While I usually finish the analyses with the fundamental discussion and start with the technicals, it seems justified to switch the usual order once again today. The reason is that a large part of yesterday’s and Wednesday’s price moves could be attributed to the FOMC (and the following press conference).
The War on Debt
With Jerome Powell, Chairman of the U.S. Federal Reserve (FED), struggling to adequately define “transitory” during his press conference on Jul. 28, the market narrative has shifted from ‘hawkish FED’ to ‘dovish FED.’ And with the U.S. dollar bearing the brunt of investors’ wrath, the ‘all-clear’ sign flashed in front of the PMs. However, with post-FED rallies mainstays in the PMs’ historical record, the recent euphoria is much more semblance than substance. Thus, while Powell’s persistent patience elicits fears of financial repression, today’s economic environment lacks many of the qualities that made the gambit viable in the past.
To explain, financial repression includes measures such as direct government financing (the FED prints money and lends it directly to the U.S. Treasury), interest rate caps (yield curve control) and extensive oversight of commercial banks (reserve requirements, controlling the flow of credit). In a nutshell: governments use the strategy to keep interest rates low and ensure that they can finance their debt. And with the U.S. federal debt as a percentage of GDP currently at 128% (updated on Jul. 29), some argue that’s exactly what’s happening. Moreover, with the U.S. 10-Year real yield hitting an all-time low of -1.15% on Jul. 28, is the FED simply turning back the clock to the 1940s?
To explain, during World War Two, surging inflation helped the U.S. government ‘inflate away’ its debt. Think of it like this: if an individual borrows $100 at a 2% interest rate and repays the balance in full after one year, the total outlay is $102. However, if inflation is running at 4% (negative real yield), putting that money to work should result in an asset that’s worth $104 by the end of the year. As a result, the individual nets $2 (104 – 102) due to the inflation rate exceeding the nominal interest rate. And as it relates to the present situation, if the FED keeps real yields negative, then asset price inflation and economic growth should outpace nominal interest rates and allow the U.S. government to ‘inflate away’ its debt.
However, the strategy is not without fault. For one, financial repression occurs at the expense of bondholders. And with pension funds still required to meet the guaranteed outlays for retirees, suppressing bond yields hampers their ability to match assets and liabilities without incurring more risk.
More importantly, though, the FED doesn’t control the long end of the U.S. yield curve. For one, the FED owns roughly 23% of the U.S. Treasury market, and it has a monopoly on confidence, not long-term interest rates. Second, the U.S. 10-Year Treasury yield has dropped because investors fear that the Delta variant and/or the FED’s forthcoming taper will depress the U.S. economy. And eager to front-run the potential outcome, bond investors have positioned for slower growth, lower inflation, and, eventually, a reenactment of the FED cutting interest rates.
For context, even Powell himself admitted on Jul. 28 that the decline has caught him off-guard:
Source: Bloomberg
Likewise, following WW2, the U.S. government implemented structural reforms that are not present today. For example, prudent fiscal policy emerged in the late 1940s, with the government reducing spending and prioritizing debt reduction. In stark contrast, today’s U.S. government is already finalizing an infrastructure package and the federal deficit as a percentage of GDP is still growing. For context, a deficit occurs when the governments’ outlays (expenditures) exceed its tax receipts (revenues).
Please see below:
To explain, the green line above tracks the U.S. federal surplus/deficit as a percentage of GDP. If you focus on the period from 1943 to 1950, you can see that after the deficit peaked in 1943, reduced spending and strong GDP growth allowed the green line to move sharply higher. Conversely, if you analyze the right side of the chart, you can see that current spending still outpaces GDP growth (green line moving lower), and stoking inflation is unlikely to solve the problem.
U.S. 10-Year Treasury Yield Decouples… By a Lot
Circling back to the bond market, the U.S. 10-Year Treasury yield currently trades at an all-time low relative to realized inflation.
Please see below:
To explain, the scatterplot above depicts the relationship between the headline Consumer Price Index (CPI) and the U.S. 10-Year Treasury yield (available data dates back to 1967). For context, the headline CPI is plotted on the horizontal axis, while the U.S. 10-Year Treasury yield is plotted on the vertical axis. If you analyze the dot labeled “Current Reading,” you can see that the U.S. 10-Year Treasury yield has never been lower when the headline CPI has risen by 5% or more year-over-year (YoY). In fact, even if the headline CPI declined to the FED’s 2% YoY target, the U.S. 10-Year Treasury yield at 1.27% would still be the lowest relative reading of all time.
However, it’s important to remember that different paths can still lead to the same destination. For example, if inflation turns out to be a paper tiger, a profound decline in inflation expectations will have the same negative impact on the PMs as a sharp rise in the U.S. 10-Year Treasury yield.
