
  • Real growth of 2% to 3%
  • That gives nominal growth of 5.0% to 6.0%.

Growth

Nominal GDP growth ticked up to 6.3% for the 12 months to September, but the long-term trend is downward.

Nominal GDP Growth

Growth in Aggregate weekly hours worked declined to 1.1% for the 12 months to October — a good indicator of real growth.

Estimated Aggregate Non-Farm Weekly Hours Worked

Continued unemployment claims are climbing, suggesting that (real) growth will slow further in the months ahead.

Continued Claims

Inflation

The other component of nominal GDP growth is inflation, where five-year consumer expectations (from the University of Michigan survey) have climbed to above 3.0%.

University of Michigan Inflation Expectations 5-Year

However, core PCE inflation (orange) and trimmed mean PCE (red) are both trending lower.

Core PCE & Trimmed Mean PCE Inflation

Services PCE inflation (brown below) is also trending lower but likely to prove more difficult to subdue.

PCE Services Inflation

Real Interest Rate

Jim Bianco suggests that nominal GDP growth will fall to between 5.0% and 6.0% in 2024 — a good approximate of return on new investment  — while the 10-year yield will rise to a similar level. This represents a neutral rate of interest  that is unlikely to fuel further inflation.

10-Year Treasury Yield & Nominal GDP Growth

Inflation builds when the 10-year yield exceeds GDP growth by a wide margin. The long-term chart below shows how PCE inflation (red) climbs when 10-year Treasury yields minus GDP growth (purple) fall near -5.0%. Inflation also falls sharply when the purple line rises above 5.0%, normally during a recession when GDP growth is negative.

10-Year Treasury Yield minus Nominal GDP Growth & PCE Inflation

Conclusion

Jim Bianco’s premise of 10-year yields at 5.5% is based on the expectation that the Fed will maintain neutral real interest rates in order to tame inflation. Whether the Fed will be able to achieve this is questionable.

Japan and China have stopped investing in Treasuries, commercial banks are net sellers, and the private sector does not have the capacity to absorb growing Treasury issuance to fund federal deficits. That leaves the Fed as buyer of last resort.

The Fed may be forced to intervene in the Treasury market, keeping a lid on long-term yields while expanding the money supply. The likely result will be higher inflation and a weaker Dollar, both of which are bullish for Gold.

Acknowledgements

  • CNBC/Jim Bianco: 10-Year Treasury yield to rebound to 5.5%

S&P 500 rallies while consumer sentiment falls

The University of Michigan Index of Consumer Sentiment declined to 61.3 for November. Levels below 70 in the past have signaled a recession.

University of Michigan Consumer Sentiment

Consumer sentiment is in sharp contrast to robust personal consumption expenditures which at 93% of disposable personal income are well above pre-pandemic levels.

Personal Consumption Expenditure/Disposable Personal Income

Mortgage rates above 7.0% failed to dampen discretionary spending, with most households having locked in low fixed mortgage rates over the pandemic.

30-Year Mortgage Rate

Home Sales

Existing home sales declined to an annual rate of 3.8 million, with households are reluctant to give up their cheap fixed-rate mortgages.

Existing Home Sales

New home sales surged as a result, boosting residential construction.

New One-Unit Home Sales

Inflation Expectations

The University of Michigan November survey shows 1-year inflation expectations increased to 4.50%.

University of Michigan Inflation Expectations 1-Year

Five-year expectations increased to 3.2%, with the 3-month moving average of 3.0% well above the Fed’s 2.0% target.

University of Michigan Inflation Expectations 5-Year

Rising inflation expectations mean that the Fed is unlikely to cut interest rates in the foreseeable future.

Interest Rates

10-Year Treasury yields continue to test support at 4.40% after Treasury weighted new issuance towards the front-end of the yield curve — largely funded by money market funds currently invested in repo. Breach of support would offer a target of 4.0% — bearish for the Dollar.

10-Year Treasury Yield

Stocks

The S&P 500 is testing its July high of 4600. Breakout is uncertain but would not signal a bull market unless confirmed by other indices.

S&P 500

The S&P 500 Equal-Weighted Index ($IQX) has recovered less than 60% of its last decline.

