Gold toes the line, don't hold your breath for a break out

Gold prices have been remarkably well behaved for the best part of 12 months now.  As the chart on left shows, gold prices have traded in a wide, but consistent band against the US dollar trade weighted index. Gold vs. the TWI is closer to the bottom of this band at the moment, so in the very short term, perhaps gold can get a little bit of its own momentum outside of movements in FX.

A bigger question is what might shake gold out of the current trading pattern we have seen against the dollar?  As the chart below shows, we have seen several periods in the last 6-7 years where gold has broken out and the relationship against the dollar has been reset.  Most of these shifts have been bullish, with gold usually resetting to a higher level.

That said, there have been long periods where gold has maintained a very consistent relationship with the dollar.  For example, from 2006 right up until the financial crisis, gold prices behaved very consistently against movements in the USD.  The difference between then and now is that the USD was depreciating rapidly then and gold's leverage to this decline was higher, which made for exciting gains in gold prices.  Right now currency markets are  confused, leaving gold in a funk.

As I've outlined in my framework for gold (also see this post), I have supplemented this view of gold with a regression that also uses real interest rates, which has been an important explanatory variable post the financial crisis, at least up until recently.

In fact, the relationship with real interest rates seems to be all but abandoned by most forecasters.  The chart on the right shows how much market relationships have changed in the last 12 months by showing two models, one based on the last 12 months and one based on the last 3-4 years.  They continue to be very different, suggesting something meaningful has changed.  And unlike the last few years, this is a bearish shift.

This change in behaviour may not be such a bad thing for investors and they can be more comfortable about its performance as a hedge.  This is particularly the case if you are bearish on the US$, as the recent consistent behaviour suggests gold should rise 2-3% for every 1% fall in the dollar.

That, however, won't satisfy those who are looking for big gains in the yellow metal beyond FX movements.  The number one question for them will be what will shake gold out of its current holding pattern?

The popular one seems to be the risk of inflation, but that doesn't seem to be something you need to act on right now.  Inflation expectations as implied by TIPs have ticked up a little, although mostly because Treasuries have risen while the relatively illiquid TIPs have remained consistent (and very negative).

While other risks abound, I don't think there is a huge opportunity cost at the moment by watching and waiting for shift in gold's relationship with other key variables.  Indeed, as recent events have shown, it's not one way traffic for gold given the recent bearish shift against bonds.  Ideally you can wait for the first signs of gold breaking through the recent band and then make an assessment of whether its bullish or bearish.

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