Please see below:
To explain, the green line above tracks the U.S. 10-Year Treasury yield, while the red line above tracks the U.S. 10-Year breakeven inflation rate. If you analyze the gap on the right side of the chart, it’s a decoupling of the ages. However, while the two lines are destined to reconnect at some point, if the red line falls off a cliff, the impact on the PMs will likely mirror the 2013 taper tantrum. For context, gold fell by more than $500 in less than six months during the event.
Finally, and most importantly, U.S. Treasury yields are only one piece of the PMs’ bearish puzzle. Knowing that one shouldn’t put all their eggs in one basket, betting the farm on the U.S. 10-Year Treasury yield would be investing malpractice. That’s why self-similar patterns, ratios, technical indicators, the relative behavior of the gold miners, the USD Index and the FED’s taper timeline are all prudently considered when forming our investment thesis.
As an example, if gold had a perfect correlation with the U.S. 10-Year real yield, the yellow metal would be trading at roughly $1,940. However, with many other factors worthy of our attention, gold’s material underperformance indicates that a mosaic of headwinds undermines its medium-term outlook.
In conclusion, Powell’s party was in full swing on Jul. 29, as the PMs and the USD Index headed in opposite directions. However, with the yellow metal still confronted with a tough road ahead, the fundamental outlook remains dicey over the next few months. For example, with the all-time imbalance in the U.S. Treasury market eliciting little optimism, it took Powell’s dovish remarks to ignite the recent fervor. And with both developments likely to reverse in the coming months, the PMs’ upside catalysts may fade with the summer sun.
It seems that the markets reacted to the Fed’s comments at their face value, but as the time goes by, the markets are likely to start reading between the lines and note what’s coming. And since the markets are forward-looking, yesterday’s price moves are likely to be reversed, and it seems that we might not have to wait too long for that to happen.
In fact, if it was the case that recent rallies were triggered just by a very emotional reaction to the news without due analysis, it could be also the case that they will be reversed soon, as analysts will dig into the comments and report to investors soon.
The implication of the above is that perhaps the price moves and their technical implications shouldn’t be taken at their face value just yet.
Having said that, let’s look at the technicals.
Rally or Fakeout?
Gold rallied yesterday, and it even moved above its rising short-term resistance line that I marked with a red, dashed line. This seems bullish until you compare it with a very similar price action that took place in mid-February when gold was after a very similar pattern (sharp decline, corrective upswing to the 50% retracement, another move lower, and then another move up before sliding).
It seems that we are in the “then another move up” stage right now. Back in February, gold moved to about 38.2% Fibonacci retracement based on the initial big decline before turning south. Gold just breached the 38.2% Fibonacci retracement that’s based on the initial big decline, but it didn’t move far above it.
That’s not the only analogy to the recent past. I marked two more similar cases with red ellipses. As you can see, based on these two 2020 examples, the breakouts in gold above the short-term resistance lines (that supposedly change the outlook completely) are fairly common. And they are not necessarily bullish, especially if they follow a sharp, big decline and then a consolidation.
Therefore, is gold’s rally really bullish right now? Or is it a fakeout just like what we saw in mid-February and twice in 2020? The context suggests that the fakeout scenario is more probable.
The USD Index
The USD Index invalidated the breakout above its inverse head-and-shoulders pattern, and in yesterday’s analysis I wrote that if I had a long trading position in the USD Index, I would close it based on this development, as it suggests that the USDX might move a bit lower before rallying. I would plan to re-open this position just a little lower, though, as the next support provided by the 38.2% and 50% Fibonacci retracements is quite close. There’s quite a big chance that this move lower will be reversed too, based on the temporary nature of yesterday’s news.
However, as I explained on Wednesday in the “Letters to the Editor” section, I don’t hold a position in the USD Index but in the mining stocks.
Indeed, the USD Index declined to its 38.2% Fibonacci retracement and moved back up a bit. Was that the end of the short-term decline? That’s quite possible, but I wouldn’t bet the farm on that scenario. The USDX could bottom a bit lower, for example, at its 50% Fibonacci retracement, which is also close to USD’s late-June lows. These two levels provide a quite strong short-term support.
Before moving to mining stocks, let’s take a look at the recent move higher in the value of the linear correlation coefficient between gold and the USD Index (bottom part of the chart). There were a few similar periods when it rallied and gold moved higher as well. I marked those cases with vertical dashed lines. In all three cases, it was right before gold turned south and declined in a quite profound manner. In one case (Sep. 2020), gold moved back and forth for several days before declining, but it then declined significantly anyway. The implications for gold and the rest of the precious metals sector are bearish.
