Fed walking well-worn track, dollar most at risk?

The latest round of Fed-speak and projections have again pointed to downgrades for the outlook for growth and inflation. While the key word "patient" was removed from the statement in regards to maintaining the current stance of policy, it's not clear why policy rates would be rising in the foreseeable future with downgrades to key forecasts.

This is not a new phenomenon, with the Fed consistently overestimating growth for the last couple of years.

The unemployment rate has been much lower than forecast and these downgrades to growth weren't a barrier to the tapering of QE3. A hike in policy rates, however, is a different proposition and it will be a difficult sell if the Fed continue to downgrade economic growth. With recent employment and ISM data tending to be weak, there isn't a clear catalyst in the short term to turn this downgrade cycle around

It's also quite marked how far expectations for the Fed Funds rate by end 2015 has been downgraded in the last 3 months. The chart on the left shows these expectations, with the size of the bubble representing the number of Fed members providing projections at a given level of the Fed Funds rate for the end of this year.

Over 2014, expectations tended to drift higher, with most members suggesting rates would lift to over 1% by the end of this year.  The rapid drop inflation, oil prices, slower leading indicators and a higher dollar have seen those expectations shift quite a bit, with the only 4 members of the FOMC now seeing rates above 1%.

While bonds have responded to a more dovish Fed with yields very low, perhaps the bigger implications are for the US dollar.

The dollar has dipped ~3% from its highs following the latest Fed announcement (on a Trade Weighted basis), although is still very strong.

The biggest driver of this gain has been the narrative of a divergence in policy between the Fed and other major central banks.  But the path for the Fed Funds rate is perhaps not as clear as previously perceived.

Indeed, the economic data is perhaps not as divergent either. Leading indicators for Europe are now tending to be better than elsewhere, even if they are coming off a lower base.

This will perhaps put some doubt in the story that has driven the rampaging US$. And this could be particularly important for commodities that have been crushed in the first quarter of this year. While fundamentals in China may not be shifting too much, a halt in the rise in the US$ would help support those commodities which have seen supply cuts in the face of weak demand.

Central bank watch

After the ECB eased policy via rate reductions and the introduction of asset purchase programs, the attention is now shifting to the Fed and BoE and when the might start making policy less accommodative.

The Federal Reserve continues to play a steady hand in terms of managing expectations, with its commentary and forecasts not deviating a huge amount in the last 3-4 months.

Growth forecasts have been revised downwards thanks to an increasingly weak Q1, while private sector forecasters are revising Q2 lower as the post-winter bounce hasn't proved to be as strong as initially hoped.

This weakness, however, hasn't derailed employment growth, which has proven to be stronger than expected in the last 6 months.  We have also seen an uptick in actual and expected inflation closer to 2%.

The stronger employment and inflation data have tended to embolden expectations for a rate hike from the Fed in 2Q15.  It has also had an interesting impact on the yield curve, with the short end of the curve rising, but the longer end remaining very well bid.

It's interesting that the 2-5 year spread has remained consistent at ~125bps since the start of the year, while the 5-10 is now at its narrowest level since 2009.

There seems to be a bit of an inconsistency here. Markets are happy to sell bonds of 5 years and below on the increasing likelihood of Fed Fund rate hikes next year.  But the 10 year part of the curve remains very strong.  It would seem that sooner or later, 10 year bond yields will also rise in conjunction with the shorter end of the curve if the economy proves strong enough for the Fed to consider hiking rates.

The economic data out of the UK have continued to be on the stronger side of expectations, with employment growth in particular now strong and the unemployment rate lower than anticipated.

Market expectations appear to be much more in tune to what the Bank of England has been projecting rather than what the data has doing and this has prompted Governor Carney to state is a speech that the timing of Bank Rate hikes are data dependant and that "it could happen earlier than markets currently expect".

The Bank of England is also making more of a foray into macroprudential policy in help reduce risks from indebtedness.  The Bank has stressed that it is indebtedness, not the growth or level of a particular asset price, which is central to their concerns.  They have also stated that it is not a substitute for monetary policy and may not affect the future path of the Bank Rate. But these policies would restrain high LVR mortgage lending, as they have done in places like New Zealand.

The ECB are likely to sit on their hands for a while as they assess the impact of recent policy changes, with the TLTRO program beginning in September.

One area where they haven't gotten much traction yet is on the Euro, although it has stopped rising.  There is also a growing expectation that it will fall over time, given Europe is in a different stage of the economic cycle than other major currency areas.

