The Macro Blind Spot

Gold
May 1, 2016

The rally in commodities over the last month has pushed inflation
expectations higher, prompting investors to buy gold. It appears that the
FED will allow inflation to overshoot its target before it acts. As long as the
FED continues to allow inflation to climb, investors will seek inflation
protection. Even if the FED acts sooner than anticipated and fuels a dollar
rally that does not necessarily mean that gold will fall.

The Blind Spots

1.

Inflation Target Not

Yet Met

2.

Gold Dollar Myth

3.

Producer Short
Squeeze

Contrary to popular belief, gold and the US dollar do not always trade
inversely. In fact, during times of rising inflation and a rate hiking cycle, spot
gold has produced returns as high as 88% over a three-year period.
Adding to the potential for a sustained breakout, gold producers continue
to hedge production. Despite apparent industry expertise, producers have
been notoriously bad a timing hedges.
Given the fundamental and technical setup for gold, I plan to buy the
breakout.
Where could I be wrong?
There are two developments that could prove me wrong. First, the FED
could surprise me by being more hawkish and not allowing inflation to run
above target. Second, a rising dollar/rising gold is a rare event and this
could prove to be one of those times they do not trade in tandem.

Blind Spot #1
FED Might Want to Overshoot 2% Target

Inflation
Target Not Met
They say generals are always fighting the last war. I will leave it
to you to decide who they are and whether they are correct.
Like generals, traders and investors are often slow at dropping
old assumptions. This could be happening in the gold market,
and if so, could present an opportunity.

5-Year Inflation Breakeven Rate

For the better part of the last 18 months the dominant theme in
the markets has been deflation. The narrative (which I
subscribed to) was that a strong dollar was the reason for oil
weakness and deflation. Once again they have a pithy
saying about deflation or low prices and its is, the cure for
low prices is low prices. Lo and behold, this maxim has held
true for oil as it rallied over 48% in the last few months.
This rally in oil prices has not gone unnoticed by the bond
markets and interest sensitive stocks. Indeed market measures
of inflation expectations have been soaring along with oil. In
January 2016, the 5-year expected rate of inflation was less
than 1%; today it is approaching 2%. The mathematically
challenged, that is a 100% increase in inflation expectations.
Getting even deeper into the fixed income world we can look
at the FEDs preferred measure of inflation expectations, the 5yr, 5-yr Forward Inflation rate. This wonky financial market is
used to make bets on what the rate of inflation will be over a 5
year period beginning 5 years from now. I dont know about
you, but I can hardly predict what gas is going to cost me next
week, let alone 10 years from now, but the FED seems to think
this number is special and as such it worth watching. No matter
how you slice it, the financial markets are expecting the prices
of things to rise over the next 5 and 10-year horizon, aka
inflation.

5-Year, 5-Year Forward Inflation Expectations

I have always thought of gold as the global price index that is

to say if the prices of things are rising then the price of gold
tends to rise as well. The same holds true for when prices are
falling globally. There is an old saying that an ounce of gold will
buy you a nice suit in London. This relationship has held for
centuries and I am willing to make a bet that it will continue to
hold.
The bottom line is that as inflation expectations rise, investors
will look toward assets that can protect them; during times of
rising prices that asset is gold. Moreover, as the headline chart
indicates, the FEDs target for inflation is 2% and has yet to be
fully met. Barring a sudden epidemic of hawkishness, I would
expect the FED to let inflation run a little hotter than normal. In
turn this should be supportive of gold prices.

The Blind Spot - May 2, 2016

Blind Spot #2

The Gold and

Dollar Myth

3-Year Rolling Correlation Gold vs. Dollar

There is a popular myth on Wall Street that gold and the US

Dollar trade inversely to one another. The logic is that since
gold is priced in dollars (the denominator), as the price of the
dollar falls then the price of gold should rise and vice versa. For
the most part this relationship holds, but as the top chart
illustrates there are periods of time when both the US dollar and
gold rise together.
The top chart is the 3-year rolling correlation of gold and the US
Dollar; a positive number indicates gold and the dollar trading
in the same direction. Whats interesting is, while its rare, when
gold and the dollar become positively correlated it tends to last
for some time.
When Do Gold and the US Dollar Trade Together?
Yep, you guessed it, gold and the US dollar rise when the FED is
hiking interest rates and inflation is rising. This makes intuitive
sense as investors not only seek the inflation protection of gold,
but currency investors also find the higher interest rates more
appealing and begin to buy US dollars.
The table to right illustrates the periods when the FED was hiking
interest rates and there was a positive correlation between gold
and the dollar. There were five such periods and three
produced positive returns for gold while two produced negative
returns. The one period I would highlight is June 2004September 2007 this is when oil was spiking to all time highs
and the FED hiked rates 425 bps. While oil is currently
demonstrably depressed, it has had a tremendous price spike in
a short period of time. Will history rhyme?
While the sample size is small, the analysis is key because it
means I do not necessarily need a weak dollar for a long
position in gold to work. This means my odds of success during
this very rare period of time may be increased.

