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The following article was originally published on 29 November 2018.
It reminds me of 2008…
US stocks rallied around 2% overnight (the NASDAQ jumped slightly more) on news from the Fed. The Australian Financial Review has the story…
‘Donald Trump’s constant browbeating of Jeremy Powell may just be working, with the Fed chairman conceding for the first time that US interest rates are now near their so-called neutral level, suggesting he may slow the pace of normalisation in 2019.
‘Stocks leapt, bond yields declined and the US dollar fell after Mr Powell said the Fed’s benchmark rate is “just below” estimates of where it neither adds to nor detracts from growth. The Dow was more than 500 points higher at about 2.25pm in New York.’
Given that US stocks haven’t broken below crucial support levels on the charts, it looks like Jeremy Powell’s comments will put a floor under prices for now. It was just what a battered, bruised and uncertain market needed.
The power of narrative is so important in financial markets. It dominates short-term price movements. By ‘narrative’, I mean the story ‘everyone knows that everyone knows’.
And now, ‘everyone’ in the financial world knows that rates aren’t going up as much as they were, and that this will be good for stocks. It should be enough to provide the impetus for a decent rally into the end of the year.
But here’s the thing. When market psychology has got to a point that it desperately needs the central bank to provide confidence and support, you know the underlying fundamentals are on the nose.
That’s why it reminds me of 2008. Back then, there was a desperate hope that interest rate cuts from the Fed would support the housing and stock market. The rate cuts fuelled massive bear market rallies, but ultimately deteriorating fundamentals took over.
I reckon a similar thing is playing out here. To be clear, I’m not suggesting we’re in another 2008 scenario. There isn’t a global property bubble sitting on banks’ balance sheets.
But we are at the tail end of a long expansion. It’s just how the cycle works, and we’re due for a slowdown. Why do you think Powell is talking about getting close to the ‘neutral rate’? It’s his way of acknowledging the economy is showing signs of slowing, and he’s going to ease off the rate hike rhetoric.
By the way, the Fed hasn’t got a clue where the neutral rate is. It’s the mythical level of interest that neither constricts nor stimulates an economy. Still, the language is important. The Fed is telling the market that they’re reconsidering the pace of interest rate hikes.
And as I said, that will provide support for markets, until we get further evidence coming through of the cyclical slowdown.
One asset class Powell’s comments might be particularly important for is gold. While stocks — in my humble view at least — are topping out here, gold could well be forming a bottom. This comes after a pretty ordinary 2018, despite the volatility experienced by the broader market.
What happened to gold’s safe haven status?
In short, it’s because of US interest rates. Gold isn’t going to be a safe haven while inflation remains low and the Fed is on a tightening path because of a strong economy.
While the narrative is ‘the US economy is strong, that’s why the Fed is raising rates’, gold isn’t going to get a look in.
You can see in the graph below that traders have made heavy bets against gold in the second half of this year. It shows the positioning of ‘managed money’ in the futures market for copper, silver and gold.
The positioning in the gold market shifted to ‘net short’ in July and has remained that way since. When the market is net short, it means more traders think gold will fall than rise. This is very rare for gold. The last time gold was in such a position was in late 2015, just before it experienced a significant rally.
Futures market positioning is often a good contrarian indicator. Futures traders, because of the leverage offered by futures contracts, are very short-term in their thinking. They tend to herd together.
The net short position now, is even larger than it was at the 2015 low. It could be the largest in the history of the futures market.
Which means that for prices to go lower, you need even more traders to take a short position. That’s not impossible, but the odds don’t favour it. With the Fed now backtracking on interest rates, there’s a good chance this short position will decline. And if the economy continues to slow into 2019, you should see gold getting a safe haven bid, which will continue to push prices higher.
That’s my theory, anyway. But theories need testing. I like to test them by looking at the charts. The charts tell you what the market is thinking. If its thinking is in line with yours, then you might be on the right track.
With that in mind, let’s have a look at a chart of the gold price in US dollars.
I have drawn lines at the closing lows and highs of the recent trading range. In October, gold broke above that range, signifying that the August low could be THE bottom. It dipped briefly back below support in mid-November, but that was short-lived. It bounced off support overnight (the chart hasn’t updated to reflect the latest move) and looks like it’s headed higher.
To confirm, gold needs to trade above US$1,240 an ounce. I think it could get there soon given the Fed’s stance.
In Aussie dollars, the long-term trend looks excellent, as you can see in the chart below. In Aussie dollar terms, gold has trended higher since the 2014 low. That’s thanks to a much weaker currency than the US dollar. This is in turn thanks to the fragile nature of our economy (which relies too much on housing) and our ongoing political circus.
If Aussie dollar gold is to continue this long-term trend, it’s due to head higher soon.
The conclusion here is that gold is the market to watch. I believe it’s putting in a bottom, while major US indices are in a topping out phase.
Having said that, gold still needs to jump some hurdles. Tomorrow, I’ll show you which ones gold needs to clear before becoming more confident that a new bull market is underway.
Editor, The Rum Rebellion
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