Gold liquidation explained.
Please read the Disclaimer before reading this article.
This past week has been quite an eventful week for gold.
On Monday, we saw a 50 dollar move higher in gold that brought us back above resistance.
In my article from December 20, I wrote: “the bullish arguments clearly outnumber my concerns, I really like how gold is behaving.”
This break above resistance on Monday increased my conviction that gold was ready for it’s next sustained advance higher.
But on Wednesday, everything changed. I’ve been warning in every article I wrote that fundamentals are very unclear to me and are not really supportive for gold as they were during the period Q4 2018 – Q3 2020.
On December 20th, I wrote: “Short-term fundamentals are still not clear to me. US bond yields look like they want to break higher, which would probably not be that good for gold.”
(Those that don’t know about the strong link between nominal/real rates and gold, can read this article I wrote on it.)
On Wednesday, this is what happened, US interest rates broke out.
(I tweeted the following chart on Wednesday with the comment: “Big move in US interest rates. 10 year yield finally broke out. Those who have read my articles know that this was the biggest risk for gold that I was seeing. Gold holding strong given this move in rates. Gold should hold the 1930 level.”)
So early in the day, gold was holding strong. However, this quickly changed. Prices started to decline and we lost the 1930 support level. We were now in a situation where we had a false breakout and US interest rates were clearly signaling that they were not supportive for a move higher in gold.
I sold my whole portfolio and went to cash. When the facts change, I change my mind.
(By the closing of the day, I felt rather stupid because I sold at the lows of the day and the mining shares had a very strong close. The following days showed however that getting to cash was the right decision to make. Risk management is key. I made a nice profit on the trade and sold my portfolio around 3% from its all-time high value.)
A lot of gold bulls were writing on twitter that higher nominal rates are no problem because inflation expectations will rise more quickly, thereby lowering real rates which is good for gold.
However, if you look at the following chart, you can see that the TIPS breakeven curve is inverting. Historically, this has led to a (temporary) peak in inflation expectations. As I’ve stated many times in the past, be careful of analysts that use narratives that are not supported by data to express their macro opinions.
Source: Arbor Data Science
When I looked at the technical picture on Wednesday evening, I was rather concerned. The following chart shows that during the correction in gold from August to November, two horizontal lines are able to explain most closing candles and wicks. (A good reminder that you don't need to add 10 lines and 10 indicators to do technical analysis. The easier, the better.)
(I shared these following two charts on Wednesday evening on twitter, see here.)
When I looked at the close on Wednesday, it looked like a breakdown and a retest from underneath, of the lower horizontal line.
(There were other negative technical signals like the daily RSI failing to get overbought.)
This analysis proved correct and on Friday the gold price declined 80 dollars. (Of course, I didn’t foresee the magnitude of the decline, my target was around 1860.)
The question now becomes, what’s next.
Let’s have a look at what the impact on gold could be from inflation expectations (potentially) peaking.
I took the breakeven curve and extended the vertical lines (when inversion took place) to a chart of the gold price.
There are 7 lines to analyze. The first one we can ignore because this took place during the financial crisis and it was thus a liquidation event.
I’ll now group the remaining lines in 3 categories:
-gold rose after inflation expectations peaked: line 2, 4, and 7
-gold declined after inflation expectations peaked: line 3, and 6
-gold didn’t do much after inflation expectations peaked: line 5
So sometimes gold rises sharply, and sometimes it declines sharply. Not much we can learn from it. However, when we take it a step further, we can come to a conclusion. When inflation expectations peak, the question becomes how nominal yields react to this. I overlaid the above chart with the US 10-year yield.
Let’s take the above categories again and add how nominal interest rates reacted:
-gold rose after inflation expectations peaked: line 2, 4, and 7 -> in each instance, interest rates declined sharply after the peak in inflation expectations
-gold declined after inflation expectations peaked: line 3, and 6 -> interest rates declined a bit after line 3 and rose sharply after line 6
-gold didn’t do much after inflation expectations peaked: line 5 -> interest rates declined
It’s now clear that historically, gold needs declining interest rates to start rising again when inflations expectations have peaked.
How big is the chance we’ll see rates declining again?
Well, they have been consolidating for a month right below the resistance level and have only broken out this week. I think it’s wrong to assume this move higher in interest rates is over. If we look at history, once interest rates break out, they move rather quickly (see my tweet and charts on it here). Probabilities suggest that this move higher in rates is just beginning.
Since the December 2015 bottom in gold, every big sustained decline (second half of 2016 and 2018) has been accompanied by rising rates. (see chart below, the vertical red lines show that when yields peaked in the past, they did so with the weekly RSI for the 10-year yield being much higher than now, implying that we have room to go higher in US yields.)
With yields breaking out on Wednesday and gold losing both support levels, my decision to become bearish was quickly taken.
If we look at a weekly chart of US interest rates, we can see that the 1,47% level looks like a logical target. Will it get there? I don’t know. But the probability that this mover higher in interest rates is over is very low in my opinion.
So, is the bull market in gold over? Certainly not. But probabilities suggest that the next sustained move higher won’t be starting in the short term.
As I wrote in a previous article, I suspect that the fed will step in at some point with yield curve control. At that point, with nominal rates being capped and my inflation models showing that inflation will come back higher than most expect, real interest rates can start to decline again. (Looking at my models, my best guess is that in the second half of 2021, inflation will be around 2,5%. We are currently around 1,2%. High inflation with yield curve control will lead to a very bullish macro backdrop for gold.)
As long as we stay on a weekly closing basis above the 1790 level, the big picture bullish gold scenario remains fully intact. We probably only need more time for the fundamentals to come in line with the technicals and sentiment.
I’ll end with repeating what I wrote at the end of my previous article: “As I’ve explained before, I always have a plan for every situation that can unfold. Nobody is right all the time and with investing, this isn’t necessary either. What is necessary however is that you have a plan.
As legendary investor George Soros put it: “It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.”
I hope I’m right so that I’ll make a lot of money in the coming months. But as I’ve shown in previous articles, I have a strict trade management that will prevent me from losing money in this investment (since I already have a profit since I went all-in). That’s the key to trading/investing. And it is probably also the most difficult thing to learn.”
My plan and trade management worked perfectly this week. If I’m wrong in my view that this move higher in interest rates is not over, or imagine that gold can rise with rising real interest rates (it’s unlikely but it happened in the past, as I showed here), I’ll know when to get back in. (a break above 1934 will probably get me bullish again)
In the meantime, I’ll be investing in other sectors that show more potential (I’ve written an article on it, I’ll upload it somewhere next week.)
If gold struggles to rise on a sustained basis in the coming weeks (this is what I expect), I’ll be ready to get in as close as possible to the bottom. At that time, technical, sentiment and fundamentals will align to set us up for a monster trade. I’m looking forward to sharing with you when that time comes.
For the short term, we will undoubtedly have sharp rallies but I’m not interested in capturing those. Only a break above 1934 or a clear bottom later in 2021 will get me back into gold. There are a lot of other things that will do much better with yields breaking out.
Thank you very much for reading my article, I hope you liked it.
You can follow me on twitter: @adaptiveinvest
Bonus: A lot of charts of individual mining shares still look bullish. If you look at the chart of GDX, you can see that it’s short term uptrend was not yet violated. If GDX can get above the high of January 5, this would make me reconsider my thoughts. If you look at it from a bearish perspective, this could be a bear flag.