Gold and the USD: A warning flag for government bonds?

If the run-up in gold prices and the fall in the USD is driven by or is fuelling inflation fears, thenthe situation for government bonds will become more challenging, as not only are equities continuing to rise amid improving real growth expectations but rising gold prices and the weak USD (and associated with that rising oil prices) threaten to reverse - at least temporarily - a key reason for the bond performance of the last weeks: waning inflation fears.

Trade-weighted USD vs. Gold: Close relationship

Source: Bloomberg

As the chart above shows, gold and the USD (I used the trade-weighted index) have been moving in a close relationship over the past year, barring the armageddon-like environment at the start of the year which drove investors into the safe haven of the USD and gold at the same time. However, the usual relationship is the opposite: a weak USD is going hand-in-hand with rising gold prices. A weak USD can be judged to be inflationary for the US which would help gold but additionally, a weak USD can be a sign of waning confidence in the US economy and its institutions.
Now if we compare the performance of the USD and gold with the development of 10y UST yields, at first sight there exists no meaningful relationship. The first chart shows the last 5 years of 10y UST yields and the USD (inverted).

10y UST and USD: no meaningful relationship over the longer term

Source: Bloomberg

The next chart compares 10y UST and gold over a shorter time frame (the period of the financial crisis) and again I can detect no meaningful relationship.

10y UST and gold: no meaningful relationship during the financial crisis

Source: Bloomberg

However, it gets much more interesting if we use break-even inflation rates instead of nominal yields. Given that 10y TIIs have been suffering ever since the financial crisis started from very high liquidity premia, the incorporated break-even inflation rates have been distorted and I think that 10y inflation swap rates provide a more accurate picture about the development of inflation expectations. The first chart below, therefore, shows 10y inflation swaps vs. the trade-weighted USD. It shows a relatively close co-movement during that time period, however, again at the start of this year clearly an opposite directionality.

10y inflation swap rate vs. USD

Source: Bloomberg

If we compare the swap rate with gold, then the co-movement - while far from perfect - appears closer.

10y US inflation swap rate vs. gold: a relatively close co-movement during the financial crisis

Source: Bloomberg

What I take from these developments is that a) inflation expectations are indeed as is frequently stateed a key driver for gold prices but b) while gold seems to be a good hedge against a systemic financial crisis it is not a good hedge against a deflationary development. For government bonds, though, if the recent performance in gold and the USD is driven by or is causing renewed inflation fears, then this would bode very ill for the near-term outlook. As I have written on several occasions, the reason for the apparent discrepancy between equities (up) and government bond yields (down) over the past weeks can be found in easing inflation pressures as evidenced by a falling commodity price index.

Discrepancy between equities and government bond yields explained by commodity prices

Source: Bloomberg

As I stated previously, I still fail to see how inflation pressures will intensify in the US and Europe (baring the UK) amid huge overcapacity and limited credit creation but admit that the latest price action in gold and USD are raising a warning flag for government bonds as it might suggests that markets' inflation fears are on the rise again which would take away a key support for govies if it carries through into the broader commodity complex.

But was the surge in gold prices really been driven by inflation fears? The usual suspect behind anything that moves these days, the Chinese, have naturally been cited. However, the behaviour of nominal USTs does not fit this picture as the 10y US T-Note futures is trading unchanged from its Friday close. If indeed the Chinese were behind this move (as they lose faith in the USD), then nominal US Treasuries should have suffered more this week, especially given the heavy supply. It rather seems to be that a large gold producer (Barrick Gold) is unloading its gold hedges (i.e. buying back the gold it sold forward). This article refers to research by UBS which states that between July and September 7, Barrick has reduced its fixed price contracts from 5.4moz to 3moz and apparently has reduced outstanding contracts further over the past days to a level closer to 2moz. If this is indeed the prime reason behind gold's recent bull run, then it would rather constitute a temporary increase in demand for paper gold (via the closing of outstanding contracts) offset by a future increase in supply (via the selling of then unhedged physical gold). In turn, I would not regard this explanation as having an inflationary spin.

