With its inverse correlation with the yellow metal, the next move in the 10-Year-Treasury yield can cause gold to have a rough time.
Gold declined yesterday (Apr. 22), and the GDXJ is back below its late-Feb. highs. All things considered, the rallies in both appear to be over or almost over.
Just as I did yesterday, I will start the analysis with the long-term picture of the HUI Index – the flagship proxy for gold stocks.
Please note that the 2007 – 2008 and the 2009 – 2012 head and shoulders pattern didn’t have the right shoulders all the way up to the line that was parallel to the line connecting the bottoms. I marked those lines with green in the above-mentioned formations. In the current case, I marked those lines with orange.
Now, even though the above wasn’t the case, in both cases, the final top – the right shoulder formed close to the price where the left shoulder topped. The left shoulder that formed in early 2020 topped at 303.02.
I previously wrote that it wouldn’t be surprising to see a move to about 300 in the HUI Index, and that’s exactly what we saw – this week’s high was slightly above 299.
This means that the recent rally is not a game-changer, but rather a part of a long-term pattern that’s not visible when one focuses on the short-term only.
The thing is that the vast majority of individual investors and – sadly – quite many analysts focus on the trees while forgetting about the forest. During the walk, this might result in getting lost, and the implications are no different in the investment landscape.
From the day-to-day perspective, a weekly – let alone monthly – rally seems like a huge deal. However, once one zooms out and looks at the situation from a broad perspective, it’s clear that:
What has been will be again, what has been done will be done again; there is nothing new under the sun. (-Ecclesiastes 1:9)
The rally is very likely the right shoulder of a broad head and shoulders formation. “Very likely” and not “certainly”, because the HUI Index needs to break to new yearly lows in order to complete the pattern – for now, it’s just potential. However, given the situation in the USD Index (i.a. the positions of futures traders as seen in the CoT report, and the technical situation in it), it seems very likely that this formation will indeed be completed. Especially when (not if) the general stock market tumbles.
Miners: GDX and GDXJ
As far as the GDX ETF is concerned, I previously wrote that it could move slightly above $37, and even if it did, it would not invalidate the broad head and shoulders pattern. Well, the GDX didn’t move to $37, but it was quite near to doing so. It was close enough for this rally to be very similar to what we saw in May, 2020.
The GDXJ – a proxy for junior mining stocks – declined yesterday, and it’s now back below its late-Feb. highs - please note how weak it remains relative to other proxies for mining stocks. Unlike the HUI or the GDX, the GDXJ didn’t move visibly above its late-Feb. highs and it had already invalidated this small breakout.
The ratio between the two ETFs has been declining since the beginning of the year, which is remarkable because the general stock market hasn’t plunged yet. This tells us that when stocks finally slide, the ratio is likely to decline in a truly profound manner – perhaps similarly to what we saw last year.
Gold: Is the Top In?
Now, as far as gold is concerned, we saw a move lower after an attempt to rally above the psychologically important (due to it being a round number) $1,800 level and the 300-day moving average (at $1,801.39).
This perfectly fits the scenario in which the HUI Index will start to decline soon, thus completing the broad head and shoulders formation so similar to the patterns that triggered the massive 2008 and 2013 slides.
Interestingly, gold didn’t rally today despite the pre-market lowering in the USD Index, which suggests that the top might have already been formed.
Indeed, the USD Index declined once again, and traders likely thought that the short-term correction was over, so they got back in the sell-USDX mood. However, the 61.8% Fibonacci retracement was not broken, and, consequently, it’s likely to stop the current attempt to move lower once again.
Please note that during the previous important short-term bottom – in late Feb. 2021 – the USD Index’s bottom took a few days and ended with a very brief – intraday – slide. This was the thing that triggered the next big upswing in the USDX, and the sizable downswing in the PMs. This time the following rally is likely to be even bigger.
I wouldn’t be surprised to see this weekend without any major reversal, but we could see one on Monday. Some traders won’t be able to adjust their stop-loss levels at that time, so if anyone “big” wants to squeeze the profits out of individual traders shorting the USDX before the latter rallies, it would be a perfect time. The idea could be to trigger a small sell-off early on Monday, which would then trigger stop-loss selling, and it would allow the “big” market participant to re-enter the long positions at lower prices. I’m not saying that it’s the most likely scenario, though, only that it wouldn’t surprise me to see something like that.
Having said that, let’s take a look at the markets from a more fundamental angle:
The Ball Is In Your Court
With a late-afternoon freak-out on Apr. 22 – incited by U.S. President Joe Biden’s rumored increase in the region’s capital gains tax – ushering gold back below $1,790, investors’ ‘get me out of here’ attitude was the first real bout of volatility that we’ve witnessed in over a month.
However, while Biden’s new-found fondness for austerity garnered all of the headlines, a slightly more important event was already unfolding. Case in point: despite the weakness in U.S. equities causing a bid for U.S. Treasuries, the U.S. 10-Year Treasury yield still managed to hold its 50-day moving average (MA). Moreover, with the October 2019 and January 2020 lows not far behind, the U.S. 10-Year Treasury yield may be only five basis points away from forming a lasting bottom.
Please see below:
Along for the ride, the U.S. Treasury 10-2 spread fell to 1.39% on Apr. 22. More importantly, though, the milestone marks a 20-basis-point decline from its March peak, and if the bottom is in, the duration from peak to trough has reached 18 trading days.
Please see below:
To explain the significance, I wrote on Apr. 20:
When the green line above is rising, it means that the U.S. 10-Year Treasury yield is increasing at a faster pace or declining at a slower pace than the U.S. 2-Year Treasury yield. Conversely, when the green line above is falling, it means that the U.S. 2-Year Treasury yield is increasing at a faster pace or declining at a slower pace than the U.S. 10-Year Treasury yield.
