THE HEDGEYE EDGE
We are adding Gold on the long-side to investing ideas. The quantitative set-up is what we call a Bullish Formation (i.e. bullish on all 3 of our core risk management durations, TRADE, TREND, and TAIL).
Back on our Q2 Macro themes call we highlighted our #consumerslowing theme by showing a visual of the annual income and expenditure picture for the average American. Reiterating some notable statistics since hosting the call on April 8th, the average American spends more than 20% of after-tax income on food and utilities and nearly 30% on housing. One-Third of Americans rent and as Keith McCullough noted in today’s morning look:
“On US rents (34% of Americans have to rent, and like it) and cost of living hitting all-time highs this week, this is what one of the most uninformed members of the US Federal Reserve, Bill Dudley, had to say:
"prices look likely to firm, somewhat"
Taking the New York Fed president’s word to heart, the wealth-effect must finally be “trickling” down to rescue the consumer. Unfortunately, the average American only gets 1.38% of income from interest, dividends, and other property related income (although 34% spends on inflated rent). Adding to the pain, wage growth is nowhere to be found (which we have been told signals that inflation is non-existent)
How does this have anything to do with Gold?
Consumption is 70% of GDP, and on what items do Americans spend their depreciating dollars?
- The CRB food index is up +21% YTD
- WTI Crude Oil, which is now in a bullish trade and trend set-up, is +5% YTD
- Coffee: +64% YTD
- Orange juice: +17% YTD
- Wheat: +9% YTD
When commodity inflation squeezes the consumer, a spending slowdown ensues which is a leading indicator of economic activity. When consumption slows on the margin, growth slows. In turn GDP, one of the most-anticipated measures of economic activity globally, surprises to the downside:
- Inflation: Core PCE for Q1 surprised to the upside printing at +1.3% vs. consensus expectations of +1.2%
- Growth: Q1 Annualized Q/Q GDP printed at +0.1% vs. expectations for +1.2%.
The bond market, a proxy for the growth expectations, reflects this change. Once the slope of forward expectations turns downward (2nd derivative negative), linear growth expectations many periods into the future become very unrealistic when you take this convexity into account. Gold remains highly sensitive to monetary policy and tightly negatively correlated with the USD. As growth surprises to the downside, the problem is met with an increase (relative to expectations) in the money supply. This is a fact of global central planning today.
Gold historically has a -.65 correlation to arithmetic mean of the USD-UST 10-year dating back to 1980. The correlation becomes stronger as growth expectations decrease.
INTERMEDIATE TERM (TREND) (the next 3 months or more)
To explain the behavioral expectation for fed tapering moving into 2014, net long-short futures and options positions in the ten-year treasury market as reported from the CFTC showed a net short position of -175,641 contacts on 12/31/2013. Going into this week the market was now net long +23,948 contracts.
As growth slows (with the bond market confirming this slowdown), the expectation for the monetary response/dollar devaluation increases over the intermediate-term.
The market was net long +58,316 Gold futures and options contracts on 12/31/2013 and moving into this week was now long +119,077 contracts. As expectations for more dollars infiltrating into the system (lower chance of tapering than consensus expected), the Gold market stays true to its historical sensitivity to monetary policy. The fed model gets easier and easier when growth surprises to the downside.
The market has confirmed this inverse correlation in our quantitative set-up. The ten-year yield broke its TAIL line support of 2.60% while Gold broke out above its previous TREND line and now sits in a bullish formation. In a note from last week we highlighted this broken level on the ten-year:
LONG-TERM (TAIL) (the next 3 years or less)
Unless an ideological change manifests at the Federal Reserve, the predictable policy response to growth slowing data points will continue from our viewpoint. As growth slows, the fed becomes more dovish and perpetuates the cycle, creating more and more inequality between those who benefit from the “wealth-effect” and those who get squeezed (the average American consumer).
Ironically, we have continuously shown that the classes of people who are modeled to spur demand and spend more money in the Fed’s Keynesian framework ultimately get squeezed. Our long-term directional stance is always subject to change, but our view on Gold’s interaction with the U.S. Dollar via the treasury market as growth surprises on the margins continues to drive our macro process.