Saturday, August 24, 2013

The Gold, Treasuries, Emerging Markets triangle

Treasuries surged and yields dropped on Friday as a result of a dismal new homes sales report.  The consensus expectation was for 487k in new sales while  sales actually plunged with a reading of 394k.  Treasuries rallied and yields dropped on the news but look at what also took off:

(click on chart for larger image)
This is a daily chart of the SPDR Gold Trust ETF which is the popular trading vehicle for investors who won't or can't trade the actual metal in the futures market.  GLD has penetrated a long term resistance trend line going back to November, 2012 and looks set for an advance up to the 143 area (translated to $1,420.00 spot price).
On the face of things, market practitioners would simply say that Gold's surge was a knee jerk reaction to the day rally in Treasuries.  Gold, being a physical commodity that doesn't reward investors for holding it, fares better in a low interest rate environment.  To this I do not disagree except to say I believe Gold has been sending a much deeper message to the market since it bottomed in late June.
In past commentaries and blog posts I have raised concerns regarding the abnormally low rate of inflation in this country.  Simply, in a fiat monetary system, moderate inflation is a necessary by- product of economic growth.  The Fed's target rate for inflation is 2% and but the year over year rate less the volatile food and energy complex is running at only 1.2%. The mediocre economic reports we have been receiving validate this disinflationary trend.
What has happened since May is that interest rates have surged mostly on the back of expectations that the Fed will soon taper its asset purchases which have served to keep our economy afloat since the onset of the Great Financial Crisis.  The debate presently rages on the street as to whether the tepid rate of economic growth we've seen in this country is also partly responsible for the rise in rates.
My thesis is that the recent strength we have seen in the "yellow metal" is actually coincident and possibly predictive of an intermediate term top in Treasury yields.  Indeed, PIMCO's Tony Crescenzi wrote an insightful piece on their website on Friday articulating the same opinion but for different reasons. 
How does this all tie into the Emerging Markets?  Emerging market economies have been battered lately by a "triple whammy":
- the recent rise in US yields has caused capital to flee their countries as speculative money moves into higher yielding assets that carry less risk
- higher US interest rates threaten EM economies because it makes it more difficult for them to finance their current account deficits
- as money flees their countries their currencies weaken, forcing these countries to defend their currencies in the FOREX (foreign exchange).  They've been defending by selling US Treasuries, which has served to pressure the bond market
But Gold seems to be sending the message that the pressure of higher rates is slackening, at least in the short term.  And Emerging Markets, which have taken a beating, seem technically to be setting up for a rally:
(click on chart for larger image)
This is a weekly chart of the iShares MSCI Emerging Markets ETF.  The candlestick circled is classified as a "hammer" which is a key reversal candlestick and is predictive of a bounce in the ETF.  If interest rates stabilize as I suspect they will, the pressure on Emerging Market economies will dissipate and the technical signal on the chart above seems to validate my thesis (so far).
As an aside, everyone is waiting for the expected stronger US  growth going into year end.  It's almost like a mantra.  My response is that we need to start seeing some serious improvement in the economic stats for this "growth" to happen.  If Friday's new home sales report is any indication, all the talk of stronger growth going into 2014 is simply "the stuff dreams are made of"!
I don't want my readers to misunderstand.  I'm a long term bull on the financial markets and the global economy but more for secular reasons than some of the wishful thinking I'm hearing from various economists and market pundits. 
Central bank policies which were needed to see our way out of the post Lehman mess have distorted debt and currency markets and until these distortions are unwound, I'm in "wait and see" mode.  We will know soon after the Fed meeting on September 17th whether the concerns I raised here ( ) have any merit.  If equities can shrug off any cutback in Fed asset purchases and move higher, then any concerns I have raised will have turned out to unfounded.  In that case, interest rates should continue to move higher which is reflective of normal market and economic conditions.  But if my concerns are valid, the Fed will be caught in the quandary I've identified in the link in this paragraph. 
In the meantime, I'm watching Gold because it will be predictive of interest rate direction going forward. 
Always remember, the bond market is the "dog that wags the tail", that tail being equities.