S&P 500 Equal-Weighted Index

The Russell 2000 Small Caps ETF (IWM) is even weaker, retracing less than 50% of its last decline, suggesting that investors have little appetite for risk.

Russell 2000 Small Caps Index iShares ETF (IWM)

Dow Jones Transportation Average has also retraced less than 50%. The Trend Index below zero continues to warn of selling pressure.

Dow Jones Transportation Average ($DJT)

Gold and the Dollar

The Dollar Index retraced to test resistance at 104. Respect is likely and breakout below 103 would offer a target of 100.

Dollar Index

The weakening Dollar is bullish for Gold which is testing resistance at $2000 per ounce. Breakout would offer a short-term target of the previous high at $2050.

Spot Gold

Commodities

Dow Jones Industrial Metals Index ($BIM) fell sharply, warning of another test of primary support at 153. Breach would warn of a global recession, especially if mirrored by a similar breach in Copper.

Dow Jones Industrial Metals Index ($BIM)

Copper is testing its descending trendline at 8300. Reversal below primary support at 7800 would warn of a global recession. China consumes about 50% of the world’s copper production, most of it used in construction. So a lot depends on China’s efforts to rescue their ailing property sector.

Copper

The downward spiral of China’s ailing property sector shows no sign of abating despite the government’s rollout of a seemingly endless series of supportive but as yet ineffective measures, with the crisis stretching for over three years…..

The market for Chinese developers’ dollar-denominated bonds has seen a meltdown over the past two years, losing 87% of its value. The rout has wiped out $135.5 billion of value from $154.9 billion of outstanding notes, according to analysis by Debtwire. (Caixin)

Brent crude is testing resistance at $83 per barrel. Respect would warn of another downward leg to $72 and strengthen a bear market warning from Copper and base metals.

Brent Crude

Conclusion

Personal consumption expenditures remain strong despite falling consumer sentiment. The S&P 500 is testing resistance at 4600 but the advance is narrow, with investors avoiding risk in the broader market.

The Dollar weakened on the back of falling long-term Treasury yields, boosting demand for Gold which is testing resistance at $2000 per ounce. Breakout would offer a short-term target of $2050.

Copper and base metals are expected to again test primary support as doubts remain over China’s ailing property sector. Breach of support would warn of a global recession.

Inflation expectations remain persistent, with five-year expectations at 3.0% in the November University of Michigan consumer survey, well above the Fed’s target of 2.0%. The likelihood of rate cuts in early 2024 is remote unless a major collapse in financial markets forces the Fed’s hand.

Acknowledgements

Macrobusiness: China’s property black hole sucks in the CCP.

Moody’s negative outlook and falling consumer sentiment

Ten-year Treasury yields continue to respect support at 4.50%. We expect another test of resistance at 5.0%.

10-Year Treasury Yield

Moody’s kept their AAA rating for the US government but changed their outlook from stable to negative. The reasons cited  — large deficits and a polarized ineffective Congress — are strong arguments for higher Treasury yields:

Moody's Rating

Japan has also broken above 150 yen to the Dollar, increasing pressure on the BoJ to relax their cap on long-term JGB yields. Any move to relax yield curve control would be likely to cause an outflow from US Treasuries and the Dollar, driving down prices.

USDJPY

Inflation

Inflation expectations are rising, with University of Michigan 1-year expectations jumping to 4.4% — and the 3-month moving average to 3.9%.

University of Michigan Inflation expectations 1-Year

Five-year expectations are also rising, reaching 3.2% in October, with the 3-month moving average at 3.0%.

University of Michigan Inflation expectations 5-Year

Higher inflation expectations add to upward pressure on long-term yields.

Financial Conditions

Financial conditions remain loose — despite the strong rise in long-term yields — with the spread between Baa corporate bonds and the equivalent Treasury yield at a low 1.84%.
Moody's Baa Corporate Bond Spreads

Economic Outlook

Low consumer sentiment, with the University of Michigan Index at 64, continues to warn of a recession.
University of Michigan Consumer Sentiment

Heavy truck sales — a reliable leading indicator — are falling steeply. A fall below 35,000 units would be cause for concern.

