Gold and Treasury yields are overextended
US Treasury yields and gold have been on a tear, confounding many traders in the market who have been caught off-guard or left behind. Within the space of a month, the 10 year yield has rebounded from a low of 3.6% to 4.2% today. What’s even more impressive is that it’s rebounding in the middle of a Fed rate cut cycle.
Those who have been following my blog know I’ve been looking for a rebound in yields for over a month now.
As for gold, the relentless rally has taken me by surprise. I exited my long in gold a month too early, thinking that the low in yields would also mark the top in gold. I expected that rebounding yields, a strengthening dollar, excessive long positioning, and a rotation out of defensive assets into risky assets would put a top into the gold market, but gold has continued to rally despite all this.
I wrote a primer last year on what drives the gold price. In summary the main drivers are real and nominal yields, USD FX, geopolitics, and central bank buying.
What’s unique about this current episode is that the gold price is not being driven by what’s happening in yields or USD FX, but by geopolitical narratives. The first narrative is Trump’s growing lead in the US elections, and the possibility that a Republican sweep would bring about larger budget deficits. The logic is that more borrowing will lead to more inflation, and therefore a higher gold price. However, does this narrative hold water when compared to the previous episode when the market was concerned about excessive government spending and borrowing? Just last October we saw a deep selloff in long bonds due to these same concerns, and gold sold off instead of rallied. When Yellen decided to frontload issuance in Tbills and reduce issuance in the long end, bonds rallied and so did gold. It’s puzzling that gold would react to a same set of circumstances by rallying while bonds are selling off.
The other dominant narrative is that Russia, China, and other BRICS nations are gathering this week for the BRICS Summit, where they are discussing how to reduce their reliance on the US dollar. There are rumors of plans to develop a gold-backed currency or stablecoin, but nothing has been confirmed or announced. The way that gold has rallied relentlessly into the BRICS summit is a sign that the market is long in anticipation of an announcement of a gold-backed currency. If such an announcement doesn’t materialize, gold may sell off in disappointment. My trader instincts tell me that this last leg of gold’s rally is running on fumes, and I caution against being long at current levels.
Turning our attention back to Treasuries, the question on everyone’s mind is how much further they have to sell off? When I adopted a bullish view on yields last month, I had a mental target of 4.2-4.4% for the 10 year yield. We are already there on the back of higher odds of a Trump win and a Republican sweep. While I’m not going outright long here, I believe the risk/reward of shorting Treasuries at current levels is poor. A Trump win is not a foregone conclusion, and it wouldn’t take much for Treasuries to squeeze higher on any signs of Harris taking the lead on election day. Even if Trump does win, I am skeptical that he will be able to deliver all the tax cuts he has promised to his constituents.
Fed funds futures are now pricing in three cuts over the next four Fed meetings. The market has over-extrapolated last month’s strong employment data by repricing the terminal rate for this cutting cycle higher by over 50 bp. Current pricing doesn’t leave much room for the possibility of weak and disappointing US data releases that would suggest the economy isn’t recovering as quickly as the market expects.
Treasury option skew is also heavily bid for puts vs calls. The last two times the skew reached this level, bonds were a screaming buy.
Finally, now that the curve has uninverted, Yellen is better positioned to issue more debt on the front end while holding back issuance on the long end. This should go a long way in keeping long end Treasury yields in check for as long as the cutting cycle remains underway.
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