Overall, the jury is still out on whether inflationary fears are likely to rise once again in the short term which would see government bond yields moving higher. So far, I stick with my assesment from Monday (Rates Strategy: Indecision): government bonds are still undecided about the next move and I still do not yet see enough reasons to change by bullish tactical stance.

Baltic Dry Index as a leading indicator for stocks?

Trader Narrative in Baltic Dry Index continues leading the stock market has this interesting chart below. It states that 'While the Baltic Dry Index is a leading economic indicator, lately, it has been also behaving as a leading indicator of the stock market.' It adds: 'In fact, if you compare the S&P 500 index for the past few years with the Baltic Dry Index (BDI), it would seem that shipping rates have lead the equities from 1 to 3 months in both rallies and tops.'

Baltic Dry Index vs. S&P500

Source: Trader's Narrative

However, while the chart at first sight looks good, it does not provide a convincing story. Rather, the Baltic Dry Index seems to be more closely correlated to commodities:

Baltic Dry Index vs. CRB Index

Source: Bloomberg

As I suggested in Commodities and related markets to fall first?, commodities seem to be falling as the Chinese re-stocking cycle has ended (and with that shipping rates which rose during the re-stocking have eased again). If it is indeed due to less demand amid an ending of re-stocking (or due to increased supply) as opposed to lower end demand amid weak growth, then lower commodity prices as well as the drop in the CRB index are a positive for equities (as they increase the purchasing power of households and reduce costs for corporates in net-commodity consuming economies) while they are also rather positive for government bonds amid lower inflation pressures. In turn, the drop in the Baltic Dry Index would also explain the diverging performance of bond yields/commmodities on the one side and equities on the other and does not necessarily need to be associated with lower equity prices. Therefore, we can not yet tell whether indeed the significant drop in the Baltic Dry Index is a warning signal that stocks are about to fall or whether this is yet another positive (amid lower costs for shipping and for commodities) for the economy and therefore stock markets.

Rates Strategy: Indecision

Last week, I suggested to stick with a long duration view despite the upcoming supply in the US which might warrant some price concessions (Rates Strategy: Still long despite upcoming supply).
In the mean time, 10y USTs have tested their 3.31% mid-July lows, however, on a closing basis failed to overcome this level. As the chart below shows in yield terms, 10y UST have taken out their upward trend which guided trading in the first half of this year. However, in order to become more bullish, the 3.31% level stands in the way and offers a major support.

10y UST yields

Source: Bloomberg

On the other side, the adjusted 10y TNote future was able to overcome the mid July highs, however, it is still trading far below its downward trendline which started late last year.

Adjusted 10y TNote future

Source: Bloomberg

In the Eurozone, 10y Bund yields - in contrast to their US counterparts - have traded below their mid-July lows but are still guided by the slow upward trend which started earlier this year.

10y Bund yields

Source: Bloomberg

Finally, the adjusted Bund future is the only one which was able to take out the mid July highs and to break through its downward trend.

Adjusted 10y Bund future

Source: Bloomberg

So overall, the technical picture is somehwat mixed at present with cash-yields and futures price charts giving a different picture. Technically, I tend to lean towards a slightly bullish interpretation (given the developments in the Bund future) but admit that effectively we are in a bit of a no man's land with decision time coming closer.

Furthermore, the diverging performance between equities on the one side (up) and commodities and government bonde yields on the other (sideways to lower) continues as the chart below shows.

Equities vs. 10y Bunds and commodities

Source: Bloomberg

Ceteris paribus, lower commodity prices means lower inflation (which is good for bonds) but constitute a positive terms of trade shock for net-commodity importing countries (which is good for corporates and households as it raises their purchasing power and therefore it is good for equities). In turn, the inflation outlook remains supportive for bonds even though the ongoing rally in equities - amid improving expectations for real growth - constitute a significant headwind. The combination - lower inflation pressures and higher real growth - suggest that expectations for nominal growth remain more or less unchanged which confirms the indecision in the technical picture.
In turn, the near term fundamental developments as well as the technical picture are not sending a clear bullish or bearish signal for government bonds and near-term performance is likely to be muted/guided by the upcoming supply. So overall, this does not send strong signals yet to change my view and I stick with my tactical long duration stance for the time being.