Heavy Truck Sales

Stocks

The S&P 500 ended the week stronger, with a bullish candle testing resistance at 4400.

S&P 500

Small caps continue to warn of weakness, however, with the Russell 2000 iShares ETF (IWM) likely to test primary support at 162. Trend Index peaks below zero warn of strong selling pressure. Small caps tend to outperform large caps by a wide margin in the first phase of a bull market — clearly not the case here.

Russell 2000 Small Caps iShares ETF (IWM)

Global Economy

Copper is retracing for another test of primary support at $7800 per metric ton. Breach would warn of a global recession.

Copper

Gold

Gold broke support at $1900 per ounce, indicating a test of $1900. Rising long-term interest rates are undermining investor demand for Gold.

Spot Gold

But Gold is supported by strong central bank purchases, led by China.

Central Bank Gold Purchases & Sales

Australia

The ASX 200 retreated below 7000 on Friday but a bullish close on the S&P 500 should see retracement to test resistance. Declining Trend index peaks, however, warn of rising selling pressure.

ASX 200

Conclusion

We expect upward pressure on long-term Treasury yields to continue, boosted by Moody’s negative outlook for the US, a weakening Japanese Yen and rising inflation expectations.

Declining heavy truck sales and weak consumer sentiment are bearish for the economy. The S&P 500 remains bullish but small caps are more bearish, warning that this is not a broad-based recovery.

Copper breach of $7800 per metric ton would warn of a global recession.

We remain overweight cash, money market funds, short-duration term deposits and financial securities (up to 12 months), defensive stocks, critical materials and gold.

Acknowledgements

The Big Picture: War, Energy, Bonds and Gold

Two inter-connected themes likely to dominate the next few decades are War and Energy.

War may take the form of a geopolitical struggle between opposing ideologies, with conventional wars limited to proxies in most cases and nuclear exchanges avoided because the costs are prohibitive. But it is likely to involve fierce competition for energy and resources in an attempt to undermine opposing economies. The impact is likely to be felt throughout the global economy and across all asset classes, including bonds, stocks and precious metals.

War

War can take many forms: conventional war, nuclear war, proxy war, cold war,  economic war, or some combination of the above.

Nuclear war can hopefully be avoided, with sane leaders skirting mutually assured destruction (MAD). For that reason, even conventional war between great powers is unlikely — but there is a risk of it being triggered by escalation in a war between proxies.

Cold war, with limited trade between opposing powers — as in the days of Churchill’s Iron Curtain — is also unlikely. Global economic interdependence is far higher than sixty years ago.

Greg Hayes, chief executive of Raytheon, said the company had “several thousand suppliers in China and decoupling . . . is impossible”. “We can de-risk but not decouple,” Hayes told the Financial Times in an interview, adding that he believed this to be the case “for everybody”.

“Think about the $500bn of trade that goes from China to the US every year. More than 95 per cent of rare earth materials or metals come from, or are processed in, China. There is no alternative,” said Hayes. “If we had to pull out of China, it would take us many, many years to re-establish that capability either domestically or in other friendly countries.”

What is likely is a struggle for geopolitical advantage between opposing alliances, with economic war, proxy wars, and attempts to build spheres of influence. This includes enticing (or coercing) non-aligned nations such as India to join one of the sides.

Such a geopolitical arm-wrestle is likely to have ramifications in many different spheres, but most of all energy.

Energy

You can’t fight a war without energy. A key element of the geopolitical tussle will be to secure adequate supplies of energy — and to deprive the opposing side of the same.

The situation is further complicated by the attempted transition from fossil fuels to low-carbon energy sources.

Since the Industrial revolution, development of the global economy has been fueled by energy from fossil fuels, with GDP and fossil fuel consumption growing exponentially. Gradual transition to alternative energy sources would be a big ask. To attempt a rapid transition while in the midst of geopolitical conflict could end in disaster.

Global Energy Sources

The challenge is further complicated by attempts to replace fossil fuels with wind and solar which generate intermittent power. Base-load power — generated from fossil fuels or nuclear — is essential for many industries. Microsoft are investigating the use of nuclear to power data centers. The US Department of Defense (DoD) has commissioned Oklo Inc. to design and build a nuclear micro-reactor to power Eielson Air Force Base in Alaska. Renewables are a poor option for critical applications.

