A Tale of Two Expectations
By Ryan J. Puplava CMT, June 28, 2010
One of the major risks to bond investors is inflation risk. As inflation expectations rise, risk premiums adjust by lower bond prices and higher yields. As inflation expectations rise, gold’s inflation hedge attribute should cause it to also rise. So why are bond yields falling while gold is rising? I believe this is commonly known as the "safety" trade due to gold's other main attribute: as a store of value; however, the pair (gold and bond yields) can’t avoid each other for much longer and will need to rejoin at the hip eventually as they did in 2008. Whether that means gold will fall or yields will climb, remains to be seen while both are near long-term resistance and support (respectively).
If investors are correctly selling their stock funds to buy bond funds, they are discounting economic weakness in the months ahead. This would cause bond yields to fall. Looking at the 10-year Treasury, it is clear that investors have driven the yield down over the past couple of months as they sell stocks and buy bonds. The 10-year Treasury yield has fallen from 4% to 3%, where we’ve seen support over the past year. The Intermediate trend is down (orange dotted trend line).
When asking the question, "are inflation expectations rising or falling?" gold and bonds are telling two different stories as they did in 2007; however, in 2008 they both told the same story. From July of 2007 to March of 2008, gold prices rose as bond yields fell. I remember quite well that this was during a time that inflationary expectations were running high. So why did bond yields fall? They fell because of credit and interest rate risk.
Expectations were growing for the fed to lower interest rates in response to the housing and credit crisis. Do you remember the famous Cramer quote, “they know nothing” on August 3rd, 2007? Take a look at Fed Policy soon afterwards.
Now that the monetary policy is a 0-25 basis point target, do bond investors really need to worry about interest rates falling much further? Probably not as much as bond investors had to worry about reinvesting at lower rates like they did in 2007.
In the second half of 2008, deflationary fears took over in full force. It was a lot easier to follow the relationship between the CRB and treasury yields than by just gold and treasury yields. The reason again is because of gold’s store of value quality. Here we clearly show how the CRB fell in sync with falling yields, and how gold eventually fell.
One would expect to see economically sensitive metals begin falling in anticipation of weak economic conditions. Within the precious metals industry, silver and platinum miners are more economically sensitive than gold miners because of their industrial uses. If expectations for inflation were to change from rising expectations to falling expectations, we might see platinum and silver stocks lead gold stocks in such a turn. Below you’ll find a few well known silver and platinum miners that aren’t following their golden neighbors to higher highs in June.
Platinum and Palladium Miners
While gold stocks are near 52-week highs
Many silver and palladium/platinum producers are lagging the gold stock run as shown in the predominantly gold producer weighted Market Vectors Gold Miners ETF (GDX) since May. One would expect their weakness to start weighing down the rest of the precious metals industry group. So far, signs of weakness continue to unfold in precious metal stocks as expectations for inflation begin to fall.
Breadth has begun to deteriorate within the GDX exchange traded fund as there are fewer advancing issues this time (at $55 on the GDX). That means there are fewer companies participating in the May-June rally back to all-time highs. That’s a major sign of weakness near a possible top.
Right now, gold is telling us it is a store of value while the world is worried about sovereign debt defaults. Rising gold prices also tell us there are higher inflation expectations. On the other hand, bonds are telling us that expectations for inflation are falling. So whether gold and gold stocks fall or yields reverse and begin to climb higher, inflation expectations need to be reconciled as they were in 2008. Because stock markets are falling, credit risk is rising, and yields are falling since April, it is very likely that inflation expectations could continue to fall and gold and gold miners could reverse their course until inflationary pressures resume.
© 2010 Ryan Puplava