This is also the view from BoJ Governor Kuroda, which has expressed satisfaction with the current settings of policy and the BoJs forecasts.  The slow-down in activity from the introduction of the VAT has been in line with expectations, with growth and inflation forecasts little changed. While energy prices will start to fall out of the inflation equation in 2H14, the BoJ expect labour market tightness and wages growth to lead to a broadening of inflation later this year.

This hasn't lead to a sense of complacency though, with Governor Kuroda suggesting they are half-way through the battle in achieving the 2% inflation target.  And until that war is won, they are likely to maintain an aggressive policy stance.

FOMC to backtrack on growth and rate hikes

The FOMC announcement this week is likely to be dovish. Growth has been weaker than expected, not just due to weather, with the recovery in the housing market proving to be more fickle than expected.

This will change the forecasts and perhaps the rhetoric from the FOMC, but probably won't change the path of tapering of QE. The Fed clearly sees diminishing returns to asset purchases and probably don't feel compelled to change tapering if interest rates remain at low levels.

Q1 GDP looks set to contract by more than 1.5% on an annualised basis, with the bounce into Q2 not appearing as vibrant as many were hoping.  This leaves the March forecast of annual growth of a little under 3% too high.

There was a huge amount of focus on the "dots" on the FOMC projections in March, with a slight shift in expectations for rate hikes in 2015 shifting market expectations significantly.

With growth forecasts likely to be forecast downwards, it seems likely that the "dots" or blobs in the chart below will shift back to the same configuration seen back at the end of 2013.

Rate hike expectations have actually shifted up a little over the past few weeks according to Fed Fund futures, although these are likely to track back to end-May levels following the release of the FOMC projections.

The sogginess of inflation may see some downward revision to inflation forecasts, but inflation expectations have actually picked up to be much closer to 2% than they have been for about a year.  This is another factor that will keep the FOMC on a steady path even if the actual inflation numbers have been disappointing.

Central bank watch - ECB the big mover in May

The big change in the last month is the clear signals that the ECB is ready to provide some kind of inflation given their concerns with a stronger exchange rate and the prospect of persistently low inflation.

ECB Governor Draghi gave a very strong signal that it was prepared to act at in June, and has given several speeches outlining the risks surrounding a period of ultra-low inflation.

The big question is what kind of easing does the ECB plan on implementing?  Purchasing sovereign bonds is not a legally viable option under their current mandate, with the members of the governing council having raised the prospect of purchasing other kinds of covered bonds.

The prospect of negative interest rates has also been floated.  This wouldn't be a first, with Denmark experimenting with negative rates in the last 12-18 months, although this isn't something that has been tried by any of the larger central banks.

It also runs into the problem of bank's switching deposits into cash, which has some storage costs but would be cheaper than holding an account with the ECB.

To me it seems unlikely that the ECB would go for a relatively untried policy measure like negative interest rates and are more likely to announce some kind of bond buying program along with lowering the main refi rate to zero.  It may also provide stronger guidance to match what has been done by other central banks.

Key to the ECB strategy will be to ensure markets aren't disappointed, as one of the key objectives will be to try and shift momentum on the Euro. The fact that the real Euro has been stubbornly strong has been a central concern to the ECB and the inflation profile.

Elsewhere, central banks are largely maintaining the course set at the start of the year.  The Fed is likely to continue with tapering asset purchases despite a likely downgrade to 2014 GDP expectations and more caution around housing markets.  But with 10 year treasuries dropping below 2.5% in the last month or so, it seems the market is doing a good enough job of easing monetary conditions without the Fed having to change course.

The Bank of Japan has maintained its aggressive stance, with more recent information on activity suggesting growth had slowed following the rise in the VAT.  Interestingly, Governor Kuroda has started to make more noise about about the rise in the Yen and slower pace of reform from the Abe government.  This has traditionally been off limits from BoJ Governors.

The Bank of England released its inflation report, with gelled with the consensus that the bank rate will start to rise slowly in 2015.  Whether bank rate hikes come earlier will depend on the pace of improvement in labour markets and wages.  If wages start to rise a little more quickly in the second half of the year, it seems likely that the bank rate will rise earlier.  This is a legitimate risk given labour markets have improved much fast than the Bank previously envisioned.

What is a flatter yield curve signaling?

The yield curve has been an excellent leading indicator of activity in the US, with a flattening yield curve more often than not a sign of weaker activity.

The start of this year has seen the longer end of the yield curve flatten, although spreads to the shorter end of the yield curve are still large.  The visible shorter end of the yield remains fairly steep in comparison.  

When using estimates for the "shadow Fed Funds rate" , the shorter end of the yield curve is incredibly steep.

