Gold Reaches Highest Price Since 2012

July 6, 2020

Gold bullion1 continued to deliver strong performance and was up 17.38% YTD through June 30, 2020, and 26.36% YOY. At the same time, gold mining equities (SGDM)2 have gained 25.88% YTD, and 44.00% YOY as of June 30. This compares to -3.08% YTD and 7.51% YOY returns for the S&P 500 TR Index.6 Silver posted substantial gains in June and is on the move again; silver is up 1.99% YTD and 18.88% YOY as of June 30.

Month of June 2020

Gold rose $51 in June to close at $1,781 per ounce, its highest level since Q4 2012. Gold's performance in June was propelled mainly by the fall of the U.S. 10-YR Treasury Real Yield. Investor interest continues to climb, with gold bullion in ETFs reaching an all-time high and year-to-date buying at a 55% annualized rate. Gold equities and silver consolidated gains near their recent highs as the precious metals bull market marches on.

Figure 1. Gold Continues to Outperform Other Major Asset Classes (Short-Term View YTD 2020)

Long-Term View (2000 - 6/30/2020)

Source: Bloomberg. Data as of 6/30/2020. Gold is measured by GOLDS Comdty; S&P 500 TR is measured by the SPX; U.S. Agg. Bond Index is measured by the Bloomberg Barclays US Agg Total Return Value Unhedged USD (LBUSTRUU Index); and the U.S. Dollar is measured by DXY Curncy. Past performance is no guarantee of future results.

Gold as Both Long and Short Duration Asset

We highlighted in last month's Gold Report (The New Normal) that gold would begin to exhibit behavior as both a long and short duration asset. It may be early, but the bond market is starting to present some of the features one would expect under a yield curve control (YCC) environment. The most notable is the 10-YR real yield (10-year TIPs yield). After several choppy months, 10-YR TIPs yields are breaking lower from a flag pattern. As breakeven yields break higher on growth expectations (black line in Figure 2), the 10-year nominal yields remain anchored in place (red line), driving real yields more negative (green line). It is starting to look like real yields are getting ready to break much lower (deeper negative yields).

Figure 2. U.S. Treasury 10-YR Real Yields Breaking Lower as Breakeven Yields Rise (YTD 2020)

Source: Bloomberg. Data as of 6/30/2020.

As the economy continues to recover (or at least exceed expectations), breakeven yields will widen further. If nominal yields stay flat due to QE (quantitative easing) and YCC expectations, real yields will continue to fall. This yield condition may also be the desired Federal Reserve (Fed) outcome. A slightly rising breakeven yield would signal to investors that growth is rebounding, and the threat of deflation is off the table. Additionally, real yields going further negative would incentivize risk-taking and would debase debt levels.

Figure 3 highlights gold's relationship with real yields. In the past two years, R-squared is 85% (R2 is a statistical measure that represents the proportion of the variance for a dependent variable that's explained by an independent variable or variables in a regression model). The relationship between gold and real yields is the most consistent and pronounced through almost all periods ⁠— lower real yields equal higher gold prices. Gold is now exhibiting behavior as a short duration asset. If the recovery continues, real yields will fall further, pushing gold bullion higher.

Figure 3. Gold Bullion and U.S. 10-Year TIPs Yields Have Strong, Inverse Correlation (2018-2020)

Source: Bloomberg. Data as of 6/30/2020.

Though gold bullion held in ETFs is making almost daily highs, CFTC Non-Comm long positioning is not. The CFTC gold long positions remain below the highs. Figure 4 shows the relationship between real yields (black line) and CFTC Non-Comm longs (orange line, inverted scaling). As a reminder, CFTC positioning is dominated by quants or CTAs (Commodity Trading Advisors, i.e., quant funds, an investment fund that selects securities using advanced quantitative analysis). CTA positioning is generally light across most asset classes. As markets continue to normalize, we expect CFTC exposures will return to their highs, which would be a significant source of buying. CFTC longs returning to the recent highs would be about 10 million oz. of buying from current levels or nearly half of all ETF buying in 2020.

Figure 4. CFTC Non-Commercial Long Positions and 10-Year TIPs Yields: Room to Add Positions (2016 - 2020)

Source: Bloomberg. Data as of 6/30/2020.

The COVID-19 Pandemic: A Crisis Like No Other and a Policy Response Like No Other

The market action since the March lows is a stark reminder that the transmission mechanism of monetary policy to the real economy is not remotely as effective nor as immediate as the transmission to financial assets. Officially, the U.S. entered recession in February 2020 when the stock market made its all-time high. From the start of the expansion in June 2009, this was the longest positive run on record. Though the stock market may be discounting a potential V-shaped recovery, it is still too early to call an end to the recession.

This month the IMF (International Monetary Fund), OECD (Organisation for Economic Co-operation and Development) and the World Bank have come out with estimates for global GDP (gross domestic product) growth for 2020. The numbers range from -5% to -6% for 2020, based on a single wave of COVID-19 infection. GDP estimates are likely to fall an additional -1% to -1.5% if a second wave were to materialize. Perhaps the IMF summed it up the economic impact of COVID-19 best: "a crisis like no other." The simultaneous and sudden demand and supply shock hitting the entire global economy has no real historical comparisons.

