In the past few months, demand for gold has been falling amid rising optimism over the vaccination campaign and the reopening of the economy. However, two major drivers are still pricing in further upside gains in the near to medium term.
First, we saw that as inflation expectations have been rising sharply in the past few months, US real yields have continued to reach new lows and are currently pricing in higher gold prices in the short run. Figure 1 shows that the 5Y US real interest rate have co-moved strongly with gold prices in the past cycle; the 5Y real rate is currently trading at -1.81% and is pricing in a ounce of gold above the $2,000 level.
The second driver is the total amount of negative-yielding debt in the market, which could also be seen as an indicator of market stress. Interestingly, figure 2 shows that gold prices seem to have followed the recent decrease in the amount of debt yielding below 0 percent; after remaining to an all-time high above 18tr USD in the beginning of the year, the total amount of negative-yielding debt has recently decreased to 16tr USD.
However, the most important driver of gold in the medium term remains the annual change in global liquidity, which we compute as total assets of the 5 major central banks (Fed, ECB, BoJ, PBoC and BoE). Figure 3 shows that gold prices have co-moved strongly with the annual change in global liquidity in the past cycle; hence, when the market realizes that social distancing norms and travel restrictions are going to remain elevated longer than participants currently expect, gold prices should experience another significant rally.
In the past few weeks, we have noticed that the ‘Short Dollar Trade’ has remained very crowded despite the positive bounce in the USD in January. According to the CFTC, total amount of net shorts is still standing at 257K contracts, a short USD position that is mainly concentrated against the Euro (165K contracts). Even though some investors argue that the CFTC CoT only shows a minor picture of the daily 5-trillion USD OTC FX market, it is still interesting to know the dynamics in the standardized market, especially when the positioning are standing at extreme levels.
We think that the rise of uncertainty in 2021 amid elevated restrictions and travel bans between ‘high-risk’ countries may increase demand for traditional safe such as the greenback and that the lack of economic activity in the Euro area could lead to a rise in political uncertainty, which should weigh on the single currency in the near to medium term. Figure 2 (right frame) shows that rising uncertainty has historically led to a higher Dollar against most currencies.
It is interesting to see that while the Brazilian Real has remained weak against the USD in the past 9 months, the Mexican Peso has strengthened significantly (MXN is up over 25% since its low reached in the beginning of April).
What happens to Mexico in 2021? As Brazil, the country has been deeply impacted by the pandemic, and the vaccination campaign has been running very slow (0.5 doses given per 100 people), which could lead to travel bans with some countries where the vaccination campaign has been much faster (US, UK…). With the tourism industry representing 17.5% of the country’s GDP, political and economic uncertainty is very likely to rise in the coming months, which could lead to significant MXN depreciation.
The upside gain on MXN remains very limited, while the downside risk is big; watch the USDMXN rally (i.e. MXN fall) this year !
While the Fed is expected to purchase 240bn USD of Treasuries each quarter in 2021, net Treasury supply is estimated to be significantly higher at around 600bn USD per quarter (2.5 times higher); and this does not even include the recent 1.9tr USD Biden proposal. Even if the Biden administration does not end up being as aggressive as initially proposed, even a 1-trillion-dollar ‘stimulus’ program will significantly increase the divergence between net Treasury issuance and net Fed purchases.
What will happen to US interest rates in 2021? On one hand, we know that long-term interest rates cannot rise too much from current levels as a significant (upside) move in the 10Y yield could end up having a dramatic impact on the equity and/or corporate bond markets. On the other hand, if the Fed goes ‘all in’ and matches 1-to-1 the net issuance of US Treasuries as they did in 2020, other central banks (i.e. ECB, BoJ) will have no other choice than to fight the USD depreciation as policymakers will certainly not let their currency appreciate indefinitely.
In the past few months, gold has been showing some signs of ‘fatigue’ with market participants starting to price in a smooth ‘Covid-19 exit’ with the vaccination campaign. However, major drivers of the precious metal such real interest rates or the total amount of negative-yielding debt are still sending bullish signals; we think that market participants are underestimating the impact of social distancing and travel restrictions in the medium term.
With another 3tr USD of liquidity expected to reach market this year, it looks like the downside risk on gold remains limited as we think that most economies will rely on debt (therefore more liquidity) in the coming two years, which implies strong demand for the ‘currency of the last resort’.
Main risks in the near term: rising optimism over the vaccine campaign, warmer days and USD strength.
One striking observation we can notice in the past cycle has been the speed at which the equity market recovers each time it experiences a significant drawdown (> 10%). For instance, while it took it took 7 years and 3 months and 5 years and 6 months in the past two economic recessions for the S&P 500 to recover to its previous highs, US equities recovered to their February 2020 peak in just 6 months after crashing by over 35% during the Covid19 panic.
