Are investors misreading the policy ramifications?
After the Bank of Japan (BOJ) announced an increase to the upper limit of its 10-year interest rate from 0.25% to 0.50% on Dec. 19, Asian stock markets sold off and U.S. equity futures retreated. Moreover, Japanese government bonds tumbled, and a panic bid for the yen sent the USD/JPY into a tailspin.
Yet, the market-moving event ended with equities recovering their losses, while gold, silver and mining stocks rallied sharply. However, investors’ misinterpretation of the policy shift should elicit sharp reversals over the medium term.
For starters, widening the BOJ’s interest rate band is hawkish and only exacerbates the global liquidity drain. Remember, the short-term gold bulls are only focused on the first derivative, which assumes ‘USD Index down, PMs up.’ But, tighter monetary policy is profoundly bearish, and like we’ve mentioned, if QE is bullish, then what it QT?
Second, higher interest rates reduce the fundamental attractiveness of the PMs. Gold, silver and mining stocks are non-yielding assets, and bonds offer higher relative returns when rates rise. Therefore, the PMs’ daily sprint was all about momentum and not the fundamentals.
Third, investors underestimate the degree to which policy actions cascade across markets.
Please see below:
To explain, the red line above tracks the 15-minute movement of the 10-Year Japanese Government Bond (JGB) yield, while the green line above tracks the 15-minute movement of the U.S. 10-Year Treasury yield (10Y).
If you analyze the vertical gray line in the middle of the chart, you can see that the BOJ's monetary policy release sparked a sharp sell-off of the 10-year JGB and the yield soared. Likewise, with the 10Y following suit, American interest rates also rose materially.
More importantly, the U.S. 10-Year real yield jumped by three basis points on Dec. 20 to settle at 1.45%; and please remember, the metric was at 1.08% on Dec. 2, it's risen by 37 basis points in 18 days, and the development significantly reduces the appeal of risk assets. So, while the momentum investors don't care, the reality is that rising real yields should jolt investors in the weeks and months ahead.
Please see below:
To that point, while we remain short the GDXJ ETF and are more concerned about its movement, the resurgence of the U.S. 10-Year real yield is a highly ominous development.
Please see below:
To explain, the candlesticks above track the daily movement of the GDXJ ETF over the last 12 months. For context, we inverted the scale to highlight the symmetry of the negative correlation between the junior miners' index and the U.S. 10-Year real yield. Therefore, upward movement represents lower prices, while downward movement represents higher prices.
The three vertical gray lines also depict the day before the U.S. 10-Year real yield hit notable bottoms over the last 12 months. If you analyze the first instance on the left, you can see that the GDXJ ETF hit an intraday high of $50.29 on Mar. 8, which was only slightly below its Russia-Ukraine-war-induced final intraday high of $51.92 on Apr. 19. Thereafter, a major decline occurred, and the GDXJ ETF lost nearly half of its value.
During the next iteration, the GDXJ ETF recorded an intraday high of $33.83 on Aug. 1, which, again, was only slightly below its final intraday high of $35.26 on Aug. 10. Thereafter, the GDXJ ETF sunk to another 2022 low, falling below $26.
Thus, the third iteration shows that the GDXJ ETF hit an intraday high of $37.42 on Dec. 2, which is only pennies below its current intraday high of $37.48 set on Dec. 13.
As it stands, the important point is that the GDXJ ETF is materially overvalued relative to the U.S. 10-Year real yield; and with the metric inching toward its 2022 highs, the junior miners' index should be inching toward its 2022 lows.
Yet, the high-low dates above demonstrate how the PMs' reaction to the movement of real interest rates isn't instantaneous. In contrast, it takes time for market participants to digest the change. But, when the 'uh oh' moment arrives, sentiment shifts dramatically and the PMs plunge.
Furthermore, please remember that higher real interest rates are required to curb inflation; and while we've been warning for many months that the consensus underestimated (and still does) the measures required to normalize the pricing pressures, a higher U.S. federal funds rate (FFR) and a potential recession are bearish for the GDXJ ETF.
Please see below:
Source: BlackRock
To explain, BlackRock – the largest asset manager in the world – told clients that a “deep recession” is necessary to normalize inflation. If you analyze the intersecting orange and yellow lines above, you can see that trend GDP growth does not support 2% inflation.
Conversely, the dashed green line on the right side represents the demand destruction required to solve the Fed’s inflation conundrum. Consequently, BlackRock’s team wrote:
“Central bankers won't ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. Equity valuations don't yet reflect the damage ahead.”
So, while the GDXJ ETF and the gold price party like it's the summer of 2020, the fundamentals are profoundly bearish. Likewise, while the greenback's decline distracts them from these ominous developments, a higher FFR and U.S. real yields are bullish for the USD Index.
As such, while the price action suggests otherwise, the crowd is offside once again, and it's likely only a matter of time before they realize their mistake.
Alex Demolitor
Precious Metals Strategist