If you analyze the horizontal red line, 1.30% is where historical roads got a little rocky. However, after recording a major bottom, rallying above 1.30% and then suffering a meaningful correction, the 10-2 spread proceeded to rally to 2.18% (1991), 2.16% (2002) and 2.60% (2008) before suffering a second meaningful correction.
Moreover, the behavior of the 10-2 spread in 1991 and 2001/2002 is nearly identical to the current behavior: after reaching an interim peak in 1991, the 10-2 spread declined by 26 basis points over a 24-day stretch. Likewise, in 2001, the 10-2 spread declined by 20 basis points over a 17-day stretch. Conversely, the 10-2 spread followed its 1991 swoon by rallying by 80 basis points over the following 57 days. Similarly, the 10-2 spread followed its 2001 swoon by rallying by 105 basis points over the following 97 days (into 2002).
Thus, with the 10-2 spread’s current behavior mirroring 2001, a bottom could be imminent. Moreover, while the 1991 analogue implies immaterial weakness continuing into next week, whenever the 10-2 spread officially bottoms, historical precedent implies that we’ll see a significant rally off of the lows. Furthermore, while an equity rout has the potential to disrupt the timeline – as a safe-haven bid for U.S. Treasuries often coincides with meaningful stock market pullbacks – the PMs are unlikely to elicit strength once the equity market falters.
The bottom line? Once the U.S. 10-Year Treasury yield forms a medium-term bottom, expect the PMs to form a medium-term top.
And why is that?
Well, gold and the U.S. 10-Year Treasury yield have demonstrated an inverse relationship for quite some time. Case in point: back in October 2018, the yellow metal’s bottom occurred alongside the U.S. 10-Year Treasury yield’s top. Similarly, in August 2020, the yellow metal’s top occurred alongside the U.S. 10-Year Treasury yield’s bottom.
Please see below:
In addition, if you analyze the right side of the chart, you can see that battle lines have officially been drawn. With gold moving higher amid the U.S. 10-Year Treasury yield’s recent consolidation, the yellow metal has exuded confidence. However, with the current divergence occurring at a time when gold is near its historical highs and the U.S. 10-Year Treasury yield is near its historical lows, August’s reversal of fortunes is likely far from over.
But what’s stopping the U.S. 10-Year Treasury yield from moving lower?
Well, adding to the historical precedent that I already outlined above, the Cboe Interest Rate Swap Volatility Index (SRVIX) remains on high alert. After surging by another 6.14% on Apr. 20, the SRVIX has barely come down from the recent spike.
Please see below:
And with Coca-Cola announcing on Apr. 19 that the company will raise prices to offset higher commodity costs, I warned on Apr. 20 that inflation jitters are unlikely to abate anytime soon.
When asked about the company’s response to the inflationary pressures – during Coca-Cola’s first-quarter earnings call on Apr. 19 – CFO John Murphy had this to say:
So, let’s connect the dots: commodity inflation has surged and Murphy expects “pricing in line with inflation.” As a result, doesn’t the 5-Year breakeven inflation rate look more and more like a sleeping giant?
If that wasn’t enough, with lumber futures hitting ‘limit up’ on Apr. 19 – meaning that the contract rose so rapidly that regulators were forced to suspend trading for the day – we’ve witnessed a more than 50% rise in less than four months. But not to be outdone, corn futures have already surged by more than 11% this week (as of the Apr. 22 close).
Please see below:
Continuing the theme, the Empire State Manufacturing Survey – a monthly survey of business conditions conducted by the New York Federal Reserve (FED) – revealed that not only are manufacturers’ input costs rising, but their output prices have hit an all-time high.
Furthermore, if you analyze the chart below, you can see that the record print is sharply higher than any other comparable reading since the Global Financial Crisis (GFC).
And looking to front-run the action, clients of JP Morgan have pushed their U.S. 10-Year Treasury short positions to their highest level since 2018.
Please see below:
To explain, the brown line above tracks the U.S. 10-Year Treasury yield (the mid-price), while the black line above tracks the proportion of JP Morgan’s clients that short the U.S. 10-Year Treasury. If you analyze the right side of the chart, you can see that even amid the U.S. 10-Year Treasury yield’s recent consolidation, JP Morgan’s clients have been aggressively adding to their short positions.
Furthermore, with Bank of America’s latest Global Fund Manager Survey revealing what we already know, institutional investors remain increasingly fearful of a bond market sell-off. With inflation fears and a potential taper tantrum still accounting for roughly 60% of what keeps institutional investors up at night, if the prospect unfolds, the PMs won’t be the only assets affected by the unwind.
In conclusion, while Thursday (Apr. 22) afternoon was quite entertaining, the PMs’ fireworks have yet to begin. With the USD Index catching a bid on Apr. 22 and the U.S. 10-Year Treasury yield already aligning with technical and historical support, the road ahead for the PMs could become increasingly treacherous. Furthermore, while the European Central Bank’s (ECB) Thursday meeting was largely uneventful, The Governing Council said that PEPP purchases are still going to be “conducted at a significantly higher pace than during the first months of the year.” Thus, despite the EUR/USD’s muted reaction, the ‘same old, same old’ remains USD bullish, as relative outprinting and Eurozone-U.S. growth differentials should weigh on the currency pair over the medium term. As a result, the USD Index is poised to be the main beneficiary, while the PMs will likely be stuck with the short end of the stick.
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Przemyslaw Radomski, CFA