Bonds catch up to gold sell off

While gold has fallen sharply like everything else in the last week or so, it appear that it has moved back in line with other financial variables after the stand-alone collapse we saw back in April and May.

Using the framework for gold I've written about here, it now looks more like the current gold price is part of the cycle rather than a structural shift in pricing behaviour relative to other markets.

The big drop in gold in the last few days has mostly been about a stronger US dollar.  The US trade weighted index has rallied sharply in the last week or so and gold has traded consistently with dollar movements as per the last few weeks.  In fact, its very consistent with levels seen in 2011.

This is very different to the big falls in April in particular, which occurred without much going on in FX markets.

What is more interesting is the massive sell-off we have seen in bond markets, with US 10yr TIPs rapidly moving into positive territory.

Once upon a time this chart on the left was the sole focus of gold analysts, until it stopped working back in early 2012.  But what is interesting is that it looks like the gold move proceeded the sell off in bonds, with debt markets in effect catching up to the collapse in gold prices we saw in April/May.

One simple way to combine the impact of a rising currency and rising yields on the gold price is to use our simple regression model.  For more detail its best to read this post done back in December.

For the last 6 months or so, this model based on TIPs and the USD trade weighted index overestimated the gold price, although at least up until April, the direction was ok.  Interestingly, it appears that the model has now caught up to the actual price given the massive bond sell off and the more subdued movement in the gold price.

Looking at the last few months more closely provides a better understanding of the last few months.

The huge downshift in gold in April was very unusual, with the model suggesting prices should have actually gone up given movements in TIPs and the USD.

But we have seen modelled gold prices collapse in the last week or so on the huge sell off in bonds.  This has seen modelled prices catch up to reality.

There is an interesting lesson from this price behaviour. While there was a clear disconnect between gold, FX and bonds, it was not gold that corrected higher, but rather the movements were the other way around.  This was not the sequence of events I expected, but there was a correction of this disconnect.

In this instance gold was a better leading indicator for the perceived turning of the policy cycle from the Fed, with bond markets taking more convincing.  This doesn't guarantee that it will again, but it is worth watching the relative movements in gold and bonds.

Finally this analysis suggests that there hasn't been a structural change in gold pricing behaviour and prices today make sense in the context of the last 4-5 years. While the model hasn't been perfect in picking up turning points and events have turned out to be unusual, the framework has actually worked pretty well when stepping back from day to day price movements.

So from a forecasting perspective, the bet is about whether you believe markets have gone too far on pricing in a better US economy and a winding down of QE.  I tend to think they have at this stage and perhaps gold should move higher in the near term.  But from a longer term perspective, the pressure on prices is to move lower, not withstanding the potential structural moves, which if anything would be lower if the world gets better.