Gold Performance During Rate Hikes

Time Period
May 1983-Oct 1984

Fed Funds
Increase
225 bps

Spot Gold
Return
-17.37%

Feb 1988-June 1999

312 bps

-18.56%

April 1993-July 1995

300 bps

+8.03%

July 1999-Dec 2000

175 bps

+6.37%

June 2004-Sep 2007

425 bps

+88.61%

Breaking of the gold v dollar myth coupled with the view that
the FED may let inflation climb above its target of 2% before it
acts, could mean that there is a window for gold to continue its
outperformance.

The Blind Spot - May 2, 2016

Blind Spot #3

Producer Short
Squeeze
The nearly 20% rally in gold year-to-date was fueled not only by a slightly
weaker dollar but also by a short squeeze. According to CMEs
Commitment of Traders Report, Managed money (aka hedge funds) had
a net short position in gold futures at the beginning of 2016. In the last
few months, hedge funds have covered those short positions and are
now net long gold futures. One might be tempted to think that the short
squeeze is over, but there is another group in the gold market that is still
net short. the gold producers themselves.
The headline chart on this page shows that as gold rallied 20%, producers
have been hedging and now have a net short position. Its this short
position that may provide the fuel for the next leg of the gold rally.
Dont be fooled by the apparent expertise that producers posses, they
are historically terrible at timing hedges. For
example, from November 2012 to January 2014
gold producers went from a net short position to
a net long position. During this time gold fell from
$1753 to $1236 an ounce, or -41%. It pays to
fade, not follow the producers.
I want to point out one serious flaw in the
Commitments of Traders (COT) report, it does not
account for OTC transactions. If a hedge fund or
producer enters into an over the counter (OTC)
hedge transaction it will not necessarily show up
in the COT report. Dealers and brokers may use
futures to hedge these OTC transactions, but the
real position of market participants is still
unclear.
That being said, the COT report does give a high
level view of investor and producer sentiment. More specifically, I find
the change in positions to be the most informative. In the current situation
the increase in producer net short positions coupled with historic bad
hedging decisions, should be supportive of gold prices.

The Blind Spot - May 2, 2016

Spot Gold Daily Bar Chart

Price Analysis

Breakout

The one chart that I have seen passed around the most over
the last few weeks is the one presented above. It is the daily
chart of spot gold prices that appears to be forming a
pennant. BK does not fancy himself a classical chartist, but
he does like to use this type of technical analysis to identify
consolidation zones. Even more important, I use these support
and resistance areas as entry and exit signals. This clearly
defined daily pennant formation gives me a very clear entry
upon a breakout and I can set my stop loss just below the
bottom of the formation.
The second piece of price action that encourages me is the
breakout from the pennant is not just happening at the daily
time frame. When we look at the weekly chart, the price
action clearly shows a weekly closing price breakout. I have
found patterns that break on multiple time frames to be the
most reliable trade signals.
Turning to the trend indicators, aka-moving averages, it
seems that the 50-day moving average has been serving as
support. Its interesting to note that the 50 day moving
average also correspond closely with the bottom of the
pennant. When multiple technical indicators suggest the
same level of support I take notice. Since traders and
investors use different types of indicators I prefer to have
multiple indicators supporting the same price action. The
thesis is that multiple confirming indicators could mean that
buyers from various disciplines are likely to enter the market.
The last group of buyers I want to capture is the
momentum/quantitative investors. Given the similarity in
strategies this type of investor exhibits powerful herd behavior,
especially in commodities. One of the biggest determinants
for momentum investors to enter a market is that the current
price must be above the price from one year ago. In fact, this
is how many trend following and quantitative investors define
momentum.

Spot Gold Weekly Chart Close Only

Spot Gold Daily 50 and 200 DMA

Spot Gold Daily w Year Ago Price Line

In the case of gold, the current price has been above the
year ago price for the better part of 2016. Add in the fact
that the 50-day moving average is above the 200-day
moving average and we have a very nice setup for
momentum investors.
The bottom line is that gold not only sets up positively from a
price perspective, but the pattern presents a well-defined
range that can be used for risk management.

The Blind Spot - May 2, 2016

The The
Reversion
Trade

Buying GLD

byline

Lorem Ipsum
I have been long gold since December 2015 and remain constructive based on the underlying fundamental drivers and
the potential for a large technical breakout. The current price pattern provides an excellent opportunity to get long
gold via the SPDR Gold ETF (GLD) with a clearly defined stop. The entry, stop-loss and target levels indicate that the riskreward ratio could be as much at 8:1.
When considering a trade entry my most important
factor is risk to reward. My target risk reward is over
4:1. Using this risk-reward ratio I can be correct on
timing only 40% of the time and still make money
over the longer run. This gives me a comfortable
margin for error.
Based on this risk-reward requirements here is how I
am trading this breakout in gold.
The Trade
Buying GLD:

$121.20

Stop Loss:

$118.00

Total Risk:

$3.20

Potential Targets:
Determined by measuring the Dec 2015-Mar 2016
move and adding to the bottom of pennant.
Target #1: $136
Potential Profit: $14.80
Risk/Reward: 4.6 to 1
Target #2: $149
Potential Profit: $27.80
Risk/Reward: 8.68 to 1

The Blind Spot - May 2, 2016