The rearview mirror perspective among policymakers was that during the GFC (global financial crisis of mid-2007 o early 2009) period, there was too much focus on debt-to-GDP, and a premature shift back to austerity produced a weaker than expected post-GFC recovery (not enough stimulus). This time, there is even greater willingness to provide more stimulus, especially on the fiscal side. Since February 2020, the balance sheets of the Fed, ECB (European Central Bank) and the Bank of Japan have increased by $3.8 trillion to $19.5 trillion (+24%), and more stimulus is coming. The U.S. is flirting with outright deflation as core CPI (Consumer Price Index) is now negative for three straight months. The latest data shows a marked increase in the savings rate and concerns of higher expected future taxes will blunt the effect of fiscal stimulus. The Fed will counter by disincentivizing savings with negative real yields, and use QE to push investors out and down the risk curve. If needed, the Fed may engineer a de facto negative rate policy by further increasing the size and scope of QE. Holders of gold bullion have long recognized this relationship of gold to the money supply (see Figure 5).

Figure 5. Total Known ETF Holdings of Gold and U.S. M2 Money Supply (2016 - 2020)
The R2 91% over the past five years.

Source: Bloomberg. Data as of 6/30/2020.

Fed Not Even Thinking About Thinking About Raising Rates

Post the GFC, the market has looked to the Fed to address every problem, and it has obliged. The GFC version of QE saw the Fed trying to channel liquidity to firms via the banks who were reluctant to lend. Eventually, much of that liquidity ended up in financial engineering uses such as M&A (mergers and acquisitions) and stock buybacks instead of the real economy. As such, the unwinding stimulus has become nearly impossible without significant financial market disruptions. The small steps to unwind the balance sheet eventually caused the financial plumbing system to seize up (remember the repo market in September 2019).

Every new crisis becomes more profound and more difficult. The stockpiling of past unresolved problems over time prevents the market from ever normalizing. The shifts in the short end and belly of the yield curve signal that the market is already pricing in that rates will not normalize for years. Fed Chairman Powell's quote, "We're not even thinking about thinking about raising rates," may become a permanent statement. This structural inability and unwillingness to normalize interest rates is one of the reasons that gold will be a very long-term bullish position.

Finding Diversification in a ZIRP and YCC World

Multi-asset portfolios that rely on bonds for diversification will now need yields to fall into deep negative levels to offset any double-digit equity declines. Correlations are also becoming less negative, and realized volatility patterns are also changing. In a ZIRP (zero interest rate policy) environment, bonds will not have enough convexity to act as a sufficient diversifier of equities. With current U.S. Treasury 10-year yields at about 0.70%, a decrease in yields to 0% would provide only a 6% return. The standard 60/40 balanced portfolio is at risk by being rendered ineffective, or at least inadequate, from a diversification point of view. When yield curve control arrives, bonds will provide close to zero yields, and little capital appreciation for the next few years. The utility of bonds as an equity diversification asset will drop further.

Figure 6. Equity and Bond Negative Correlation Has Historically Provided the Bulk of the Diversification in a Typical 60/40 Portfolio (2011-2020)

Source: Bloomberg. Data as of 6/30/2020. "Equity" is represented by the SPY ETF, and "Bond" by the TLT ETF.

Some funds are exploring "equity bond proxies" as a means of diversification. However, with implied intra-stock correlations near all-time highs (the current range is 0.60 to 0.80), this will limit equity diversification as there is minimal equity idiosyncratic risk; it is mostly systemic and correlated. Equity bond proxies may act as a relative volatility buffer but will not lower correlations.

Gold bullion is the last remaining major asset class that will have both capital appreciation potential and will provide diversification.

We believe we have left the extremely low volatility period of the past few years. With the Fed suppressing volatility in fixed income, we believe volatility will stay elevated for equities. Despite the market rally, the VIX7 is staying in the 30 range (95%-tile over the past 10 years). An equity sell-off with a 30 VIX reading would overrun a 60/40 portfolio with current yields. In only the first six months of 2020, there have already been more 3-sigma moves than during all of the GFC. The extreme market sell-off in March highlighted the self-feeding loop between systematic flows, volatility, and market depth with VaR (value-at-risk) rules acting as the forced selling driver. Pre- and post-March, the bullish feedback loop was fully engaged as flows, volatility and market depth all improved fueled by Fed liquidity. The results of this market structure saw equity markets record one of the best short-term return periods after one of the worst in only a few short months. In short, the market structure described will act as a volatility accelerant producing fat tails (a statistical term describing enhanced risk). With the vast majority of the equity investment world having gone passive and quant, we would expect this to continue.

By any fundamental measure, the market has dislocated from the underlying economic conditions. The S&P 500, at one point, had retraced almost all of its losses while the Nasdaq Composite8 has made new recent all-time highs. Despite the rally, sentiment remains near the bear lows, and significant short positions remain in the E-Mini S&P 500 Futures. A volatility shock (i.e., a second wave COVID shutdown, China tension, an incendiary tweet, etc.) under the right conditions can restart the selling feedback loop again. The market continues this tightrope walk between Fed liquidity optimism and harsh economic reality. In the absence of a viable bond hedge, gold bullion makes more and more sense by the day.

Both Gold and Gold Equities are Underinvested

In time, or when the next market correction occurs, we expect another round of inflows into gold bullion from investors seeking diversification for their portfolios. Gold remains relatively underinvested, and with the state of the bond market, it now has two features that are becoming in short supply: diversification and positive convexity. The re-rate in gold bullion will also pull gold equities higher. Though gold bullion may be relatively underinvested, gold stocks are underinvested outright. Given that gold companies have a fixed cost structure and are trading at low historical valuations, gold stocks would have the higher upside potential if investment flows were to migrate to gold equities. In every past cycle, the market has decided that the return potential outweighed the risks associated with gold equities. Typically, that has happened when the market becomes convinced that gold bullion had positive convexity.