Mining Stocks
The senior and junior gold miners moved higher yesterday (and quite visibly so), which didn’t change much, as I already wrote about the most important technical detail yesterday. Namely, the GDXJ invalidated the breakdown below the head-and-shoulders pattern. Yesterday, I wrote that this invalidation might make the junior miners rally for a day or a few days. However, just as the nature of gold’s rally seems temporary, so is the nature of this tiny upswing in junior miners.
The volume on which miners rallied yesterday was not low, but it was not huge either. Consequently, it might or might not be the case that the rally burnt itself out just yet.
This uncertainty and lack of clarity with regard to the short term is not concerning, though. And the long-term HUI Index shows why.
The HUI Index
First of all, my yesterday’s comments on the above HUI Index chart remain up-to-date:
It seems very likely that gold miners are declining similarly to how they declined in 2008 and 2012-2013. In both cases, there were local corrections within the decline. However, if one completely ignored the corrections and kept their short position intact, the profits on the entire slide would have been immense. The current small correction is really just a blip on the radar screen, and the odds are that in a few months nobody will remember about it, as what will happen between now and then (the huge decline) will be so profound that it will displace all those small upswings in one’s memory.
Consequently, it seems to me that the uncertain (it might be even reversed today) rally is not something that really justifies adjusting our short positions in the junior mining stocks. I continue to view them as justified from the risk to reward point of view.
But, did you see the tiny buy signal from the Stochastic indicator? To clarify, we’ll see it if it’s not invalidated by today’s session (the above is a weekly chart and the trading week ends today), but for the sake of being prepared, let’s assume that it’s already valid. Shouldn’t one expect a huge rally based on it? Well, if gold miners are repeating their previous huge declines, then let’s check what happened in the most recent case. Namely, let’s see what the HUI Index did when we saw a small buy signal, the Stochastic indicator was already below the 20 level, and the HUI was in the process of forming the right shoulder of a huge, medium-term head-and-shoulders pattern. It was in late 2012. Let’s zoom in.
Well, what happened after the buy signal from the Stochastic indicator in mid-December 2012? Nothing, actually. The HUI Index just moved slightly higher, and it was just a pause before the decline continued – at an accelerated pace.
Consequently, should we really be concerned with the current short-term situation? Not really. Whatever bullish takes place, it’s likely to be short-lived and limited in terms of size, at least in the case of mining stocks.
And what about silver?
Silver
The white metal moved sharply higher yesterday, but it ultimately closed the day below its June lows (in terms of the closing prices). As there was no invalidation of the breakdown, the technical picture for silver hasn’t become more bullish.
A word of caution, though. Silver is known to break out above its resistance levels / lines right before plunging. Consequently, it would not be surprising to see a little more strength in silver before it turns south – it would be a normal part of the short-term correction within a bigger downtrend.
Overview of the Upcoming Part of the Decline
- The biggest corrective upswing in gold might already be over, and it seems that we won’t have to wait long for the current small correction to end either.
- After miners slide in a meaningful and volatile way, but silver doesn’t (and it just declines moderately), I plan to switch from short positions in miners to short positions in silver. At this time, it’s too early to say at what price levels this would take place – perhaps with gold close to $1,600. I plan to exit those short positions when gold shows substantial strength relative to the USD Index, while the latter is still rallying. This might take place with gold close to $1,350 - $1,500 and the entire decline (from above $1,900 to about $1,475) would be likely to take place within 6-20 weeks, and I would expect silver to fall the hardest in the final part of the move. This moment (when gold performs very strongly against the rallying USD and miners are strong relative to gold – after gold has already declined substantially) is likely to be the best entry point for long-term investments, in my view. This might also happen with gold close to $1,475, but it’s too early to say with certainty at this time.
- As a confirmation for the above, I will use the (upcoming or perhaps we have already seen it?) top in the general stock market as the starting point for the three-month countdown. The reason is that after the 1929 top, gold miners declined for about three months after the general stock market started to slide. We also saw some confirmations of this theory based on the analogy to 2008. All in all, the precious metals sector would be likely to bottom about three months after the general stock market tops.
- The above is based on the information available today, and it might change in the following days/weeks.
Please note that the above timing details are relatively broad and “for general overview only” – so that you know more or less what I think and how volatile I think the moves are likely to be – on an approximate basis. These time targets are not binding or clear enough for me to think that they should be used for purchasing options, warrants or similar instruments.
Summary
To summarize, it seems that the bigger corrective upswing in gold might already be over, and that we won’t have to wait for the current small correction to end, either. While the next few days may (!) bring temporarily higher prices, it’s unlikely that they will hold. In particular, just as mining stocks had local corrections that didn’t change the nature of the huge medium-term declines in 2008 and 2012-2013, it’s unlikely that the current local correction changes anything.
It seems that our profits on the short position in the junior mining stocks are going to grow substantially in the following weeks.
