- The prospects for precious metals remain attractive, as we believe the initial move lower in the dollar this year sets up a much larger breakdown headed into Q4 and 2017.
- Historically, the dollar still appears significantly stretched, which trended to a performance extreme last year as the Fed moved off ZIRP and as rate hike projections peaked.
- For the US dollar index, a break below 93 would begin the next phase of a large retracement move, which should coincide with lower real yields and higher precious metals prices.
Yet even
with a gain of nearly 30% this year, we suspect the current rally in gold will
eventually break its cycle high (more than 40% away) of $1924 an ounce, achieved in
September 2011. For silver
bulls, the gains have been even more exceptional, tacking on more than 49% from
last year’s close. With a cycle high of nearly $50 an ounce in the spring of 2011,
the prospects for silver are proportionally much larger – albeit with
greater volatility and risks.
Generally
speaking, the precious metals sector has performed as we had hoped this year,
with gold leading the initial move in Q1 and with silver confirming the trend reversal
and taking the performance pole position over gold in Q2. This bullish
dynamic was presaged at the end of last year (see Here) by the rare positive
momentum cross in the long-term silver:gold ratio, that strengthens when risk
appetites build and broaden within the sector and that also typically leads a rising inflation trend.
The bottom line is despite healthy gains in precious metals this year, we believe significant
returns lie ahead as a weaker US dollar
and declining real yields target their respective lows from 2011. Over the past
decade, the dollar and US real yields have trended closely together, as the
dollar strongly influences inflation and as the reach of nominal yields has
largely remained under pressure.
As we were looking for coming into the year, a buy the rumor/sell the news reaction in the dollar
manifested after the Fed moved modestly off ZIRP – and as
expectations of further rate hikes peaked and have gradually drifted lower. And while the Fed’s dot-plots have
consistently trended down over the course of this year, they still have a ways
to go in aligning expectations with historic precedence within the long-term
yield cycle (see here); a multi-generational force – that as the Fed and participants
have learned, is influenced less by policy and perhaps more by proportion.
From our perspective, the prolonged
nature of the Fed’s expectation phase in the face of multiple large easing
initiatives around the world, allowed participants an abnormally large and
fertile window to build positions and faulty assumptions in the dollar –
regardless that the Fed would likely never achieve the same reach as they had in more recent tightenings and that were postured to the market in the Fed's dot-plot projections. The net effect was a high achieved
in the dollar last year – arguably as stretched as the performance extreme in 1985, that we suspect will be further retraced as policy
expectations continue to diverge from more contemporary tightenings and as markets and economies make their way across the transitional divide to the next secular growth cycle; a condition that eventually will be capable of carrying and sustaining the weight of a stronger US dollar and higher nominal and real yields. Until the growth cues of stabilizing and strengthening nominal yields materialize for a considerable period, the notion of a more secular continuation of a stronger US dollar is as irrational as the dot-plot projections have been towards rate expectations.
Currently, the lower rail support of the broad top carved over the past two years in the US dollar index sits just ~ 2 percent lower around 93. From our point of view, it’s more
likely that the retracement rally that began in May has exhausted and that the
index will break down below this key support in the coming weeks – ushering in
the next phase of the move and supporting assets like precious metals and
commodities that benefit from a weaker dollar.
As we noted earlier in the year (see here, here, here), gold traded out of its
post rate hike low, akin to the taper low in December 2014. And unlike
gold’s Q1 2014 rally that coincided as the US dollar was basing, but failed in
Q2 as the dollar broke out – gold moved out of the low in Q1 as
the dollar exhausted from its relative performance extreme and hasn’t looked
back as the dollar now flirts with a potential breakdown from its range over the past two years.
Considering that gold
already trades close to $1400 an ounce while the dollar remains historically
stretched, the prospects for precious metals continue to appear attractive to us as
the markets catalytic converter for lower real yields has much further room to
fall. Moreover, from a historic cyclical perspective, the broad top potential in
the dollar now aligns structurally with the explosive and final retracement
declines in real yields around 1978 and 1946, respectively. Should history repeat, we would
expect new highs for both gold and silver as real yields plum the cycle low.
