Is ‘Gold Up, Dollar Down’ the New Normal?

The new narratives on Wall Street have resulted in major imbalances. 

With the Bank of Canada (BoC) expected to raise its overnight lending rate by 25 basis points today, the global liquidity drain remains highly bearish; and with the ramifications of the unprecedented withdrawal poised to end with mild-to-major recessions, the U.S. dollar’s best days should lie ahead. 

Conversely, with Eurozone economic data outperforming the U.S. recently, the crowd assumes that a new EUR/USD bull market has begun. 

However, with their optimism shortsighted, they don’t realize that the ECB is in a much more precarious position than the Fed. For example, the ECB must conduct monetary policy for 19 countries, while the Fed only has to worry about one. Therefore, the latter has fewer chess pieces to maneuver, and it’s much easier to monitor the real-time effects of a higher U.S. federal funds rate (FFR).

Second, the ominous fiscal conundrum confronting Italy – the Eurozone’s third-largest economy – means the ECB will need to manage the situation more carefully than the Fed. As such, the FOMC has more ammunition to remain hawkish for longer. To explain, we wrote on Dec. 30:

The EUR/USD accounts for nearly 58% of the USD Index’s movement; and with the currency pair bouncing off a ~20-year low, the momentum has upended the dollar basket. Yet, investors have applied relative interest rate analysis to support their bullish euro positioning.

In a nutshell: with the ECB late to the party, Eurozone rate hike expectations have increased at a faster pace than U.S. rate hike expectations (which remain near 5%) in recent weeks, and the development has helped boost the euro. But, with the economic ramifications of higher interest rates poised to weigh on the Eurozone economy, a hawkish ECB is counterintuitively bearish for the EUR/USD. 

Please see below:

Source: Reuters

To that point, the fundamental weakness confronting the USD Index stems from renewed hopes for a soft landing. With China’s reopening increasing growth optimism and Europe avoiding the worst of its energy crisis, the crowd assumes that prominent risks have been eliminated. In contrast, the recent calm for risk assets is likely a lull in what should be a tumultuous 2023.

Please see below:

To explain, the ‘dollar smile’ visualizes how the greenback rallies during periods of U.S. outperformance and global panic. Although, the new narrative of “synchronized global growth” has risk-on currencies rising as fear dissipates from the financial markets. As a result, while the USD Index is stuck in the bottom part of the smile right now, we expect a profound reversal over the medium term.

As further evidence, fund flows into emerging market (EM) debt and equities have soared recently, which highlights the consensus belief in “synchronized global growth.”

Please see below:

To explain, the red bar on the right side of the chart depicts how China’s reopening has created a record bid for EM assets. Yet, EM securities are highly risky, susceptible to U.S. dollar strength, and much more exposed to the global business cycle than developed countries. Consequently, the misguided belief that the inflation crisis is over has led to substantial re-pricings across several markets. 

Conversely, with real recession fears poised to amplify in the months ahead, a sharp reversal of these flows should support the USD Index and upend gold, silver and mining stocks. 

Please see below:

To explain, the dark blue line above tracks the change in The Conference Board’s Leading Economic Index (LEI), while the light blue line above tracks the year-over-year (YoY) percentage change in U.S. GDP. If you analyze the vertical gray bars, you can see that every time the LEI turned negative since 1969, the U.S. experienced a recession.

Likewise, if you focus your attention on the right side of the chart, you can see that the dark blue line has reached that negative milestone. Ataman Ozyildirim, Senior Director of Economics at The Conference Board, said on Jan. 23:

“There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. Meanwhile, the coincident economic index (CEI) has not weakened in the same fashion as the LEI because labor market related indicators (employment and personal income) remain robust.”

And therein lies the conundrum. We have been bullish on the U.S. economy and the FFR and have maintained that demand is resilient, despite the crowd’s recession calls in July and October. Furthermore, Ozyildirim noted how the CEI contrasts the LEI right now because U.S. labor markets “remain robust.” 

Therefore, our thesis has been consistent that as long as Americans have jobs and record checkable deposits, a real recession (GFC-like) is unlikely to materialize in the short term. However, that doesn’t mean it won’t happen in the months ahead.

Remember, nine of the last 10 inflation fights since 1948 have ended with recessions, and the results support the conclusions from the LEI; and we expect this bear market to end with a sharp recession and major Cboe Volatility Index (VIX) spike that pushes the USD Index to new highs and risk assets like gold and the S&P 500 to new lows. It’s simply a matter of timing.

Please see below:

Source: The Conference Board

To explain, the horizontal red line on the right side of the chart shows how the LEI’s recession signal has already flashed; and with this and the chart above highlighting its historical accuracy, it’s simply a matter of when, not if, the next bout of panic arrives. 

Finally, we warned numerous times that the PMs’ price action has been driven by momentum and not fundamentals; and with positioning drastically out of whack with what’s likely to occur, when the reversal arrives, it should be epic. 

For perspective, EUR/USD speculative net longs are near their ~10-year high, EM flows have surged, and a reversal of these two metrics alone could upend the financial markets. Yet, there is a positioning imbalance specific to the PMs that highlights why the bulls should be nervous.

Please see below:

To explain, the candlesticks above track Goldman Sachs’ tally of Commodity Trading Advisors (CTAs) positioning across different assets. For context, most of these players use trend-following algorithms. 

If you analyze the candlestick furthest to the right, you can see that CTAs are overwhelmingly net long the PMs (the green star). As a result, their affection has helped keep the PMs afloat over the last few months. But, this is purely a momentum bid, and when it reverses, CTAs’ net positioning can go from +20 to -20 in a heartbeat. So, while patience may be required, we view gold, silver and mining stocks as having little upside and substantial downside. 

Overall, a lack of fundamental catalysts have kept risk assets calm; and with the crowd assuming the Fed is near the end of its rate hike cycle and global growth is poised to accelerate, they are eager to sell risk-off assets. However, we believe this optimism will prove unprofitable, and risk assets’ medium-term lows still await us. 

Do you believe in mean reversion? If the CTAs are nearly all in, who is left to buy gold? Should we trust the soft landing narrative or follow the LEI?

Alex Demolitor
Precious Metals Strategist