Real Yields may have bottomed:
I have been bullish on Gold since May last year, primarily because of falling real yields (Nominal Rates - Inflation Expectation) which historically have an inverse correlation with the yellow metal, the large stimulus that was provided by the US government has driven Inflation expectation Up while the central bank keeping the short end of the curve at near zero, the result is a falling Real yield, as we can see in the chart below.
But now with the expectation of a strong recovery in 2021, we're starting to see nominal rates (10-year Treasury bond yield) on the rise, and with Inflation expectation already above the Fed target of 2% there is very little room for upside there. The outcome of this is that Nominal rates will start to go higher faster than Inflation Expectation I,e Rising Real yields which is the enemy of Gold. This can seem controversial for some people because there is a popular belief that Gold can be a hedge against Inflation. While this is true, you always have to ask this key question who is rising faster is it Inflation or nominal rates?
Last year we saw the former taking place, but now I think we're going to see the latter. as the chart below shows.
The risk to this outlook:
From what we've heard from the Central bank speakers lately there is a willingness for the Fed to tolerate higher rates, because they believe that Inflation will stay subdued in the near to medium term. The key thing here is the pace, in other words, if rates rise faster than expected while the economy is still in a bad shape that can cause a lot of headaches to the Fed. because the cost of debt service for Governments, companies, and households start to rise while Income and output are falling. Which is a recipe for stagflation. Of course, this is not my main case scenario as I believe that the recovery is still intact.
But what the Fed can do in the worst-case scenario? Well there is something called Yield Curve Control which means pressing the yields on the long term bonds duration. This is another way of stimulating the economy by keeping the long-term yields anchored at a certain level thus lowering the cost of debt for businesses and households, Something that Japan did in 2016. As I said this not my main case scenario but it's something to watch for in the second half of this year.
Bottom line: For now stay away from Gold, you can short long term bonds, and go long Financial Stocks because they benefit from a rising long term Interest rates environment and steepening of the yield curve.
--- Written by Halim Haddad,
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