Gold and bonds waiting for Fed direction

A couple of times this year, gold has proven to be more informative about the path for monetary policy than bonds.  The huge slump in gold prices back in April led the move in bonds on the rethink on tapering, while the relative rally in the gold price in August gave a better signal about the prospects of tapering in September.

At the moment, it doesn't appear that gold is telling us anything different to other markets.  As the chart left shows, it has more or less been moving in line with bond yields.

The other key variable for gold, the US dollar, has been a little stronger lately following the cut in rates by the ECB.  This has undermined the gold price, with gold currently at the bottom end of the band it has been more recently against the USD TWI.

We can add the the impact of both bonds and the USD on gold using a simple regression model, with modelled and actual prices shown on the left.

Based on the relationships that prevailed from 2009 to today, the gold price could expected to be a little higher given the level of real interest rates and the US TWI,  but the difference is not particularly compelling, with the error not too different to that seen earlier in the year.

The indifference to a strong view on gold at these prices can be seen in futures positioning.  After covering shorts that built up mid-year, speculative positioning could be seen as relatively neutral when accounting for passive investment by exchange traded products.

Physical ETF holdings also continue to drift, albeit at a slower rate than earlier in the year.  This physical flow is easily being absorbed by increased buying in China in particular, but I don't think this West to East flow of physical holdings is really changing the balance of what is ultimately driving prices at this stage.

More important is the path for bond yields and the USD, which are ultimately related.  Since the start of September, we have seen a big rethink by money markets on the likely path for the Fed Funds rate over the next couple of years, with market expectations now largely inline with Fed projections.

The big question is how much of this is related to the decision not to taper bond purchases, which could potentially be unwound if the FOMC signal that it is back in play.

I think that policymakers will be confident that they can guide markets to maintain expectations close to the current curve on the Fed Funds rate, even if they decide to reduce bond purchases in the not too distant future.  To be sure, communication on the timing of taper from FOMC members has been that while tapering may have been delayed a couple of meetings, its by no means indefinite.  Furthermore, key pieces of data have been better, with employment meeting a key threshold of adding 200k jobs, on average in the last 3 months.

The impact on the longer end of the yield curve is also likely to be more muted as it appears that the term premium is no longer as large.

If we rewind back to when yields were very low at the start of the year, a large factor driving this was the change in the term premium (more detail in this post).

This factor suppressing yields has reduced over the last 6 months, perhaps in part due to changing outlook for the size of the Feds balance sheet, but I think more due to a reduction in macro risks stemming from European weakness and fiscal contraction in the US.

So the Fed probably doesn't have to be as worried about the changing term premium forcing yields drastically higher again.

For gold, none of this is good news, with higher yields and a stronger dollar bearish for prices.  But perhaps a good deal of the downside from tapering is already in the gold price, so the downside risk is perhaps not overly severe.  But definitely not worth being long at this point.