Gold continues to catch a bid

The recent strength in the gold price has continued to attract an increasing amount of speculative interest, with short positions being closed out and fresh longs also being built.

Gold's strength has been supported by falling bond yields and a somewhat weaker dollar, but has also posted gains outside of the usual relationships.

Being long gold has been a nice contrarian bet since the start of the year with most analysts including myself expecting prices to continue to fall.  This story is not too dissimilar to bonds.

At this stage it seems more likely that the price strength is temporary rather than a renewal of the bull run. But if you own gold at the present, its probably not a "slam-dunk sell" just yet, particularly if the FOMC manages to persuade markets to maintain current conditions following its statement on the 19th of March.

Gold and real interest rates continue to diverge. They are heading in the same direction, but gold has clearly risen at a fast clip.

A little of this can be explained by a somewhat weaker dollar.  But when regressing gold against real interest rates and the TWI, its clear that gold has had its own momentum outside the relationships seen between these variables over the past 4-5 years.

Its not immediately clear that it is physical demand from China that is forcing the recent strength. Arbitrages into SGE physical prices have actually turned slightly negative as LBMA prices have climbed, although turnover on the exchange remains healthy.

One interesting development that might help explain golds strength is that shadow rates (discussed here and here) continue to drop to a little under -2.5 in February.  This would suggest that the FOMCs current policy stance is becoming increasing accommodative.

The shadow rate is derived from complex econometrics, although intuitively we may be able to say something about why shadow rates have dropped so sharply by looking at the observable part of the yield curve.

I am assuming that the shadow rate is calculated from monthly averages, so its important to take that in mind when looking at the daily data in the chart on the left.

What we can see that the shadow rate started its decline since the middle of 2013, which is right around when the yield curve started to steepen.  It has tended to fall further in the later stages of 2013/early 2014 as longer dated interest rates have fallen, while spreads between 2-5 year treasuries in particular have remained wide.

If these rates and spreads remain stable through March then we should see the shadow rate remain a bit more stable.  Spreads are around as wide as they have been in the last decade, so perhaps shadow rates will now move with longer bonds.  It seems more likely that yields will move up than down from these levels, although this move doesn't appear imminent.

The Federal Reserves announcement on the 19th is likely to set the tone for gold for the month or so.  It seems that the FOMC will be cautiously optimistic, stating the case for a continued reduction in bond purchases and better growth, but will recognise the recent weakness in the data and the risks from low inflation.

There maybe some change the the wording of guidance given that the unemployment rate is approaching the threshold to considering a changing in policy.  The Bank of England managed to change its commentary without too much difficulty or disruption to markets and the FOMC might go for a similar tactic.

But overall, the aim of the FOMC will be to keep expectations on rates where they are today.  Indeed, if the shadow rate does encapsulate the stance of Fed policy, then they will be happy that they are able to keep rates low while winding back QE.

The dovish tinge to FOMC commentary should keep gold and bond prices firm.