As we previously mentioned, the drastic rise in liquidity to finance the high cost of lockdowns has been one of the major forces behind that historic rebound, and that a repeat of the 1930s period with stocks having a period of hope followed by a drastic selloff will be very unlikely this time.
Hence, market participants have constantly tried to buy the dip each time the market was experiencing a selloff. Figure 2 (left frame) shows that people were looking to buy stocks at the heart of the panic regardless of how dramatic the impact of Covid19 will be on the economic activity, especially on the service sector. Even though it has not always been a successful strategy in the past 100 years, ‘buy the dip’ has been a winning trade in the past 25 years (to the exception of 2002, 2008 and 2018); figure 2 (right frame) shows the average weekly performance of the S&P 500 following a negative week. If investors bought the dip in 2019 and 2020, they would have generated a positive average performance of 0.6% and 0.7%, respectively.
With another 3 trillion USD expected to reach markets this year (at least), we think that the ‘buy the dip’ strategy will prevail in the near to medium term.
In the past 15 years, we have seen that the dynamics of the exchange rate in Japan (JPY) has had a significant impact on equities; it has been described as a negative ‘Pavlovian’ relationship where a cheaper currency has usually been associated with higher equities. This chart shows the significant co-movement between Japanese equities – TOPIX – and the USDJPY exchange rate; hence, we are confident that policymakers in Japan are strongly aware of that relationship and therefore the BoJ is carefully and constantly watching the exchange rate.
It is interesting to see while the Japanese Yen has been constantly appreciating against the US Dollar amid the aggressive liquidity injections from the Fed (relative to BoJ), equities have strongly recovered from their March lows and are currently trading at their highest level since October 2018. However, we do not think that this relationship will persist in the medium term; as we previously mentioned, a strong Yen will not only dramatically impact the economic ‘recovery’ but also weigh on LT inflation expectations. The last time the relationship broke down between the two times series was in the beginning of 2018, with the TOPIX rising to nearly 1900 while the Yen was gradually strengthening against the USD, but it did not take long for equities to converge back to their ‘fair’ value.
We are not suggesting that trend in equities is about to revert, but investors should be careful as the ‘Short USD / Long The Rest’ trade has become very crowded.
Despite the 13% fall since March, investors’ sentiment on the USD is still extremely negative for 2021. We previously argued that central banks (ex-Fed) will not let the greenback depreciate indefinitely as it will dramatically impact the economic ‘recovery’ (i.e. Euro area is very sensitive to a strong exchange rate) and weigh on long-term inflation expectations. In addition, figure 1 shows that a weaker US Dollar has coincided with a positive momentum in equities in recent years, especially since the February/March panic; therefore, being long US Dollar at current levels could offer investors a hedge against a sudden reversal in risky assets in the short term.
Another interesting observation comes out when we look at the seasonality of the USD in the past 50 years; while December tends to be the worst month on average for the greenback, January has historically been the best performing month with the Dollar averaging nearly 1% in monthly returns since January 1971.
Is it time for a ST bull retracement on the US Dollar?
Even though some analysts have compared the 2020 rebound in equities to the 1930 ‘hope’ phase following the 1929 crash, we think that this year has shown some strong similarities with the 1998 / 1999 period. While tech stocks were experiencing strong inflows in the second half of the 1990s amid the dotcom boom, the Nasdaq suddenly fell by 30% in the third quarter of 1998, before starting to reach new highs and surging by over 120% in the following year.
This year, tech companies’ valuations are up 90% in the past 9 months following their dip reached on March 23rd and seem on their way to reach new all-time highs in the coming months as another 3 trillion USD is expected to reach markets in the coming year.
This chart shows some strong co-movements between the Nasdaq index in 1996 – 2000 and in August 2018 – December 2020. Even though market sentiment has reached extreme levels, the bullish trend in mega-cap growth stocks could easily continue for another year amid the surge in liquidity coming from central banks to support the economies and finance the high costs of lockdowns.
As we previously saw, the massive liquidity injection from major central banks to prevent the economies from falling into a global deflationary depression has generated a significant rebound in equities prices, especially for the mega-cap growth stocks. Figure 1 shows that the FANG+ index is trading over 50% higher than its February high, which was mainly driven by the surge in global liquidity.
In addition, the major 5 central banks (Fed, ECB, BoJ, PBoC and BoE) are expected to increase their balance sheet by another 5 trillion USD in the coming 2 years, to a total of 33 trillion USD, to cover the high costs of national lockdowns. As a result, ‘Wall Street’ strategists have constantly reviewed their SP500 forecasts for 2021 to the upside in recent months, with the average forecast rising to 4,035 in December according to Bloomberg.
With central banks ‘ready to act’ as soon as we see a sudden tightening in financial conditions (due to a drop in equities), the risk reward in the SP500 is currently skewed to the upside with all the liquidity injections expected to reach markets in the coming months.