After the sell-off (that takes gold to about $1,350 - $1,500), I expect the precious metals to rally significantly. The final part of the decline might take as little as 1-5 weeks, so it's important to stay alert to any changes.
Most importantly, please stay healthy and safe. We made a lot of money last March and this March, and it seems that we’re about to make much more on the upcoming decline, but you have to be healthy to enjoy the results.
As always, we'll keep you - our subscribers - informed.
To summarize:
Trading capital (supplementary part of the portfolio; our opinion): Full speculative short positions (300% of the full position) in mining stocks are justified from the risk to reward point of view with the following binding exit profit-take price levels:
Mining stocks (price levels for the GDXJ ETF): binding profit-take exit price: $37.12; stop-loss: none (the volatility is too big to justify a stop-loss order in case of this particular trade)
Alternatively, if one seeks leverage, we’re providing the binding profit-take levels for the JDST (2x leveraged) and GDXD (3x leveraged – which is not suggested for most traders/investors due to the significant leverage). The binding profit-take level for the JDST: $15.96; stop-loss for the JDST: none (the volatility is too big to justify a SL order in case of this particular trade); binding profit-take level for the GDXD: $37.02; stop-loss for the GDXD: none (the volatility is too big to justify a SL order in case of this particular trade).
For-your-information targets (our opinion; we continue to think that mining stocks are the preferred way of taking advantage of the upcoming price move, but if for whatever reason one wants / has to use silver or gold for this trade, we are providing the details anyway.):
Silver futures upside profit-take exit price: unclear at this time - initially, it might be a good idea to exit, when gold moves to $1,683
Gold futures upside profit-take exit price: $1,683
HGD.TO – alternative (Canadian) inverse 2x leveraged gold stocks ETF – the upside profit-take exit price: $12.88
Long-term capital (core part of the portfolio; our opinion): No positions (in other words: cash
Insurance capital (core part of the portfolio; our opinion): Full position
Whether you already subscribed or not, we encourage you to find out how to make the most of our alerts and read our replies to the most common alert-and-gold-trading-related-questions.
Please note that we describe the situation for the day that the alert is posted in the trading section. In other words, if we are writing about a speculative position, it means that it is up-to-date on the day it was posted. We are also featuring the initial target prices to decide whether keeping a position on a given day is in tune with your approach (some moves are too small for medium-term traders, and some might appear too big for day-traders).
Additionally, you might want to read why our stop-loss orders are usually relatively far from the current price.
Please note that a full position doesn't mean using all of the capital for a given trade. You will find details on our thoughts on gold portfolio structuring in the Key Insights section on our website.
As a reminder - "initial target price" means exactly that - an "initial" one. It's not a price level at which we suggest closing positions. If this becomes the case (like it did in the previous trade), we will refer to these levels as levels of exit orders (exactly as we've done previously). Stop-loss levels, however, are naturally not "initial", but something that, in our opinion, might be entered as an order.
Since it is impossible to synchronize target prices and stop-loss levels for all the ETFs and ETNs with the main markets that we provide these levels for (gold, silver and mining stocks - the GDX ETF), the stop-loss levels and target prices for other ETNs and ETF (among other: UGL, GLL, AGQ, ZSL, NUGT, DUST, JNUG, JDST) are provided as supplementary, and not as "final". This means that if a stop-loss or a target level is reached for any of the "additional instruments" (GLL for instance), but not for the "main instrument" (gold in this case), we will view positions in both gold and GLL as still open and the stop-loss for GLL would have to be moved lower. On the other hand, if gold moves to a stop-loss level but GLL doesn't, then we will view both positions (in gold and GLL) as closed. In other words, since it's not possible to be 100% certain that each related instrument moves to a given level when the underlying instrument does, we can't provide levels that would be binding. The levels that we do provide are our best estimate of the levels that will correspond to the levels in the underlying assets, but it will be the underlying assets that one will need to focus on regarding the signs pointing to closing a given position or keeping it open. We might adjust the levels in the "additional instruments" without adjusting the levels in the "main instruments", which will simply mean that we have improved our estimation of these levels, not that we changed our outlook on the markets. We are already working on a tool that would update these levels daily for the most popular ETFs, ETNs and individual mining stocks.
Our preferred ways to invest in and to trade gold along with the reasoning can be found in the how to buy gold section. Furthermore, our preferred ETFs and ETNs can be found in our Gold & Silver ETF Ranking.
As a reminder, Gold & Silver Trading Alerts are posted before or on each trading day (we usually post them before the opening bell, but we don't promise doing that each day). If there's anything urgent, we will send you an additional small alert before posting the main one.
Thank you.
Przemyslaw K. Radomski, CFA
Founder, Editor-in-chief