Russia’s 2022 invasion of Ukraine highlighted Germany’s energy vulnerability despite billions of Euros invested in renewables over recent decades. You cannot run a modern industrialized economy without reliable energy sources.

Low investment in fossil fuel resources — which fail to meet ESG standards — has further increased global vulnerability to energy shortages during the transition.

Inflation

War and pandemics cause high inflation. Governments run large deficits during times of crisis, funded by central bank purchases in the absence of other investors. This causes rapid expansion of the money supply, leading to high inflation.

Geopolitical conflict and the attempt to rapidly transition to carbon-free fuels — while neglecting existing resources — are both likely to cause a steep rise in energy costs.

Energy Prices

Bond Market

The bond market has the final say. The recent steep rise in long-term Treasury yields is the bond market’s assessment of fiscal management in the US. The deeply divided House of Representatives has effectively been awarded an “F” on its economic report card.

10-Year Treasury Yield

Failure of a divided government to address fiscal debt at precarious levels and rein in ballooning deficits raises a question mark over future stability, with the bond market demanding a premium on long-term issues.

The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions. (Fitch Ratings)

CBO projections show federal debt held by the public rising from 98% of GDP today to 181% in thirty years time.

CBO Debt Projections

Rising long-term yields also add to deficits as servicing costs on existing debt increase over time. The actual curve is likely to be even steeper. CBO projections assume an average interest rate of 2.5%, while current rates are close to 5.0%.

Yield Curve

Continuing large fiscal deficits in the next few decades appear unavoidable. The result is likely to be massive central bank purchases of fiscal debt — as in previous wars/pandemics — with negative real interest rates (red circles below) driving higher inflation (blue) and rising inequality.

Moody's Aaa Corporate Bond Yield & CPI

Political instability

Interest rate suppression effectively subsidizes borrowers at the expense of savers. Only the wealthy are able to leverage their large balance sheets, buying real assets while borrowing at negative real interest rates. Those less fortunate have limited access to credit and suffer the worst consequences of inflation, further accentuating the division in society and fostering political instability as populism soars.

Commodities

Resources are likely to be in short supply, from under-investment during the pandemic, geopolitical competition, and the attempted rapid transition to new energy sources. Prices are still likely to fall if global demand shrinks during a recession. But growing demand, shrinking supply (from past under-investment) and inflation pushing up production costs are expected to lead to a long-term secular up-trend.

Copper

Gold

High inflation, negative real interest rates and geopolitical competition are likely to weaken the Dollar, strengthening demand for Gold as a safe haven and inflation hedge. Breakout above $2000 per ounce would offer a long-term target of $3000.

Spot Gold

Conclusion

We expect large government deficits and shortages of energy and critical materials — such as Lithium and Copper — the result of a geopolitical struggle and attempt to transition to low-carbon energy sources over several decades.

Rising government debt will necessitate central bank purchases as the bond market drives up yields in the absence of foreign buyers. The likely result will be high inflation and interest rate suppression as central banks and government attempt to manage soaring debt levels and servicing costs.

Our strategy is to be overweight commodities, especially critical materials required for the transition to low-carbon fuel sources; short-term bonds and term deposits; and defensive (value) stocks.

We are also overweight energy, including: heavy electrical; nuclear technology; uranium; and oil & gas resources.

Gold is more complicated. Rising long-term interest rates will weaken demand for Gold, while geopolitical turmoil will strengthen demand, causing a see-sawing market with high volatility. If long-term yields fall — due to central bank purchases of US Treasuries — expect high inflation. That would be a signal to load up on Gold.

We are underweight growth stocks and real estate. Rising long-term interest rates are expected to lower earnings multiples, causing falling prices. Collapsing long-term yields due to central bank purchases of USTs, however, would cause negative real interest rates. A signal to overweight real assets such as growth stocks and real estate.

Long-term bonds are plunging in value as long-term yields rise, with iShares 20+ Year Treasury ETF (TLT) having lost almost 50% since early 2020.

iShares 20+ Year Treasury ETF

The trend is expected to reverse when Treasury yields peak but timing the reversal is going to be difficult.

