Gold has fallen sharply in recent weeks, but that doesn’t make it a buy. In fact, the market may be trying to tell us something.
Right now, a number of factors continue to represent headwinds to the metal — and by extension, gold mining stocks — and that doesn’t look set to change anytime soon.
Why You Should Stay Away From the Little Yellow Metal
The reasons to avoid gold include both fundamental and technical factors. From a fundamental standpoint, key issues weighing on the price of gold in the past year include the strong U.S. dollar, low global inflation and the direction of U.S. Federal Reserve policy — none of which look to change for the better in the near future.
The most important consideration here is the currency markets. The U.S. dollar has surged in the past year, and it might well correct at some point. However, the key driver of the rally — the gap between yields in the U.S. bond market versus the rest of the world — remains firmly in place.
The yield spread fuels demand for U.S. bonds, and investors need to buy the dollar to get into U.S. Treasuries. Thus, a high yield spread favors the U.S. dollar. Well, as of Wednesday’s close, the U.S. 10-year note was yielding 2.13%, well ahead of the 0.38% yield of the German bund.
Even if this 175-basis-point advantage were cut in half, which is highly unlikely, the resulting gap would still work in favor of the dollar — and against gold.
The lack of global inflation also provides investors with little incentive to buy gold or gold miners. This trend is most pronounced in Europe, where inflation has been falling off a cliff and has moved into negative territory for the first time since 2009. This isn’t just a European problem: A look at this chart will show that the vast majority of nations are experiencing annual inflation below 1%.
More quantitative easing out of Europe isn’t necessarily going to be the answer to this conundrum. While gold initially performed well in the first round of the Fed’s quantitative easing policy, it languished during the QE3-QE4 period, and it hasn’t responded to Japan’s massive monetary stimulus of the past year.
This brings us to the next factor weighing on gold: Fed policy. While the likelihood of the Fed raising rates at some point in the not-too-distant future is well-known, gold tends to react negatively when the Fed is raising rates. As a result, the ongoing debate about the timing of Fed rate increases is providing a continued obstacle for gold and gold mining stocks.
The technical picture isn’t particularly bright, either.
First, the charts of both the SPDR Gold Trust (ETF) (NYSEARCA:GLD) and the Market Vectors Gold Miners ETF (NYSEARCA:GDX) have made a series of lower lows over a two-year period. This doesn’t mean that they can’t turn on a dime and rally, of course, but until either of these ETFs can break out of this downtrend, the risk of further downside remains elevated.
Further, it indicates that rallies — such as the one that occurred in the early part of this year — continue to be selling opportunities until further notice.
Second, gold has tracked the domestic bond market almost perfectly so far this year. The chart below shows the extent of the correlation between iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) in 2015. Unless you’re in the camp that yields are about to shoot higher — an outcome that appears to have a low probability given the state of inflation and Fed policy — the performance of gold and gold stocks is likely to be dampened by bond market performance as long as this correlation holds.
Finally, seasonality argues against holding off on buying gold until at least the summer. The chart below, which tracks the average performance of gold futures over the past 20 years, shows that the metal has largely been a second-half story.
Bottom Line
Gold and gold stocks will have more than their share of short-term trading rallies in the months ahead, but don’t mistake these for a longer-term shift until something changes on either a fundamental or technical basis.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