The 5-10yr part of the yield curve has flattened mainly because 10year bonds have proven to be much stickier than shorter durations. The 2 - 5 year portion of the yield curve has steepened a little, with yields around recent highs.  

As the chart on the left shows, changes in the yield curve have been an excellent guide to changes in momentum in the cycle in the US (using the ISM index as a proxy).

Is this flattening in the yield curve signaling slower growth ahead?  At this stage is probably not significant enough move to definitively say yes.  Furthermore, the 2 - 5 year part of the curve has remained relatively steep, which doesn't suggest bond markets are getting bearish.

Indeed, this move seems to be more about adjusting to FOMC guidance than a big change in expectations for growth.  The shorter end of the visible part of the yield curve has risen much more substantially than 10yrs largely as markets increase conviction that guidance will become reality.

One source of increased difficulty in understanding the current situation stems from policy rates being at the zero lower bound, so bonds shorter than 2 years are effectively squashed to zero.  

But there has been research done to estimate what the effective Fed Funds rate  might be if it could go below zero based on current financial conditions in the visible part of the yield curve (explained in this post).

These estimates suggest that the effective rate is strongly negative.  It also suggests that the part of the yield curve that is below zero would be incredibly steep at almost 300bps.

This perhaps takes a leap of faith based on the econometrics backing the estimation of shadow rates.  But it does suggest that rather flattening, some parts of the yield curve are becoming very very steep.

Another notable development is that implied inflation expectations on 5-year TIPs have shifted up towards 2% in the last week or so, which is the strongest level seen in since 1H13.

So what does this all mean? For me, much of the movement in the lower end of the curve has been about markets adapting their views on Fed guidance rather than being data driven.  So far most of the data has been a little weaker but not enough so for analysts to abandon expectations for 2H14.

In some ways, extrapolating the logic from this view suggests that a significant further flattening in the curve seems unlikely.  If FOMC guidance is to become a reality, then we should see growth and inflation indicators pick up a bit from here. It would seem odd for the yield curve to flatten a lot further if growth is getting better.

There is also the issue of the very low term premium to consider at present.  If anything the risk here is that this widens under a stronger growth scenario, rather than flattens.

So markets may be more interested in adjusting the shorter end of the curve for now, but ultimately the reason why markets are pricing an increasing likelihood of Fed guidance becoming a reality should also drive longer term yield higher to a similar degree. 

Central bank watch

The most notable change in rhetoric from key central banks is the commentary shift from the ECB surrounding the possibility of more easing and the potential for more unconventional policies.  Central banks elsewhere have largely maintained their stances seen over the last couple of months.

With inflation again showing lower growth, President Draghi has signalled that the ECB is more concerned with the impacts of the strength of the euro.

There has also been more discussion of the use of unconventional monetary policy, with this speech from ECB board member Benoît Cœuré outlining some of the key principles that might guide how the ECB will target markets.

It seems unlikely that the implementation of QE is imminent, not because of the need for more policy accommodation, but rather because of the complexity of such a program in the Eurozone.  But it does seem increasingly likely that the ECB will have some kind of asset purchase program in place in the next 3-6 months.

US Treasuries sold off following the first press conference from new Chair Janet Yellen, although subsequent speeches and the release of the minutes have seen bonds rally, most notably at the shorter end of the curve.

Markets remain sensitive to any apparent shifts in guidance from the FOMC, although so far there really hasn't been a meaningful change in their view beyond the shifting "dots".

Markets seem to want to push for a flatter yield curve on the parts that are non-zero at present, although an inflection point in some of the leading indicators suggest some caution in confidently predicting the rise of the Fed Funds rate.

The Bank of Japan remain in wait and see mode at the moment, with Governor Kuroda stating that the BoJ is confident inflation hitting 2% next year and no change to policy is imminent.  The most likely course is to maintain the current expansion of the monetary base as the effects of the rise in consumption tax become more apparent, which rose from 5% to 8% on 1 April.

The Bank of England have been quiet since they changed from quantitative to qualitative guidance on labour market conditions.  They continue to project rates to remain low until well into 2015, although the pace of improvement in labour markets could force an earlier move.

Term premium and the yield curve

There has been a notable flattening in the US Treasury yield curve since the last FOMC announcement. 2 & 5 year Treasuries have sold off more aggressively, with yields around recent highs.  10 year bonds have moved less, and at ~2.80% are still well below the recent 3% high seen at the end of last year.

Assuming the economy continues to track as the FOMC expects and we get closer to forward guidance becoming a reality, a key question will be whether the yield curve will continue to flatten.