Acknowledgements

Copper breaks support while crude gets hammered

Copper broke support at $7900/tonne, signaling a primary decline with a target of its 2022 low at $7000. The primary down-trend warns of a global economic contraction.

Copper

The bear signal has yet to be confirmed by the broader-based Dow Jones Industrial Metals Index ($BIM) which is testing primary support at 155.

DJ Industrial Metals Index ($BIM)

Crude oil

Crude fell sharply this week, after a 3-month rally.

Nymex Light Crude

The fall was spurred by an early build of gasoline stocks ahead of winter, raising concerns of declining demand.

Gasoline inventories added a substantial 6.5 million barrels for the week to September 29, compared with a build of 1 million barrels for the previous week. Gasoline inventories are now 1% above the five-year average for this time of year….. production averaged 8.8 million barrels daily last week, which compared with 9.1 million barrels daily for the prior week. (oilprice.com)

Gasoline Stocks

Crude inventories have stabilized after a sharp decline during the release of strategic petroleum reserves (SPR).

EIA Crude Inventory

Releases from the SPR stopped in July — which coincides with the start of the recent crude rally. It will be interesting to see next week if a dip in this week’s SPR contributed to weak crude prices.

Strategic Petroleum Reserves (SPR)

Stocks & Bonds

The 10-year Treasury yield recovered to 4.78% on Friday.

10-Year Treasury Yield

Rising yields are driven by:

  • a large fiscal deficit of close to $2T;
  • commercial banks reducing Treasury holdings; and
  • the Bank of Japan allowing a limited rise in bond yields which could cause an outflow from USTs.

Bank of Japan - YCC

The S&P 500 rallied on the back of a strong labor report.

S&P 500

The S&P 500 Equal-Weighted Index test of primary support at 5600 is, however, likely to continue.

S&P 500 Equal-Weighted Index

Expect another Russell 2000 small caps ETF (IWM) test of primary support at 170 as well.

Russell 2000 Small Caps ETF (IWM)

Labor Market

The BLS report for September, with job gains of 336K, reflects a robust economy and strong labor market.

Job Gains

Average hourly earnings growth slowed to 0.207% in September, or 2.5% annualized. Manufacturing wages reflect higher growth — 4.0% annualized — but that is a small slice of the economy compared to services.

Average Hourly Earnings

Average weekly hours worked — a leading indicator — remains stable at 34.4 hours/week.

Average Weekly Hours

Unemployment remained steady at 6.36 million, while job openings jumped in August, maintaining a sizable shortage.

Job Openings & Unemployment

Real GDP (blue) is expected to slow in Q3 to 1.5%, matching declining growth in aggregate weekly hours worked (purple).

Real GDP & Hours Worked

Dollar & Gold

The Dollar Index retraced to test new support at 106 but is unlikely to reverse course while Treasury yields are rising.

Dollar Index

Gold is testing primary support at $1800 per ounce, while Trend Index troughs below zero warn of selling pressure. Rising long-term Treasury yields and a strong Dollar are likely to weaken demand for Gold.

Spot Gold

Conclusion

Long-term Treasury yields are expected to rise, fueled by strong supply (fiscal deficits) and weak demand (from foreign investors and commercial banks). The outlook for rate cuts from the Fed is also fading as labor market remains tight.

The sharp drop in crude oil seems an overreaction when the labor market is strong and demand is likely to be robust. Further releases from the strategic petroleum reserve (SPR), a sharp fall in Chinese purchases, or an increase in supply (from Iran or Venezuela) seem unlikely at present.

Falling copper prices warn of a global economic contraction led by China, with Europe likely to follow. Confirmation by Dow Jones Industrial Metals Index ($BIM) breach of primary support at 155 would strengthen the bear signal.

Strong Treasury yields and a strong Dollar are likely to weaken demand for Gold unless there is increased instability, either geopolitical or financial.

Putin’s war

“The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets”.

Vladimir Putin gave some insight, last week, into his strategy to force Europe to withdraw its support for Ukraine. It involves two steps:

  1. Use energy shortages to drive up inflation;
  2. Use inflation to undermine confidence in the Euro and Dollar.

Will Putin succeed?

