Sometimes, in the market, I get a weird feeling, where something just seems off. Today was one of those days. Gold’s price action just seemed off. I like to use correlations between different asset classes to help shape a narrative for how the market is trading. While the longer duration correlation data fails to support a “risk-on”/”risk-off” narrative, this simplistic relationship does hold in shorter durations and can be helpful in spotting the beginnings of a change in how the market is trading the “macroscape.” Typically, I look at the evolution of correlations between the following assets:
- Stocks (SPX)
- Yields (US 10yr)
- Currencies (EUR*, YEN, USD Index)
- Commodities (WTI, Gold)
*Recently, EUR has had limited utility in serving as a risk barometer. This is likely due to the evolution of prevailing central bank easing policies wherein, negative rates are less effective in transmitting “risk on” signals than asset purchases are. EUR’s strength as a risk barometer began to wane once it became apparent Draghi’s first bazooka was insufficient and a second program, which would need to focus on rates – due to limited available assets, would be required. EUR’s signaling strength further decelerated with the ECB’s latest stimulus package, which purposefully targets rates, rather than assets. The YEN is still the funding currency of choice and as such, its risk signaling still has utility, albeit less so since Karoda focused the efforts of the BOJ squarely on deeper negative rates.
Broadly, the dollar’s retreat has allowed stock prices to rise, US yields to fall and commodities to rally. I view the dollar as an inverse risk-asset: dollar weakness is paired with stock buying, WTI bids and Gold purchases. I see yields as a risk-asset: falling yields tend to precede selling of stocks and WTI and gold buying. These are contradictory narratives over longer horizons, yet in the immediate to short-term, they do repeat themselves and therefore, are valuable signals to be cognizant of.
As such, when equity futures were in full-on rally mode overnight Monday into Tuesday, and then again around the European close, and were coupled by YEN weakness and rising US yields and oil prices, I expected Gold to be lower. Instead, Gold saw a nearly 2% move higher on the back of broader dollar-index weakness. The strength and persistence of this move is what had me feeling weird. Usually, we see Gold moves like today accompanied by fear and stock selling, but instead, it clearly was acting as a risk asset. Could this be a signal, that the Gold rally is getting ready to resume, in a big way?
To try to answer this question I looked to my Gold correlations analysis. The analysis looks at short (8 period), medium (24 period) and long (100 period) correlation durations between Gold and the above assets on an hourly and daily basis.
The hourly charts validate my weird feeling and highlight the divergence in Gold’s recent behavior from expectations:
- Beginning at 12:00am on 4/19 24hr correlations dramatically initiated reversals
- Oil: -0.61 to +0.80
- EUR: +0.24 to -0.93
- SPX: -0.63 to +0.51
- USD Index: -0.50 to +0.89
The big takeaway from the hourly correlation analysis was that the YEN signaled a potential sentiment reversal days before any of the other assets. The YEN’s 100hr correlation bottomed on 4/15 and the 24hr correlation bottomed during Sunday evening’s electronic session.
Clearly, Gold behaved differently today. The daily correlation analysis should provide some insight as to whether or not Gold will continue to do so.
The daily analysis has conflicting takeaways:
(1) The SPX, US 10yr yields, YEN and WTI data suggest the correlation between these risk assets and Gold is expected to strengthen in the direction of the existing trends, which is bullish for Gold in the short-term. That said, to confirm these bullish signals for Gold:
- SPX would need to go on to make a new high,
- Oil would need to make a new leg higher,
- US 10yr yields will need to challenge their February lows,
- YEN would need to continue to strengthen, despite the BOJ’s policy decision next week
(2) On the other hand, the USD index and EUR data suggest correlations are currently stretched and are likely to diverge in the near-term, which is bearish for Gold in the short-term.
The ultimate take-away from both analyses is that there’s a strong potential for today’s move in Gold to continue. I’m currently long 1250 and 1200 Gold futures May expiry puts. I’m going to consider rolling these out to June and hedging with some speculative long GDX and/or NUGT (3x gold miners) May expiry calls.
I still find the chart below to be a more compelling analysis that Gold is headed lower…