- Buying gold, despite 20%+ move since 2017, is a non-consensus trade
- US dollar remains in bearish trend thanks to optimism for global growth
- Outlook for inflation looks relatively benign thanks to weakening commodity prices
Since early 2017, gold has strengthened from lows below $1,080 to around $1,340 today. The underlying factors that have helped gold strengthen since that time remain intact. We argue that gold should continue strengthening in the longer-term thanks to (1) moderate sentiment, (2) continued weakness in the US dollar, and (3) a weak outlook for real interest rates. While recent price action is somewhat concerning, gold remains in a clearly bullish trend.
Gold bulls are few and far between
Despite the 20%+ rally in gold since 2017, gold bulls are nowhere to be found. This isn’t entirely surprising given fears of accelerating inflation. In an environment where growth and inflation accelerate simultaneously, markets tend to fear a monetary policy response. Put another way, the Federal Reserve is much more likely to hike rates when inflation surges during a bull market. This explains why gold sold off sharply in the fourth quarter of 2016 – at the time, markets expected both growth and inflation to strengthen. This caused gold prices to fall. A similar (although less dramatic) dynamic is in play today.
The good news for gold bulls is that going long gold is a non-consensus trade. Data from the CFTC’s weekly Commitments of Traders report is visually illustrated below for reference:
Not many futures and options contracts long gold…
As can be seen above, futures and options net long positions in gold are currently below 200,000. Historically, bullish extremes (two standard deviations above 1-year trailing averages) occur when there are at least 300,000+ contracts that are long gold. Today, 1-year z-scores are just 0.4x. We flag extended positioning as a risk when z-scores are at least 2.0x. The next chart looks at the net long position as a proportion of total open interest.
…and long positions relatively small as a proportion of open interest
Based on the latest COT report, net long positions as a proportion of open interest is 25%. Historically, net positioning needs to be at least 35% of the total in order to look extreme. Looking at both the absolute number of net long contracts and the position as a proportion of open interest suggests that sentiment is not weighing down the precious metal today.
US dollar remains in bearish trend
Looking at the US dollar (all else held equal, USD strength is negative for gold), the buck remains in a bearish trend. The dollar has been weak despite the market pricing in three rate hikes this year, accelerating US GDP data, and fears of inflation. As we argued in more detail in a previous commentary, this is happening because ex-US growth remains strong while markets are betting on monetary tightening in the Eurozone and Japan.
As the world’s reserve currency, the US dollar is the most widely used currency for cross-border lending. As such, the dollar is driven by both US and international economic conditions. During a global upturn, US dollars are borrowed heavily. As more and more dollars chase international investment opportunities, the dollar weakens accordingly. Other liability currencies, and the Japanese yen in particular, tend to exhibit similar characteristics. While the ongoing global expansion is nearing its end, it’s too early to call the end of the dollar bear market.
Inflation fears look overdone
Fears of surging inflation have been widely reported in the media, particularly following US tax cuts and President Trump’s push to increase military and domestic infrastructure spending. In recent months, inflation has been accelerating thanks to the crude oil rally that started last summer. While rising trade and government deficits typically spark rising inflation, we argue that falling base effects and commodity prices should keep inflation-related fears at bay. An overview of recent headline consumer price index figures are illustrated below:
Year-over-year inflation faces tough comparables
As can be seen above, inflation peaked last year in February 2017 (2.7%). While inflation in January 2018 was higher than consensus estimates (2.1% vs. 1.9% expected), year-over-year inflation next month is likely to be weighed down by base effects. Assuming the next inflation print is weak, expect interest rates and inflation expectations to fall accordingly.
Beyond math, inflation is also set to decline thanks to a recent downturn in commodity prices. As we have argued in the past, broad measures of commodity prices (such as the Dow Jones Commodity Index, or DJCI) are fairly reliable front-runners for inflation. As DJCI runs out of steam, the outlook for inflation is weaker accordingly. This is shown below:
Crude oil and commodity prices are great at predicting inflation
As can be seen above, commodity prices are now falling from the last peak in late January 2018. Observers proficient in technical analysis will also note that commodity prices made a lower-high recently. This is the first significant sign that the commodity bull market may be slowing down. While we remain generally bullish on the outlook for crude oil, we are wary of extended sentiment and surging US crude supply. If commodity prices stay flat or decline going forward, expect falling inflation to ultimately drive down real interest rates. As gold trades inversely to real rates, the precious metal should gain accordingly.
A pretty good outlook, but one factor to watch
All in all, the outlook for gold is bullish. While gold is unlikely to repeat the surge between December 2017 and January 2018, economic conditions remain supportive. One factor that goes against our bullish outlook is recent price action. Specifically, gold recently made a (slightly) lower-high. While the precious metal topped in late January above $1,355, its last peak was around $1,353 a few days ago. While this is not a good enough reason to turn bearish on the precious metal, it’s a good reason to be cautious if going long gold at today’s prices.