There are plenty of signs that Europe is experiencing economic distress.

When asked whether he expected a wave of bankruptcies at the end of winter, Robert Habeck, the German Federal Minister for Economic Affairs and Climate Action, replied:

Robert Habeck

Belgian PM Alexander De Croo also did not pull his punches:

“A few weeks like this and the European economy will just go into a full stop. The risk of that is de-industrialization and severe risk of fundamental social unrest.” (Twitter)

Steel plants are shutting down blast furnaces as rising energy prices make the cost of steel prohibitive. This is likely to have a domino effect on heavy industry and auto-manufacturers.

Europe: Steel Production

Aluminium smelters face similar challenges from rising energy costs.

Europe: Aluminium

How is the West responding?

Europe is reverting to coal to generate base-load power.

German Coal

And increasing shipments of LNG. Germany is building regasification plants and has leased floating LNG terminals but there are still bottlenecks as the network is not designed around receiving gas from Russia in the East, not ports in the West.

Europe LNG

Also, extending the life of nuclear power plants which were scheduled to be mothballed.

The new British prime minister, Liz Truss, is going further by lifting the ban on fracking. But new gas fields and related infrastructure will take years to build.

The President of the EC, Ursula von der Leyen’s announcement of increased investment in renewables will also be of little help. It takes about 7 years to build an offshore wind farm and the infrastructure to connect it to the grid.

Energy subsidies announced are likely to maintain current demand for energy instead of reducing it. A form of government stimulus, subsidies are also expected to increase inflation.

Price cap

The G7 has also responded by announcing a price cap on Russian oil. The hope is that the Russians will be forced to keep pumping but at a reduced price, avoiding the shortages likely under a full embargo.

Vladimir Putin, however, will try to create an energy crisis in an attempt to break Western resolve.

Russian Oil

Putin responded to the price cap at the Asian Economic Forum, on Wednesday, in Vladivostok:

“Russia is coping with the economic, financial and technological aggression of the West. I’m talking about aggression. There’s no other word for it…….

We will not supply anything at all if it is contrary to our interests, in this case economic. No gas, no oil, no coal, no fuel oil, nothing.”

Ed Morse at Citi has expressed concerns about the price cap, calling it “a poor judgement call as to timing.” His concerns focus on the political implications of Winter hardship in Europe, especially with upcoming elections in Italy, the potential effect of lower flows out of Russia, and the impact increased demand for US oil would have on domestic prices.

The Dollar

Attempts to undermine the Dollar have so far failed, with the Dollar Index climbing steadily as the Fed hikes interest rates.

Dollar Index

While Gold has fallen.

Spot Gold

Conclusion

The West is engaged in an economic war with Russia, while China and India sit on the sidelines. War typically results in massive fiscal deficits and soaring government debt, followed by high inflation and suppression of bond yields.

We expect high inflation caused by (1) energy shortages; and (2) government actions to alleviate hardships which threaten political upheaval.

The Fed and ECB are hiking interest rates to protect their currencies but that is likely to aggravate economic hardship and increase the need for government spending to alleviate political blow-back.

We maintain our bullish long-term view on Gold. Apart from its status as a safe haven — especially when the Dollar and Euro are under attack — we expect negative real interest rates to boost demand for Gold as a hedge against inflation. In the short-term, breach of support at $1700 per ounce would be bearish, while recovery above the descending trendline (above) would signal that a base is forming. Follow-through above $1800 would signal another test of resistance at $2000.

Acknowledgements

Brookings Institution: Discussion on the Price Cap
FT Energy Source: How Putin held Europe hostage over energy
Alfonso Peccatiello: Putin vs Europe – The Long War
Andreas Steno Larsen: What on earth is going on in European electricity markets?

Gold breaks $1850 per ounce

10-Year Treasury yields remain soft despite the recent CPI spike. The Fed is weighting purchases more to the long end of the yield curve. Breakout above 1.75% (green line) would signal a fresh advance.

10-Year Treasury Yield

10-Year TIPS yield sits at -0.78%, unaffected by the $369bn in overnight Fed reverse repurchase agreements which remove liquidity but mainly affect short-term interest rates.