Germany exports its disease

Germany is not only exporting goods and services as well as the cash-for-clunker scheme, it is also exporting its economic malaise, the "German disease". In the Eurozone there are always some countries with higher-than-average inflation rates and some with below-average inflation rates. The downside of this is that the low inflation countries have - given the same ECB repo rate - above-average real yields. Germany earlier this decade had limited growth and limited inflation, resulting in above-average real yields at levels which were deemed too high for the state of the economy. This held back investment in the domestic economy as well as demand for housing. In turn, the economy underperformed, resulting in ongoing low inflation. Two factors help to come out of such a vicious circle: time and restructuring/reforms. Time will help as lower inflation than the other currency area members (and main trading partners) will lower the relative price level of goods and services over time and help corporates to become relatively more competitive again. Furthermore, the low growth environment will force corporates to restructure to become more competitive and will necessitate structural reforms at a national level. All of this happened in Germany, rendering businesses more competitive again and in turn promote export growth. As this happens, unemployment can fall again and in a second stage revive the domestic economy. However, this is a long and painful process.
In Spain on the other side, the starting price level when joining the Euro was lower than elsewhere and Spain joined the euro with an undervalued exchange rate. Furthermore, in the run up to joining the euro, interest rates dropped close to the German Bund yield levels. This helped the domestic economy to grow and inflation to be at an above-Eurozone average level. In turn, real yields were below the average prevailing in the Eurozone. This further supported growth via increasing investments and also led to the creation of a housing bubble. However, on the downside, corporate comptetitiveness dropped over time while housing markets became overvalued, corporoates amassed a huge financial deficit and corporates & households became increasingly indebted.
The table below shows how the price levels changed in the various Eurozone countries between January 1999 and July this year (1996=100):

	Price level Jan 1999	Price level Jul 2009	Change
Eurozone	102,8	127,4	23,9%
Germany	101,9	121,1	18,8%
Austria	102,1	123	20,5%
France	101,6	123,1	21,2%
Finland	102,4	124,2	21,3%
Belgium	102,8	125,8	22,4%
Netherlands	104,1	131,4	26,2%
Italy	104,6	132,3	26,5%
Portugal	105,3	137,6	30,7%
Luxembourg	100,8	135	33,9%
Spain	104,7	141,5	35,1%
Ireland	103,6	140,9	36,0%
Greece	110,6	153,9	39,2%

Source: Eurostat

During this 10-year period, prices in Germany rose the least, by roughly 19%, whereas in Spain it rose by 35%, in Ireland by 36% and in Greece prices rose by even 39% (however, Greece only joined the Euro in 2001). So the German price level rose by up to 20% less, a significant difference. It also highlights how time helps to adjust relative differences in price levels and in turn promotes competitiveness for the underperforming and less inflationary economy within the Eurozone.
Everything changed, though, with the bursting of the housing bubble. Unemployment in Spain is skyrocketing, inflation has dropped below the Eurozone average and therefore real yields have moved above the Eurozone average. This will put further downside on the housing market and force corporates and households to reduce indebtedness. While Germany has gotten rid of its economic disease, it has not disappeared, it was just exported into the periphery of the Eurozone. Given the size of the economic challenges, it will take a long time to restore the health of corporates' and households' balance sheets and restore competitiveness. Whether the state is able to support this process via structural reforms remains to be seen.

The chart below shows that Spanish inflation for the first time during the existence of the Eurozone is now below German inflation while Irish inflation has fallen even further. This raises the risk of a debt-deflation spiral developing in these countries and suggests that Ireland and Spain have caught the German disease. Greece inflation so far has failed to fall below German inflation. However, this just delays the inevitable as it suggests that Greece continues to lose competitiveness relative to the Eurozone average.

Source: Eurostat

The consequence of all this is that while the past decade was about peripheral countries' living standards playing catch-up with a lame-growth Germany, the next decade is likely to see peripherals trying to restort competitiveness and growth will underperform vs. the core of the Eurozone. As this happens, domestic investment and consumption in the core of the Eurozone (and especially in Germany) should fare relatively well whereas it promises to be very weak in the periphery. This should also be mirrored in the relative performance of financial assets with a likely substantial underperformance of peripheral markets vs. core markets.

