A golden divergence. TIPS do well, gold drops TIPS total return index versus gold TIPS total return index

Transcription

1 Wednesday, October 19, 216 Inside this issue A golden divergence Inflation, real yields and gold: Today s note takes a look at gold following the recent drop in prices. Gold has begun to diverge from real yields. We do not expect that this divergence will persist. Market positioning appears to be much less extreme than it was a few weeks ago and recent developments suggest that central bankers are keen to let inflation rise above target without a commensurate tightening of policy. We believe that gold will recover. Inflation is back in the spotlight. The bottoming out in commodity prices, combined with the late-cycle reduction of U.S. slack, is creating a mild increase in inflation expectations. Correspondingly, Treasury Inflation Protected Securities have outperformed Treasuries in recent months TIPS bottoming out relative to Treasuries as inflation expectations pick up Relative total returns of iboxx TIPS and Treasuries indices versus 5y5y inflation swap Relative performance of TIPS/Treasuries indices, ratio 5y5y inflation swap, % Relative performance, TIPS/Treasuries (left) 5y5y inflation swap (right) E-US J A S O N D F M A M J J A S O N D F M A M J J A S O Pavilion Global Markets (Markit data via Bloomberg) 1.8 Gold and TIPS tend to be fairly correlated as increases in inflation expectations (or decreases in real yields) benefit both assets. Yet despite this bounce in inflation expectations, we saw a sharp drop in gold prices recently. As such, TIPS and gold have diverged. strategy@pavilioncorp.com TIPS do well, gold drops TIPS total return index versus gold TIPS total return index TIPS total return index (left) Gold price (right) Gold price, $/oz Pavilion Global Markets Ltd. All rights reserved. This report may not be reproduced, distributed or copied, in whole or in part, in any form, without the written consent of Pavilion. Pavilion Global Markets Ltd. is a CIPF member Pavilion Global Markets (Markit data via Bloomberg) E-US-1542 One issue that may have caused the sharp repricing in gold is market positioning. Based on CFTC data, it appears that long positions in gold were 19 October 216 1

2 at their most extreme in years, highlighting the positive sentiment that prevailed before the drop. After the sharp move from $1,35/oz. to $1,25/oz., the number of net long positions is now much closer to its longterm average. Cleaner positioning after the drop Net managed money contracts (long-short) on bullion Net # of contracts $/oz Net positioning (L) Average (L) +2 s.d. (L) Gold price (R) C-PM Pavilion Global Markets (data via CFTC) 1 5 We turned positive on gold at the start of 216 and continue to believe the metal is on an uptrend (see Rise and shine: gold in 216, February 2). We believe that Janet Yellen s speech delivered last Friday supports our positive view. When discussing the idea that persistent drops in aggregate demand can impact aggregate supply negatively (a phenomenon known as hysteresis ), Yellen offered the following comments: If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. ( ) In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient--and, hence, more-productive-- job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains ( ) The Fed Chair is describing an environment in which the Fed allows inflation to rise above target, without a commensurate tightening of monetary policy. This would be positive for USD-based debtors (e.g. emerging markets corporates). It also would be positive for gold, given the historical relationship between real yields and gold. 19 October 216 2

3 Real yields drive gold Real interest rates based on inflation expectations versus Gold spot price % $/Troy oz, inverse scale Ex-ante real 1y yield (left) Gold price (right, inverted) C-MA Pavilion Global Markets (data via Bloomberg) Whether the Fed will in fact be able to engineer a durable increase in inflation is debatable. Yet over a shorter horizon, a few factors are contributing to higher realized inflation currently. The first one is the inflation that we are witnessing in certain areas of the U.S. economy, which in our opinion has more to do with idiosyncratic industry issues than an economy that is overheating. This includes health care costs, health insurance and shelter Healthcare inflation: overheating economy or idiosyncratic issues? Year-on-year in CPI components % Medical care services (9% weight in CPI) Health insurance (1% weight in CPI) Shelter (33% weight in CPI) Core CPI Pavilion Global Markets (BLS data via Datastream) E-US-2178 Another newly inflationary development is the Chinese producer price index. China s PPI just exited deflation for the first time in about five years. This is a significant change from the past that may lead to a pass-through in terms of broader inflation numbers in China and more negative real rates as the PBOC refrains from tightening. This will make gold more attractive for Chinese savers. 19 October 216 3

4 1 China's PPI pokes its nose above zero China: GDP deflator, CPI and PPI % y/y GDP deflator CPI PPI E-CN Pavilion Global Markets (NBS data via Bloomberg) Finally, it is worth noting that freight rates have begun to pick up albeit from dismal levels. It will take time for the shipping industry to recover (see our note Shipping s perfect storm, March 11) and freight rates are still weak, but the price of certain goods will begin to reflect increasing freight rates. With central banks remaining fairly dovish, this means negative real interest rates which is good for gold. Baltic Dry Index Index (log scale) A rebound in freight rates C-MA Pavilion Global Markets (data via Bloomberg) Bottom line: Gold has fallen far and fast maybe too much so. We continue to believe that the commodity benefits from favorable dynamics. Disclaimer 19 October 216 4

5 This report was prepared for circulation to institutional and sophisticated investors only and without regard to any individual s circumstances. This report is not to be construed as a solicitation, an offer, or an investment recommendation to buy, sell or hold any securities. Any returns discussed represent past performance and are not necessarily representative of future returns, which will vary. The opinions, information, estimates and projections, and any other material presented in this report are provided as of this date and are subject to change without notice. Some of the opinions, information, estimates and projections, and other material presented in this report may have been obtained from numerous sources and while we have made reasonable efforts to ensure that that the content is reliable, accurate and complete, we have not independently verified the content nor do we make any representation or warranty, express or implied, in respect thereof. We accept no liability for any errors or omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. 19 October 216 5