10-Year TIPS Yield & Fed RRP

Gold broke through resistance at $1850/ounce. A rising Trend Index indicates medium-term buying pressure. Long tails on the last three daily candles indicate retracement to test the new support level; respect signals a test of $1950/ounce.

Spot Gold

Silver is testing resistance at $28/ounce. Rising Trend Index indicates medium-term buying pressure. Breakout above $28 is likely and would offer a target of $30/ounce in the short/medium-term.

Spot Silver

The Dollar index is testing primary support between 89 and 90. Rising Trend Index (below zero) suggests another test of the descending trendline. Respect is likely and breach of primary support would offer a medium/long-term target of 851.
Dollar Index

From Luke Gromen at FFTT:

When you are an externally-financed twin deficit nation with insufficient external funding (as Druckenmiller pointed out), there are three potential release valves:

  1. Higher unemployment.
  2. Higher interest rates.
  3. Lower currency (inflation.)

With US debt/GDP at 130%, Options #1 and #2 aren’t an option……

Conclusion

We expect long-term Treasury yields to remain low while inflation rises, causing the US Dollar to sink and Gold and Silver to advance.

Our long-term target for Gold of $3,000 per troy ounce2.

Notes

  1. Dollar Index (DXY) target of 85 is calculated as the peak of 93 extended below support at 89.
  2. Gold LT target calculation: base price of $1840/ounce + [TIPS yield of -0.87% – (nominal Treasury yield of 1.64% – real inflation rate of 5.30%)] * $400/ounce = $2956/ounce

Inflation is baked into the cake

Inflation is a hot topic at the moment. For good reason: higher inflation would drive up interest rates, affecting both bond and equity prices, as well as commodities and precious metals.

March CPI jumped to 2.64% but the increase is partly attributable to the low base from March 2020. Core CPI (excluding food and energy) came in at a more modest 1.65%. The main difference between CPI and core CPI is rising energy and food costs.

CPI & Core CPI

The annual inflation rate in the US ……is the highest reading since August of 2018 with main upward pressure coming from energy (13.2% vs 3.7% in February), namely gasoline (22.5% vs 1.6%), electricity (2.5% vs 2.3%) and utility gas service (9.8% vs 6.7%). Prices also accelerated for used cars and trucks (9.4% vs 9.3%), shelter (1.7% vs 1.5%) and new vehicles (1.5% vs 1.2%) while inflation slowed for medical care services (2.7% vs 3%) and food (3.5% vs 3.6%). Cost of apparel continued to fall (-2.5% vs -3.6%)……..a jump in commodities and material costs, coupled with supply constraints, are pushing producer prices up and some companies are passing those costs to clients. (Reuters)

10-year Treasury yields eased to 1.62% with the breakeven inflation rate at 2.33% — weakening the real 10-year yield to -0.71%.

10-Year Treasury Yield & Breakeven Inflation Rate

Inflation and the Money Supply

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

CPI & M2 Money Supply

But experience since the 1980s shows several surges in money supply growth without a corresponding rise in inflation. While an increase in money supply may be a prerequisite for a spike in inflation, it is not the cause.

More direct causes of inflation are increases in input costs for suppliers of goods and services. The two largest input costs are commodities and wages. Rises in commodity prices will mostly affect the manufacturing sector, while increases in wage rates impacts on all employers. Also, commodity prices tend to be cyclical, so price fluctuations will be more readily absorbed, while wage increases tend to be permanent and more likely to be passed on to customers.

The chart below shows a much closer correlation between hourly wage rates and CPI since the 1970s, with surges in hourly earnings accompanied by a rise in inflation.

CPI & Hourly Manufacturing Wages

Conclusion

Rising commodity prices are driving higher inflation at present. While some of the pressures may be transitory, due to supply interruptions, underinvestment in new production over the last decade is likely to act as a supply constraint for both energy and base metals. Rising demand fueled by short-term stimulus and longer-term infrastructure investment would act as an accelerant.

