Precious Metals: A Coiling Spring

Daily Speculations are for me (Alex) to share some quick thoughts on charts/trades I’m looking at, books and articles I find interesting, or maybe just some photos of my dog Mars. As the name states, I’ll be sharing something daily except for some days when I don’t.

I’ve been keeping a close eye on precious metal stocks. They’re coiling in a tight pattern and look set for an explosive move in one direction or another.

Below is XAU the gold and silver index on a weekly basis.

Here a quick rundown on how I think about precious metals.

1. Like Ray Dalio has said, “Over the long run, the price of gold approximates the total amount of money in circulation divided by the size of the gold stock. If the market price of gold moves a long way from this level, it may indicate a buying or selling opportunity.”
   1. We can view gold and silver as anti-dollars. Since they are priced in US dollars they tend to move inversely to the greenback. And the fundamentals that drive the dollar higher tend to drive them lower.
      
2. A big driver then is the relative changes in the cost of money or the real rate of interest (interest rates adjusted for inflation).
   1. Real interest rates move off of growth and inflation; both realized and expected.
3. The performance of precious metals over cycles is largely dependent on whether we’re in a “core” driven rally or “periphery” driven rally.    
   1. A core driven rally is when the US (and typically other DMs) are the market leaders relative to emerging markets (periphery). This typically coincides with a global risk-off view where EMs are deemed too risky so capital pools into safer DM markets. This helps drive the dollar higher and keeps inflation low, both of which are bearish for precious metals.
   2. A periphery led rally is the opposite. It’s where EMs are seen as more stable and an attractive investment, at least on a relative basis to core markets. In this case, capital flows into EM countries which leads to a lower dollar, higher commodity prices, higher inflation, and thus lower real rates which is bullish for precious metals.
4. So much of the movement in precious metals is centered around beliefs about the future value of the dollar. And as a result, beliefs and resulting actions about the risks in holding assets that are priced in currencies other than the dollar.
5. One of the largest influencers on these beliefs is of course the Game Masters (the Federal Reserve).
   1. Since they control the cost of money and by extension the value of the dollar, what they do and what they signal they’re going to do, matter for precious metals.

We can see on the charts below via Deutsche Bank the relationship between the market’s pricing of future Fed rate hikes and the resulting moves in precious metals; which move inversely to these expectations.

Where are precious metals likely headed from here, then?  

Well it depends on the market’s perception of the Fed’s aggressiveness in hiking interest rates during this tightening cycle.

If the Fed signals a return to a more dovish approach then the dollar will continue to sell off, EMs will continue to outperform DMs, inflation expectations will increase (and expectations over future real rates decrease) and precious metals will perform well; perhaps breaking out to the upside of their large coiling pattern.

If the Fed sticks to its current commitment of tightening in December and the market’s belief in this commitment grows, then the dollar should strengthen, DMs should outperform EMs, and precious metals should perform poorly.

What makes the immediate future of precious metals even more difficult to discern is the coming announcement of Trump’s pick for the next Fed chair. Who it ends up being and how the market reacts could have a dramatic impact on precious metals.

So for me, I’ll continue to watch from the sidelines and wait for more clarity or a strong signal from the market, in the form of a technical breakout, before I take a position.

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Thanks for reading,

Alex