Rates Strategy: still long despite upcoming supply

Since I upgraded my tactical outlook back to bullish again and brought it in line with my strategic view (see Rates Strategy: Relaxed and ready to move dated August 14), the Bund future has broken trough its July 8 high. However, over the past days the performance has been much more muted and essentially it traded in a tight range with a small upward bias. On the other side, 10y US Treasuries have over the past two weeks outperformed, gaining some 10bp relative to 10y Bunds, but the 10y TNote future is still trading half a point below its July 10 high. It might well be that USTs cheapen into next week's supply, but other than that I do not yet see good reasons to change my bullish tactical outlook and stick with it.
For one, the inflation outlook remains supportive of government bonds. As written yesterday, a key feature of US inflation developments is the significant disinflation in the core services CPI, bringing it down to a record post-WWII low. With the output gap continuing to grow and CPI being a lagging indicator, inflation in the US (and the Eurozone) does not promise to resurface soon on any meaningful degree.
Secondly, I continue to believe that growth in final demand will remain muted for a prolonged period of time amid high unemployment, limited wage growth, a negative wealth effect and the need to restore savings. In this respect I still expect the rally in risky assets to falter with prices moving markedly lower during autumn and into winter.
Furthermore, the technical picture in 10y USTs looks supportive as well. As the chart below shows, the 10y UST yield has broken through its upward trendline which guided trading all of this year.
Finally, overall positioning by non-commercial investors into US bond futures remains tilted towards the short side (positioning is long in 2y and 5y futures, but short in 10y and 30y).
The supply next week might well be anticipated with some price concessions, however, I would regard this as temporary only and stick to tactical longs.

Deflationary threat: good or bad?

I have frequently stated that most of the so-called developed markets will see only very limited inflation pressures for the next several years (with a significant risk of an inflationary outcome in the UK, however). This per se does not need to be bad for an economy. Rather to the contrary, I think that a low-inflation outcome can help countries such as Germany, France & Switzerland which do not have an overindebted household sector to shift their focus more towards domestic consumption (and away from exports) amid raising purchasing power. On the other side, in countries with over-indebted consumers such as the US, a low inflation outcome can be much more damaging for the economy as it increases the risk of a debt-deflation spiral.

Macroblog has some interesting charts on the US inflation development:

To quote macroblog: "A key observation to take away from this picture isn't the recent acceleration in core goods prices. The highly volatile behavior of goods prices tends to make them an unreliable guide to underlying inflation trends. Rather, it is noteworthy to consider the significant downward trek of core services price growth. Indeed, the 12-month trend in core services prices was a shade under 1.6 percent in July—its lowest reading in the post-WWII era and roughly 1¾ percentage points lower than this time last year."
I would add that the deflation scare earlier this decade following the bust of the dot-com bubble stemmed almost exclusively from the drop in goods prices. However, relatively more goods are tradable internationally than services and therefore international competition should play a larger role in influencing goods prices. Services prices, on the other hand, should be relatively more influenced by domestic factors. The drop in goods prices itself is likely to have stemmed from increasing globalisation as well as technological progress. This, however, is rather a positive deflationary threat down to productivity gains which helped render households richer in real terms (as they have to spend less for their goods consumption).

This time, however, the deflationary threat in core CPI stems largely from the services component. To quote macroblog again: "Some of the downward pressure on core services prices is a direct reflection of the housing crisis; a little more than half the core services price components are computed from housing rents. But that's not the whole story as a rather sharp disinflation was evident in core services excluding rents."

Services are usually more labour intensive to produce than goods (and again, the share of imports in goods conumption is higher than in services consumption). As a result, the strongly disinflationary trend in core services CPI adds to the need of cost-cutting measures which in the services sector means headcount reductions, even more so than in the goods producing sector.

Furthermore, if we look at the development of personal income (see chart below), then the picture becomes even more dramatic. Personal income is down by around 2.4% over the past 12 months. The last time personal income dropped by this amount was for a brief period just after WWII. However, personal income never dropped during the past recessions.

