Rumbles in the Bond Market Rattling Gold

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Last July the 10-Yr UST yield fell to an all-time low of 1.379%. Since that time yields have been steadily rising with the 10-Yr yield hitting 1.947%. The rise in interest rates has been greater than the rise in inflation rates which may be hurting gold since it is highly influenced by real interest rates (nominal rates less inflation). The 10-Yr UST yield is at a key level and a further rise in yields may continue to weigh on gold ahead.

Since early 2011 the 10-Yr UST yield has been in a declining trend falling from over 3.5% to a low below 1.5%. As seen below, rates have been in a well-defined trend and are now testing the upper end of the trend channel, which suggests rates are at a key inflection point. If rates breakout from here the bearish trend in yields will be broken and a new bullish trend will have emerged. Given how close we are to the upper trend line we will not have long to wait to find out which direction rates will move next.

10 yr t
Source: Bloomberg

The reason why gold investors should be watching bond yields closely is that we may be witnessing not only a rise in nominal interest rates but a rise in real rates deflated by inflation. As shown below, gold typically does best when real interest rates are declining (shown inverted in red below) and gold tends to perform poorly when real interest rates are rising. Gold peaked last September coinciding with a pickup in real interest rates (10-Yr UST less year-over-year CPI) with a further rise in real interest rates likely to weigh on gold further.

gold real rates
Source: Bloomberg

For gold to hold its ground, we need to see either the 10-Yr UST yield fail at resistance and head south again or inflation rates need to rise faster than interest rates. One potential catalyst that may lead yields on the 10-Yr UST to fall rather than rally in the months ahead is the lagged impact of energy prices on global growth. Rising energy prices eat into corporate profit margins and consumers' pocket books and as both retrench economic growth slows. The opposite occurs when oil prices fall and corporate profit margins rise and consumer discretionary spending increases and economic activity picks up. This relationship of inflation and economic activity and stock market returns is incredibly correlated as highlighted below with the rate of change in energy prices (red) shown inverted and advanced below.

citigroup economic surprise long term
Source: Bloomberg

As you can see in the close up below, the rise in oil prices six months ago suggests we see a peak in economic positive surprises and the stock market in late February to early March. Given we likely have a peak in economic activity and the stock market in 4-6 weeks based on prior oil prices, even if interest rates breakout their run is likely to be short-lived and a plunge in interest rates and rise in real interest rates (if nominal rates fall faster than inflation) may be the catalyst that sees gold stabilize and begin to advance.

citigroup economic surprise index short term
Source: Bloomberg

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About Chris Puplava