Gold and bonds diverge, is it an important signal?

Gold has been stronger over the last few weeks and while bonds have rallied, gold has risen faster than prior relationships with real interest rates would suggest.

This is important as the last two periods in which gold and real interest rates (or TIPs) diverged, gold provided a good lead on the key factor driving bond markets, namely shifting expectations on FOMC policy.

For example, the collapse in the gold price in April lead the big sell off in bonds a month or so later as a reduction in QE was priced into debt markets.  In September, a bullish move in gold was the more correct signal about the likelihood of tapering in the month, with bonds ultimately rallying back.

Is the jump in gold a sign that debt markets are complacent about the possibility of a change to FOMC policy?  The data in the US has been weaker than expected across the board, with most key indicators of consumption, manufacturing, employment and investment proving to be disappointing.

Physical ETF interest has also been a little stronger in the last month or so.  While the gains are only small, it is noticeable against the barrage of selling over the last 12 months.

It is important to not forget the other key part of the gold equation in the USD.  This has been weaker on a trade weight basis and has been supportive of gold's gains, although is not particularly weak.

When combining the influence of both real interest rates and the USD on gold into a simple model (as described here), gold's breakout doesn't look as unusual, especially in context of April 13 and September 2013, when the model and the actual went in completely different directions.

It is however, worth keeping an eye on whether this divergence gets larger, particularly as we head into the next FOMC meeting, where the members will provide updated forecasts.

The central question to whether this represents a buying or selling opportunity for gold is whether the weakness in growth is temporary, or whether the FOMC has to reassess its trajectory of forecasts and policy.

On the forecasts front, they probably have quite a bit of time before they would consider meaningfully downgrading 2014, with the Fed likely to wait and see whether the recent weakness is more to do with weather than underlying factors.

It also seems that the threshold for a big change in policy would be very high.  Consider that the latest round of QE was undertaken given the potential risks from a Euro collapse and the magnitude of fiscal contraction.  The risks now seem much smaller, even if growth is a little soggier than expected.

Its also debatable as to whether the Fed will want to respond to a changing growth profile via changing the likely trajectory for the most recent round of QE.  The FOMC clearly sees diminishing returns to further asset purchases and would want to wrap up purchases as soon as possible. Most research coming from official sources suggests that forward guidance is at least as powerful a tool to keep rates low and is less costly.

Indeed, if growth does turn out to be softer, the Fed is likely to first opt for forward guidance to try and anchor the yield curve at lower levels.  Since September, this approach has worked pretty well.

Forward guidance has proven to be clumsy in some ways, but it has still been effective even if thresholds have moved or changed or been taken away altogether.  It also doesn't appear to be meaningfully damaging credibility, although central banks are wary that credibility is finite.