2 Potential Breakout Catalysts For Gold

Gold prices remain in the narrowing trading range of the last four weeks as the impasse continues between the bulls and the bears. I’ve argued that a resolution to gold’s sideways trend is likely near, and here we’ll examine the latest evidence which points in favor of an eventual upside breakout for the gold price. We’ll focus on two factors that could catalyze a gold breakout.

Let’s start our analysis with a look back at gold’s 2-year performance. A case could be made that gold’s two main drivers since last year have been:

uncertainty over the U.S. political and corporate tax outlook, and
increasing inflation expectations.

The former reason was most evident in the months leading up to the 2016 presidential election. The stakes were high for investors in this election due to the disparity in tax policy between the two rival candidates. The gold price rocketed higher throughout the first half of 2016 before hitting a peak in July. After Donald Trump was elected last November, the gold price plunged (see chart below) as investors divested safe haven assets and loaded up on riskier equities.

After bottoming last December, the gold price embarked on a recovery this year which gradually brought its price within reach of last year’s highs by September. A pullback into October followed, and the gold price has traded in a narrow lateral range ever since. It’s noteworthy that while the gold market has been subdued lately; the gold price is still well above its lows from December 2015 and is closer to its 4-year high than it is to the low. I would argue that this isn’t a function of safe haven demand, but rather a reflection of improving economic fundamentals.

Consider the next chart exhibit shown below. This shows the Schwab U.S. TIPs ETF (SCHP), which is a useful proxy for Treasury Inflation-Protected Securities (TIPS). The principal of an inflation protected bond fund increases with inflation and decreases with deflation, as measured by the Consumer Price Index. By comparing the SCHP chart with the gold price shown above you can see that gold and TIPS have tended to move in the same overall direction in recent years. This can be attributed to the market’s inflation expectations, which have been somewhat subdued this year. That is, the market doesn’t expect much inflation in the foreseeable future.

Nevertheless, inflation expectations are at least somewhat higher this year than they were two years ago when the crude oil price was plunging and the threat of deflation was on the horizon. This fear was reflected in the gold price and the TIPS price, which had both fallen to multi-year lows by the end of 2015. Since then oil prices have experienced a turnaround as the threat of deflation has all but evaporated. This in turn has coincided with a rebounding global economy, which can be seen in the graph of the Vanguard Total World Stock ETF (VT).

Now that the world economy is on the mend, led by developed Asian countries like Japan, the inflation outlook is much improved even if U.S. inflation remains subdued. There are signs, though, that inflation is about to slowly increase in the U.S. Consider the following graph, which illustrates the rate of change in M2 money velocity. This is one way of measuring the demand for money. The demand for money was voracious in the years immediately following the credit crash as the world economy experienced strong deflationary undercurrents. As the following graph shows, however, money demand is diminishing as investors’ inflation expectations increase. If this trend continues it would bode well for a welcome return of increased inflation, in turn boosting the longer-term outlook for the gold price. Mike Wilson, Chief U.S. Equity Strategist for Morgan Stanley, has elaborated on this theme in a recent commentary which can be viewed.

The above discussion is a longer-term factor for gold. A more immediate factor which could finally serve to push gold out of its trading range to higher levels is a temporary return of safety-related demand. Specifically, it wouldn’t take much to push investors toward gold if the stock market showed definite signs of weakness. Already there is evidence of internal weakness just below the equity market’s surface, the most notable of which is a dramatic surge in the number of NYSE-listed stocks making new 52-week lows. Moreover, the differential between new highs and lows has turned negative as of this week, which is a strong indication of internal selling pressure within the broad market. This internal weakness has been fairly contained in the last two weeks; however, if the weakness continues to spread (as it appears to be doing) then it could easily spark a short-term move into gold as the major stock market indices begin slumping.

To update my position on gold, I’m currently long the iShares Gold Trust ETF (IAU) and I’m using the 12.11 level as my stop loss. IAU has managed to climb back above its 15-day moving average (my favorite marker of the immediate-term trend) as of Nov. 14 and is trying to claw its way back above the 12.40 level. A close above 12.40 would likely push the ETF higher on short covering. For now, though, the waiting game continues as the bulls and bears are still fairly evenly matched.

11/15/2017
Seeking Alpha