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Markets Crash as Treasury Yields Invert

07 December 2018

Gold Price

Gold staged a breakout this week as panic struck equity markets on Tuesday night. Gold jumped to USD $1,238 and silver hit USD$14.50.
In local currency terms, the rally in precious metals combined with a drop in the AUD/USD to 0.724c boosted gold prices past AUD $1,700 and silver back above $20 per ounce. A tip of the hat to those clients capitalising on the initial spike in AUD, which saw gold start the week at a low of $1,655.
As seen in the daily chart above, the moving averages have swung into bullish formation, as gold broke out of its recent trading range.  We warned of gold beginning a new uptrend in a recent market update and those waiting for prices to drop further may be disappointed. After all, you can’t score goals by sitting on the bench.
Dollar cost averaging remains our favoured approach, as building a position in precious metals to ride out the next few years is more important than trying to time the market.
Gold prices are benefitting from both chaos in equity markets and rising concern of potential military-political tension between the US and China as we move into 2019. Expect this rally to gain momentum if we convincingly break up past US $1,240 per ounce.

Treasury Yield Spooks Markets 

Treasury Yield Spooks Markets 

Equity markets took a beating this week with significant falls of over 3% in a day for the S&P500 on Wednesday, with the Nasdaq dropping almost 4% intraday. Tech stocks took the largest falls, with FAANG stocks shedding $140 billion in market cap on Wednesday alone, whilst the Dow dropped a massive 800 points.
A big event in the US government bond market this week has investors and traders worried that a recession is just around the corner. For a brief period on Wednesday, the spread between 2- and 10- year Treasury yields fell below 10 basis points, the narrowest since 2007.  This followed a partial inversion on Tuesday.
US Treasury Yield 
If the Fed hikes rates at its December meeting, we could easily see the 2s/10s yield spread invert, which is significant from a historical perspective, as all of the last nine recessions in the US saw this occur shortly before hand. The four most dangerous words in investing are “this time it’s different”, so banking on the US pulling a rabbit out of the hat in the next few years by avoiding a recession under a tightening Fed would be optimistic to say the least.
The last few tightening cycles in the US did not bode well for the stock market and overall economy, and we do not think this time will be any different. We are seeing a lot of the higher p/e stocks coming off in a big way in October and November, and the overall broader reason for this is that investors are slowly coming to the realisation that the ‘easy money’ party is over. The monetary experiment and joy ride that has taken place since the GFC is now unwinding, ZIRP has finished, and bond yields are rising rapidly as the Fed takes the punch away from the party.
3 month US treasury bill yieldChart via Livewire Markets
A common criticism of central banking by Austrian Economists is that by fixing rates too low for too long, you create an imbalance and distortion in financial markets, as money moves into risk assets in the hunt for higher yields. As more money floods into riskier assets, momentum can create financial bubbles, exacerbated by a credit expansion, where valuations climb far above their historical norms. Then finally when the central bank praises the performance of the economy, they reverse course, and in effect create a credit crunch as rates move higher. This pops the bubble and the process starts all over again.
These credit cycles can happen over 10+ year periods, which is why most people are completely oblivious to them occurring.  The scary thing about the next crisis is that interest rates will probably still be well below historical norms when the crisis occurs. Therefore, central banks’ ‘ammunition’ to reflate the economy through cutting rates is somewhat diminished. If the last crisis saw interest rates across the US and Europe dropping to zero, and the introduction of quantitative easing, the next ‘solution’ to a potential financial crisis in the future could mean rates move into negative territory (NIRP).
The counter-argument to this would be that governments could provide fiscal stimulus in the event of a crisis, so that central banks wouldn’t need to do as much. But when you have in the US for example, a government debt to GDP ratio of over 100%, there are limits to what can be achieved fiscally.
It has been a long wait for precious metals bulls over the past few years as we are still well below all time highs, but it is starting to look like 2019-2020 could finally see the tide start turning, as there is growing potential for money to flow out of risk-on assets and into defensive and alternative assets, such a gold.

RBA: Rate Cuts and QE an Option in Australia

We have been consistent in our view this year that there is a very decent chance the next move in the RBA cash rate is actually lower, counter to consensus. This view is starting to become mainstream as most recently we have had AMP’s chief economist Shane Oliver change his view and join the party (although late), and even the RBA itself is coming to the realisation.
This week, RBA governor Guy Debelle used a speech in Sydney that there is still scope for further reductions in the policy rate if needed, and that quantitative easing could be deployed in the event of a crisis.
The AUD tumbled on the back of these statements as it only makes sense that if this is in fact our future, the AUD/USD could drop faster than Anthony Mundine in a Jeff Horn fight.
We see property prices continuing to fall from here and this will have a dramatic impact on the overall economy. As the ‘wealth effect’ diminishes, this will slow consumer spending and hinder economic growth. 

Look for Volatility in 2019

Don’t be surprised in 2019 if the volatility in equities continues. We covered in recent updates that valuations are far above historical norms, so there is a lot of froth in the market that could come out if we indeed have a bear market over the next few years.
Investec’s co-head of multi-assets growth, Philip Saunders, shares this opinion. He said investors should use any relief rally to sell shares if they can’t deal with volatility. “We are going to be in an environment where we think growth will decelerate further in response to more restrictive liquidity conditions, fading U.S. fiscal support and trade concerns.”
More on some of his other calls can be found in a recent Bloomberg article here.
His call on gold for 2019:
  • Gold may be a “surprise” next year: positions on gold have been cleared out, so if the macro environment gets rough amid volatility and a growth slowdown, defensive assets such as the precious metal may benefit.
There is something about this recent sell-off in equities that just seems like it has more staying power. Many institutional investors share the same fears as what is covered above as 2019 shapes up to be the year we see some big changes across financial markets.
A recent report by Natixis Investment Managers outlines why Institutional Investors are largely predicting the volatility that rocked markets in Q4 will continue into the New Year. In a survey of 500 institutional investors across 28 countries, an astonishing 65% believe the bull market in equities will end within the next 12 months.
Chart by Natixis Investment Managers
Half of respondents cited volatility as a portfolio risk and 54% predict it will have a negative impact on investment performance. Furthermore, more than 60% of institutions believe the popularity of passive investments has actually increased systemic risk.
There is no doubt the switch toward passive investing in this latest bull market has lead to further distortions in asset valuations. The combination of increased adoption in passive investing and dramatic rise of algorithmic trading could combine to provide some wild moves in markets throughout the next few years.
Gold should gain favourability next year, as it tends to flourish in periods of uncertainty and performs well in periods of equity market volatility. As the age of excessively easy money is ending, the tide should turn in favour of active investors once more, and particularly those suitably hedged with a healthy allocation to precious metals.
Until next time,
John Feeney
ABC Bullion

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