Mid-week market update: It can be difficult to discern the market’s short-term outlook on an FOMC meeting day, but the Fed has spoken, and the market reaction has important signals for equity investors from an inter-market, or cross-asset, analytical basis.
The first important signal comes from gold prices. Gold staged an upside breakout to a fresh high from a multi-year base that stretches back to 2011. Point and figure charting shows upside targets in a range of 2440 to 2670, depending how the box size and reversal parameters are set.
The Fed’s dovish tone is a statement of policy that it intends to keep rates low until employment returns to pre-pandemic levels. As well, it has not ruled out yield curve control to suppress rates in longer Treasury maturities. Real yields are falling as a consequence, and real yields (blue line) have been inversely correlated with gold prices (red line, inverted scale).
Separating the real yield into the 10-year nominal Treasury yield and the 10-year breakeven yield reveals a divergence in market expectations. On one hand, the stubbornly low level of the 10-year yield indicates that the Fed is expected to be on hold for a long time. On the other hand, a rising breakeven indicates expectations of successful reflationary policies over the next few years. The risk is the economy fails to reflate, or reflationary expectations fizzle in the future. Both outcomes would deflate gold prices.
To be sure, gold sentiment is at an off-the-charts bullish extreme, which is contrarian bearish. SentimenTrader pointed out that the current rally represents a seven week winning streak for the shiny metal. “Outside of the late 1970’s run-up, every single signal showed a loss over the next month. Only one of them showed a gain even three months later.”
The same goes for silver prices. One of the bearish tripwires that I mentioned on the weekend is weakness in silver prices, which serves as a risk-off signal for equities (see Warnings. warnings everywhere, but bears should not drink…). That sell signal has not been triggered yet.
Brace for volatility
As well, there are warnings of a possible spike in volatility. Macro Charts observed that rate volatility (MOVE Index) has reached an all-time low. Low volatility episodes have been followed by volatility spikes in all asset classes.
Long bond prices (TLT) are tracing out a possible inverse head and shoulders pattern, though it has not broken up through the neckline. The 10-year Treasury yield has been testing a key support level. In light of the environment of suppressed volatility, a bond price rally could be a signal for an explosive risk-off episode.
The explosion in gold and silver prices, and the weakness in the USD, are all becoming one big macro trade. Cross-asset correlation is rising, indicating herding behavior. We have a crowded long in gold and silver, and a crowded short in the USD. With sentiment so stretched, this is setting up for a possible explosive reversal.
I wrote back in May that the falling stock/gold ratio is a sign of long-term headwinds for equity prices (see What gold tells us about confidence) and I stand by those remarks.
In the short run, however, gold prices are highly extended. A likely outcome of this upside breakout is a pullback into a cup and handle pattern, which is still long-term bullish.
Tactically, we don’t have the bearish triggers yet. Near-term event risk is high, as roughly 40% of the weight of the NASDAQ 100 report tomorrow. My inner trader is staying on the sidelines but monitoring the situation carefully. He is prepared to jump in on the short side should we see a bearish trigger. My inner investor remains neutrally positioned at roughly his investment policy targets for each asset class.