This certainly was the experience at the beginning of the last tightening cycle from the FOMC, that began in 2004. At the beginning of this cycle, the yield curve from 2 - 10 years was about as steep as it is now (although the Fed Funds rate was at 1% rather than the zero lower bound).

There are a wide range of differences between this time around and 2004, with the unwinding of QE, depth of recession and trajectory for growth and inflation particularly important.

One area I want to focus on is the term premium in 10 year treasuries. This is typically thought of as the premium investors are paid for holding bonds of longer maturities above what would be earned from rolling over bonds of short maturities.

At present, the term premium is still very low and has only just recently turned positive (according to BIS calculations). Indeed, for much of 2012 and 2013, rather than being compensated for interest rate risk, investors were paying a premium to be in longer maturities (vs rolling shorter maturities).

A central question as to whether the yield curve flattens forward guidance come closer to reality depends on whether the term premium remains very low or moves back towards recent history of 50-100bps.

One piece of fairly recent research from the FRBNY, which can be found here, suggests that history suggests the commencement of tightening doesn't push term premia significantly higher. That said, there is the caveat that current circumstances are quite different given the current size of the Federal Reserve's balance sheet.  To be sure, it was a shift on expectations on the size of the Fed's balance sheet that probably helped push the term premium from -100bps back towards zero.

So for now markets seem happy to let the non-zero parts of the yield curve flatten a little. But I think it is fairly limited as to how far this can go given the risks around the term premium.

While a flattening or steepening yield curve has lots of implications for growth and financial markets, in the commodities world, the clearest link is to gold, for which real interest rates are particularly important.

While rising interest rates is a negative for gold in the absence of a weaker dollar, a flattening yield curve would mean the outlook is perhaps less bearish than some are projecting.

Gold can have is ow momentum and has seen several paradigm changes in the way it moves against bonds and the USD in the last 30 years (see this post).  More recently, however, these periods where gold has diverged from bonds have tended to be short lived.

Markets caught off-guard by Fed comments

Markets were caught off-guard by some of the rhetoric from the FOMC projections and comments from FOMC Chair Yellen in the accompanying press conference. On balance it would suggest the FOMC believes rate hikes may come a little earlier than previously projected, although this is of course data dependant.  Furthermore, while long bonds have sold off, yields still remain very low.

There was a lot of focus on the "dots" in the projections, which signify the level of the Fed Funds rate by year end for the next few years.  These showed some upward drift compared to the last meeting.  Ive been representing this for sometime, although more as blobs than dots, so we can compare more than just one meeting to the other.

As the chart above shows, there has been a slight revision to levels in 2015 upwards, with more participants seeing rates at ~1% by the end of the year. That would imply the first move in rates would be earlier than previously envisaged by more Fed members.

Chair Yellen tried to hose down the importance of this change, although given the Fed chooses to publish it and it represents the views of FOMC members, it is not unimportant.  But it is perhaps not as important as other projections which shape the path for policy.

On this front little has changed.  GDP for 2014 has been revised a little lower, although mostly due to weather in Q1 rather than anything else.  Forecasts for 2015 currently stand at around 3%.

Significantly, inflation forecasts remain unchanged, with core PCE forecast to remain 2% over the projection horizon.

Unemployment rate expectations have been revised lower, although the quantitative threshold on this has been dropped from forward guidance.  Markets didn't react too much to this.

What gained greater attention was the comment from Chair Yellen that "a considerable period of time" was perhaps something like 6 months, depending on data.  This, along with the projections, pushed markets to think rate hikes might come a little earlier than was previously priced in.  The chart on the left shows the movement in Fed Fund futures, which repriced ~25bps from levels a month ago for the end of 2015.

A little perspective is needed here given the amount of noise surrounding these announcements. Firstly, rate hike expectations are way below where they were in September, when the Fed started to talk about winding down QE.  The fact they have started this process and rates remain low suggest markets moved quickly when it was clear they were getting ahead of themselves. Fed speeches in the next few months are likely to have the same affect, where they are likely to reinforce the tone from the official statement, where "The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements."

Its also worth noting that while the long end of the curve sold off, at 2.75, 10 year Treasuries are still someway below their recent highs.  This will mean that while the Fed will perhaps want to massage the markets through upcoming speeches, it won't be panicked.

What does this mean for commodities?

A change in Fed thinking is most important for precious metals and gold in particular, which sold off today.  But this doesn't represent a seachange in the view, with the guidance around the timing of the first rate hike likely to be much more explicit when the Fed is confident when it will occur.

