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Chris Weston
Comex Gold

I have 10,500 (trend resistance and R3/pivot) as my upside target here, although there is signs of divergence between price and the 9-day RSI, which puts the index on alert for potential fatigue.

What’s driving this? Positioning, systematic funds drip feeding further capital into the market chasing the trend and perhaps more from retail. As detailed in yesterdays report (and video) the bond market holds the clues and it’s the same reason why gold has broken out to the highest levels since 2012.

As a gold bull I would have liked to have seen WTI push through $41.15 (the March gap), and more of a bid in copper, which would have lifted inflation expectations even higher. However, as it is, we still see US 5- and 10-year breakevens up 3bp apiece. However, again, we saw no move in the US 2 through to 10yr Treasury curve (UST 30 did move up 3bp) – so once again we see real yield moving deeper in negative territory.

When gold is viewed by the market as a zero-coupon bond, when real (or inflation-adjusted) Treasuries head lower, the relative attractiveness of gold increases. This chart tells the story of gold:

  • Upper pane – we see gold (inverted) vs US 5yr real yields. For the stats heads out there, a 2-year regression shows the correlation coefficient between the two variables at 0.904. That being, 90% of the variance in gold can be explained by the inflation-adjusted US Treasury – incredibly significant.
  • Middle pane – the construct of real yield. We see 5-year inflation expectations moving higher, yet nominal bonds remain anchored. The perfect backdrop for gold, albeit, the absolute level of inflation expectations will in no way trouble the Fed.
  • Lower pane – the total USD value of bonds (globally) that has a negative yield. While the correlation with gold comes and goes, if global bond yields head lower then gold will find buyers as a hedge against diminishing returns in fixed income.

We can also marry the moves in the bond market with positive market semantics, which has caused the USD to weaken on a broad basis, with capital repatriated out of the USD. That is all we need to know for gold and precious metals more broadly.

The USD is important because while you can trade gold in USD, EUR, GBP, CHF and AUD with Pepperstone, we naturally want to be long an underlying asset in the weakest currency (or conversely to be short in the strongest). For perspective, the NOK was the strongest currency on the day, and gold priced in NOK is flat.

What I also like about the breakout in gold is that there are very signs of euphoria and gold is not over owned. Let’s look at the evidence for this call.

Gold futures

as per the weekly CoT report, managed money holds 105,000 net long gold futures contracts. The blue line represents the average from 2006 (when the CFTC started to compile the data), where we see 1 & 2 standard deviation moves either side of the mean. As we see, gold is below the average.

Sentiment in the options market

Upper pane – Gold 1-week implied volatility minus 1-year implied vol. If traders were betting on an impulsive rally, we’d see this spread moving markedly wider, with traders’ bigger buyers of ST volatility, just like we did in March.

Middle pane – Gold 1-month risk reversals (RR). RR take 25-delta call volatility and subtract put vol. The higher this is the greater the demand for bullish options structure. So, we see call vol trading at 1.8 volatility premium to puts, which shows the market is bullish, but I’d be concerned at euphoric conditions above 4. All very neutral.

Lower pane – Gold 6-month risk reversals. A similar set as above but using 6-month options.

Gold ETF flows (GLD ETF) – this is where we can see some signs of euphoria, with the estimated money

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Chris Weston, Head of Global Research at Pepperstone.

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