US personal income yoy vs. recession

Source: Bloomberg

Amid the strong disinflation in core services CPI as well as the fall in personal income coupled with the highly indebted households, I continue to see the risk of a bad deflation outcome in the US, i.e. one where the gain in purchasing power amid lower prices does not outweigh the additional burden brought about by higher debts in real terms.

The situation is different, though, in countries where households are not overly indebted (and house prices are not falling) such as Germany, France or Switzerland. Here, the positive effect on purchasing power by the currently low to negative readings in CPI promise to be far more substantial. For one, households balance sheets are not overly leveraged (i.e. households indebtedness is relatively low) while house prices have not bubbled to the same extent as elsewhere and are therefore not dropping significantly at present. Furthermore, so far unemployment has risen only moderately, leaving personal income largely intact. In turn, the current low to negative CPI further supports the rebalancing of these economies away from their large export-dependency (especially in Germany and Switzerland) towards more domestic consumption.

Lessons from the Swiss investment case

I have already previously written about my relatively positive medium term economic outlook for Switzerland (see Switzerland 2 - 0 UK dated July 13). I suggested that the combination of higher tax rates in other countries coupled with a weakening banking secrecy for non-residents renders moving to Switzerland for wealthy and/or high-earning indviduals as well as corporates attractive. This in turn helps to fuel domestic consumption, raise real estate prices (especially in the high-end areas) and supports the tax intake of the Swiss government amid a larger tax base.
This Evening Standard article (Darling's 50% tax sends tycoons to Switzerland) supports my argumentation. It states that: "The advent of the 50% tax rate appears to be the final straw for many hedge funds and other money firms who are being actively lobbied by the Swiss authorities to decamp to Zug, Zurich or Geneva. They are being promised that in Switzerland they can hide from increasing European Union regulation or the intervention of watchdog agencies like Britain's Financial Services Authority."
However, besides this investment case, Switzerland also provides an interesting basket case in terms of rebalancing an export-dependent economy as well as insights into a likely outlook for government bond markets elsewhere.
Firstly, even more so than Japan and Germany, Switzerland is overly dependent on export (accounting for roughly 50% of GDP with the current account surplus standing at 10% of GDP in 2008). Otherwise it does not have significant internal imbalances (no overvalued housing market, no overindebted/undersaving consumers, no weak fiscal position). Therefore, fiscal easing in combination with ultra-low interest rates promises to be able to support domestic consumption to a significant extent. Finally, given that neither households nor corporates and also not the state are overly indebted, a debt-deleveraging spiral is not on the cards. Rather to the contrary, low and even slightly negative inflation rates help to maintain purchasing power and keep bond yields at ultra-low levels.
Secondly, as the chart below shows 10y Swiss government bond yields are at an interesting crossroad. Even though the global economy has stabilised and risky assets could recover significantly, 10y Swiss govie yields are back to the lows prevailing early this year. Technically, they are in a so-called triangle, with a strong support at current levels given that it has been tested several times this year. On the other side, there is a clear downward trend prevaling since June. Which one will win out is not clear from a technical perspective. However, fundamentally, the prospects for ongoing low nominal GDP growth (amid non-existent inflation and subdued export growth) as well as the fact that the fiscal situation of Switzerland remains healthy (relatively low indebtedness and a roughly balanced budget) would suggest that longer-dated Swiss government bond yields can stay low for longer and even fall further amid a flatter yield curve.

Swiss government bond yields back to their lows

Source: Bloomberg

The low yields clearly help to rebalance the economy away from exports and more towards domestic consumption and investment with low inflation not standing in its way. This could as well be the case for Germany where there is no significant debt overhang which would be accompanied by the risk of a debt-deflation spiral. Again, growth is likely to be muted over the medium term amid subdued growth in exports. However, low inflation would help to maintain purchasing power while low yields would support domestic investment and the housing market.
Within Europe, I remain more optimistic for Switzerland and Germany than the overly indebted countries such as the UK, Spain or Ireland from an asset allocation perspective. Furthermore, the Swiss example supports the notion that government bond yields can fall further, especially in export-dependent countries with limited inflation pressures such as Germany.