For other metals and bulks, this is really a side show to developments in China.  Demand in the rest of the world is still a positive, although that has faded with slower leading indicators.  But clearly there is huge uncertainty about Chinese demand, much more so than there is around Fed policy.

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.

Falling shadow rates, rising precious metals

Forward guidance by central banks appears to be garnering some criticism from journalists and analysts, claiming that shifting goal posts have left many confused.  But the evidence from markets is that central bank credibility remains firmly intact.

One marker for the effectiveness of current policy settings that is comparable to history is to look at "shadow" policy rates, which I've written about here.  This is a statistical derivation of what central bank controlled policy rates would be if they could be negative based on information from non-negative parts of the yield curve.

Interestingly, the Fed shadow rate has become increasingly negative in the last couple of months.  This is not really intended, as the FOMC haven't looked to ease policy.  In fact they probably see tapering of asset purchases as the reverse.

But the drop in the shadow rate over the last couple of months suggests the FOMCs credibility on its forward guidance remains firmly intact. This is despite protests from some parts about the problems with the unemployment rate threshold of 6.5%, which soon maybe reached.

These data are also available for the Bank of England's Bank Rate, which similarly remains very low.  It will be interesting to observe this statistic in the coming months, given explicit guidance on thresholds appears to have been replaced with a more vague promise on labour market conditions.

But so far, it doesn't appear that the better-than-expected improvement in economic growth and labour market conditions have moved the needle substantially when it comes to shadow rates.

To be sure, BoE Governor Carney stated in December that "The strength of the UK and the fall in the unemployment rate suggest that the equilibrium real interest rate is now rising towards zero." The shadow rate would suggest current policy is much more accommodative than this.

The drop in shadow rates has accompanied a rise in precious metals prices, which have again risen today without too much happening in other markets.

Its also notable that gold has outperformed in the precious metals space against a more industrial metals like platinum.

It seem like gold is outperforming on the expectation that weak economic data is increasing the risk that the FOMC changes tack on current policy.  But if the shadow rate is to be believed, it would appear that bond markets are already suggesting that there has been a sizeable move in effective policy rates.

Central bank watch

Key global central banks have mostly held the line in February.  The notable exception is the Bank of England, which modified its forward guidance, although this was more changing guidance to suit the current settings of policy rather than changing policy in light of the economy approaching guidance thresholds

Disappointing data in the US has tilted the risk of some kind of change to policy, with gold and bonds rallying.  Key indicators like payrolls, the ISM index, retail sales and housing market activity have all disappointed in a way that cannot be entirely explained by weather.

The FOMC meeting minutes didn't suggest this softness would change the current tack for policy, with QE tapering continuing at a steady rate.  Recent speeches also seem to suggest the threshold for modifying the current pace of tapering will be higher than some softer data and would more likely require some meaningful changes to full year forecasts.

It also seems that the Fed would be much more open to changing forward guidance rather than QE, given the relative costs involved. But so far the market is doing the work for them, with the recent rally in bonds likely to cushion the weakness seen in housing markets.

The Fed may end up taking a leaf out of the Bank of England's book by changing guidance given the unemployment rate threshold of 7% is only months away.  The FOMC have hedged their statements a bit better given inflation is well below target, while the BoE are projecting inflation around their 2%.

Nevertheless, the BoE have dropped the single employment measure to be more encompassing of labour market conditions, with the diagram on the left from the BoE's most recent Inflation Report. The closer the line is to the center of the spiderweb, the closer the variable to more normal levels

In particular, they continue to see significant slack in terms of hours worked, at least compared to assessments since 1992.

Its important to remember that monetary policy is currently very loose, so the BoE won't wait to wait for labour market conditions to return to that inner part of the web before raising interest rates.  Indeed, it has been surprised by how quickly labour market conditions improved over the course of 2013, so it seems likely that they will be moving earlier than they are currently projecting.

The ECB are stuck with an entirely different problem, with the Bank still poised to do something more but its not sure what to do.  The recovery in activity has continued in the last few months, but inflation has been sliding.

The ECB currently doesn't believe its on the path to deflation, but you don't want to wait for that to happen before reacting.  It does appear that the ECB will cut interest rates again, but most are suggesting that some kind of quantitative easing will be required.

But doing this under the Euro is much more difficult given the restrictions on buying sovereign bonds.
The BoJ has largely left its stance unchanged as it waits to see the impact of a rise in consumption taxes in April.  Growth has been a little bit weaker than expected in Q1, but so far they have got inflation on a trajectory that it hasn't been on for many years. So its wait and see mode for the BoJ.

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.