Wage rate increases are so far restrained, but that is likely to change as the economy recovers, boosted by decoupling from China and on-shoring of critical supply chains. Shortages of skilled labor are expected to drive up wage rates, maintaining upward pressure on inflation in the longer-term. Training and education of suitable staff will take time.

We have all the ingredients for an inflation spike. A massive boost in the money supply, accompanied by record stimulus payments, much of which has been channeled into savings. This will help to fuel increased demand in the longer term, while restricted supply will drive up commodity prices and wage rates for skilled labor.

Gold testing resistance despite Dollar rise

Signing of the US-China phase one trade deal did little to quell demand for Gold, with the precious metal continuing to test resistance at $1560/ounce. But a strengthening Dollar makes another test of primary support at $1450 likely.

Gold (USD/ounce)

Silver is similarly testing resistance at $18 to $18.50, but declining Trend Index peaks below zero warn of stronger selling pressure. Expect another test of support at $16.50.

Silver (USD/ounce)

The Dollar Index rallied off support at 96.50. Breakout above 98 would offer a medium-term target of 99.50.

Dollar Index

China’s Yuan, on the other hand, is strengthening against the Greenback, with rising Trend Index troughs indicating buying pressure. Expect retracement to test support at 14.35 US cents, but the outlook for the Yuan against the Dollar is bullish and respect of support would offer a target of 15 US cents.

CNYUSD

10-Year Treasury yields are ranging between support at 1.70% and resistance at 2.00%. A rising Yuan is bullish for yields and may cause another test of resistance at 2.0%. Breakout would offer a target of 2.50%. But increased use of mortgage-backed securities (MBS) as collateral in Fed repo operations may help to suppress long-term yields.

10-Year Treasury Yields

In summary:

  • A rising US Dollar is bearish for Gold.
  • Rising treasury yields increase the opportunity cost of holding precious metals and are bearish for Gold.
  • Geo-political instability (e.g. ongoing US-China/US-Iran tensions) is bullish for Gold.
  • Low oil prices and low inflation are bullish for the Dollar and bearish for Gold.

Nymex Light Crude

Australia

Australia’s All Ordinaries Gold Index is testing resistance at 7200 after a brief retracement to 6800. Breakout from the trend channel is bullish for Gold stocks. Follow-through above 7200 would strengthen the signal.

All Ordinaries Gold Index

Patience

Gold is in a long-term up-trend and the current correction may offer an attractive entry point. We have a breakout from the downward trend channel but could still experience a re-test of support at 6000. Proceed with caution.

Gold bearish on imminent phase 1 deal

The U.S. and China are finalizing a bevy of long-running corporate deals ahead of a high-profile ceremony to sign a trade deal next week that the world’s largest economies seek to cast as a major breakthrough and a marked warming in the relationship. Along with a Chinese delegation led by top negotiator Vice Premier Liu He, executives from American and Chinese companies will also attend the White House event to sign the phase-one agreement on Jan. 15, said the people, who asked not be named discussing private plans. (Bloomberg)

Gold retreated on news that signing of the US-China phase 1 deal is imminent. A tall shadow on the weekly chart warns of selling pressure.  Another test of primary support at $1450 is likely.

Gold (USD/ounce)

Silver also retreated, while declining Trend Index peaks below zero warn of strong selling pressure. Expect another test of support at $16.50.

Silver (USD/ounce)

China’s Yuan broke resistance at 14.35 US cents, while rising Trend Index troughs indicate buying pressure. Expect retracement to test support, but the outlook for the Yuan against the Dollar is turning bullish.

CNYUSD

10-Year Treasury yields found support at 1.70% and a rising Yuan is likely to cause another test of resistance at 2.0%. Breakout would offer a target of 2.50%.

10-Year Treasury Yields

Rising treasury yields increase the opportunity cost of holding precious metals and are bearish for Gold.

Australia

Australia’s All Ordinaries Gold Index penetrated the upper border of its downward trend channel but this week’s tall shadow warns of selling pressure and another test of support at 6000.

All Ordinaries Gold Index

Respect of support at 6000, with follow-through above 7000, would signal that a base has formed.

Patience

Gold is in a long-term up-trend and the current correction may offer an attractive entry point. But we first need a clear breakout from the downward trend channel to confirm that the up-trend is intact.