While stocks and bonds have been battered, the PMs remain in investors’ good graces.
Despite the carnage confronting stocks and bonds in December, gold has largely ignored the hawkish economic news and rising real interest rates. However, with the USD Index poised to rally over the medium term, the PMs should feel the pain.
For example, 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:
To explain, the red line above tracks the EUR/USD, while the green line above tracks Italy’s inverted (down means up) 10-year government bond yield. If you analyze the relationship, you can see that higher Italian interest rates are bearish for the currency pair because of the country’s debt conundrum.
Furthermore, if you focus your attention on the gray arrows, you can see that when the EUR/USD attempted to rise alongside Italy’s 10-year government bond yield in 2022 (the two lines diverging), the former eventually suffered sharp reversals.
To that point, the major divergence on the right side of the chart highlights the misguided optimism uplifting the EUR/USD. Despite the Italian interest rate approaching its 2022 high, the EUR/USD assumes the development is bullish. Conversely, with the recessionary impact of higher Eurozone interest rates poised to bite in 2023, the euro should decline sharply and help uplift the USD Index.
Please see below:
Source: Reuters
To explain, Italy is Europe's fourth-largest economy, and Italy's Deputy Prime Minister Matteo Salvini called the ECB's rate hikes "unbelievable, baffling [and] worrying."
Moreover, Italy's Prime Minister Giorgia Meloni reiterated that message on Dec. 29, saying, “In the current situation, it would be better [for the ECB] to avoid making pejorative choices.”
Please see below:
Source: Reuters
Thus, while the crowd assumes that higher interest rates support a stronger currency, the rule only applies if an economy can handle the rate rise. If not, a recession unfolds, capital flight ensues, and the bulls are left holding the bag.
Therefore, while we warned for many months that the U.S. economy could handle higher interest rates, the prediction has proved prescient, as consumer spending, GDP growth and the U.S. labor market have remained resilient.
In contrast, the ECB has to conduct monetary policy for 19 countries, and a region like Italy offers a poor risk-reward proposition for bond investors.
Please see below:
Source: Robin Brooks
To explain, the colored bars above track the purchases of Italian bonds by various market participants. If you analyze the light blue bars on the right side of the chart, you can see that the Italian Central Bank has been the only (or nearly the only) buyer of Italian bonds over the last few years.
On the other hand, if you focus your attention on the purple bars on the right side of the chart, you can see that foreigners have been net sellers of Italian bonds recently, which highlights the lack of appetite among private investors.
As a result, while we warned about the ECB’s dilemma throughout 2021, investors responded in kind. But, with the crowd mistakenly assuming that higher interest rates are bullish, a resurgent USD Index should weigh on the gold price in 2023. To explain, we wrote on Oct. 6, 2021:
The USD Index’s fundamental strength is underwritten by the ‘dollar smile.’ When the U.S. economy is trudging along, the U.S. dollar tends to underperform. However, when the U.S. economy craters and a safe-haven bid emerges, the U.S. dollar often outperforms. Conversely (and similarly), when the U.S. economy is booming and higher interest rates materialize, the U.S. dollar also outperforms.
Please see below:
Thus, our bullish 2021/2022 dollar thesis was driven by the left side of the smile. With the U.S. economy outperforming the Eurozone and Japan (the largest weights in the USD Index), the stage was set for a hawkish Fed to boost the greenback.
In contrast (and similarly), the stage is now set for a “synchronized global slowdown” in 2023, where recession fears and an eventual realization spark a panic bid for the dollar. As such, the right side of the smile should weigh heavily on the gold price in the months ahead.
Overall, spiking Italian yields are bearish for the euro, not bullish; and while the crowd assumes otherwise, the economic ramifications should lead to a major EUR/USD reversal in 2023. Therefore, while gold, silver and mining stocks remain uplifted for now, their bear markets should have plenty of room to run.
Alex Demolitor
Precious Metals Strategist