Gold and gauging the tightening tantrum

If asked 12 months ago which commodities would perform relatively well in the face of a strong USD bull market, few would have said gold. But gold prices have been remarkably steady in the face of a much strong dollar.

The chart below shows gold vs. the USD trade weighted index on a broad basis. This is the broadest measure of USD movements, with other indices like the DXY failing to take into account the importance of the RMB (even if its managed).

The last time the USD TWI was at this level was 2004 and gold was trading a little under $400/oz back, or roughly a third of its current value.

The big difference between now and then is that following the financial market dislocation in 2008, not only have real bond yields fallen (10 year TIPs at 0.1% today vs. ~2% in 2004), but gold's premium relative to these variables has also increased. As discussed in this post, the behaviour of gold relative to real bond yields and the USD shifted dramatically in 2008.

Broadly speaking, the model of gold vs. the dollar and real yields since 2008 continues to perform reasonably well, suggesting the paradigm shift gold experienced following the financial crisis remains in place today.

That said, the gold price has held up much better than the model predicted given the movements in the USD and real yields, particularly since the start of this year.

Divergences between modelled outcomes and actual gold prices have not been the unusual in the last few years, although ultimately actual gold prices have moved back in line with real yields and the dollar, or visa versa.

So what is gold telling us at the moment that relative to bonds and the dollar? Part of the modelled weakness was due to a rise in long term real yields, although bonds have rallied as markets have becoming much less hawkish on the prospect of Fed hikes. Similarly the USD has sold off following the Fed announcement, although it remains significantly stronger than the start of the year.

Much of the recent market volatility has been around shifting expectations on a change in the policy stance of the Federal Reserve. And since 2013, this has been the main source of diverging paths gold and bonds/USD.

Back in early 2013, the gold price fell spectacularly despite little movements in other markets following a speech from then FOMC Chairman Bernanke. This ultimately turned out to be a leading indicator of the "taper tantrum" that followed in June.

In September 2013, gold staged a surprising rally as most predicted that the Fed would begin tapering. This ultimately proved to be correct as the Fed delayed tapering until December after being spooked by the big jump in yields in the preceding months.

So have gold investors proven again that they are more in tune with the likelihood of action from the FOMC than other markets? Perhaps the jury is out given there are potentially other influencing factors.

But movements in gold should be watched keenly by FX and debt markets, as it may give a good indication of the scale of the potential "tightening tantrum" when the FOMC gives clearer signals that rate hikes are in the not too distant future.