Best of the Week
Most Popular
1.The Brexit War! EU Fearing Collapse Set to Stoke Scottish Independence Proxy War - Nadeem_Walayat
2.London Terror Attack Red Herring, Real Issue is Age of Reason vs Religion - Nadeem_Walayat
3.The BrExit War, Game Theory Strategy for What UK Should Do to Win - Nadeem_Walayat
4.Goldman Sachs Backing A Copper Boom In 2017 - OilPrice_Com
5.Trump to Fire 50 US Cruise Missiles To Erase Syrian Chemical Attack Air Base, China Next? - Nadeem_Walayat
6.US Stock Market Consolidation Time - Rambus_Chartology
7.Stock Market Investors Stupid is as Stupid Goes - James_Quinn
8.Gold in Fed Interest Rate Hike Cycles- Zeal_LLC
9.The BrExit War - Britain Intelligence Super Power Covert War With the EU - Nadeem_Walayat
10.Marc Faber: Euro to Strengthen, Dollar to Weaken, Gold and Emerging Markets to Outperform - MoneyMetals
Last 7 days
Bifurcated US Stock Market - 29th Apr 17
Damn the Deficits, Huge Trump Tax Cuts Ahead! - 29th Apr 17
Gold Hostage to Stocks - 29th Apr 17
Warren Buffett Hates Gold… But Here’s Five Reasons You Need To Own It - 29th Apr 17
Stock Market Sentiment, Re-Fueled Along the Way - 28th Apr 17
Calling out the Central Bankers - 28th Apr 17
Fed's Third Inetrest Rate Hike and Gold - 28th Apr 17
USD/CAD - Invalidation of Breakout or Further Rally? - 28th Apr 17
What Happened to the Stock Market Crash Experts Were Predicting - 28th Apr 17
Earth Overshoot Day - Human Population Growth - 28th Apr 17
Misunderstanding GDXJ: Why It’s Actually Great News For Junior Miners - 28th Apr 17
What Makes Bitcoin Casinos So Remarkable? - 28th Apr 17
Financial Markets Improvised Explosives - 27th Apr 17
More Stock Market Short-Term Uncertainty As Stocks Get Close To Record High - 27th Apr 17
Elliott Wave Theory: Is Elliott’s Theory Enough? - 27th Apr 17
Billionaire Investor Paul Tudor Jones Says Stock Market Valuation Is “Terrifying” And He Is Right - 26th Apr 17
The Great BrExit Divides - Britain, USA and France - 26th Apr 17
10 Facts That Show Our Taxes Are Worse Than You Thought - 26th Apr 17
What Trump’s Next 100 Days Will Look Like - 26th Apr 17
G20: SURPASSING THE 2nd GLOBAL STEEL CRISIS - 26th Apr 17
What A War With North Korea Would Look Like - 25th Apr 17
Pensions Are On The Way Out But Retirement Funds Are Not Working Either - 25th Apr 17
Frank Holmes : Gold Could Hit $1,500 in 2017 Amid Imbalances & Weak Supply - 25th Apr 17
3 Reasons Why “Spring Forward, Fall Back” Also Applies To Gold - 25th Apr 17
SPX may be Aiming at the Cycle Top Resistance - 25th Apr 17
Walmart Stock Extending Higher - Elliott Wave Trend Forecast - 25th Apr 17
Google Panics and KILLS YouTube to Appease Mainstream Media and Corporate Advertisers - 25th Apr 17
Gold Price Is 1% Shy of Ripping Higher - 25th Apr 17
Exchange-Traded Funds Make Decisions Easy - 25th Apr 17
Trump Is Among The Institutionally Weakest National Leaders In The World - 25th Apr 17
3 Maps That Explain the Geopolitics of Nuclear Weapons - 25th Apr 17
Risk on Stock Market French Election Euphoria - 24th Apr 17
Fear Campaign Against Americans Continues Nuclear Attack Drills in New York City - 24th Apr 17
Is the Stock Market Bounce Over? - 24th Apr 17
This Could Be One Of the Biggest Winners Of The Electric Car Boom - 24th Apr 17
Le Pen Shifts Political Landscape- The Rise of New French Gaullism  - 24th Apr 17
IMF Says Austerity Is Over - Surplus or Stimulus - 24th Apr 17
EURUSD at a Critical Point in Wave Structure - 23rd Apr 17
Stock Market Grand Super Cycle Overview While SPX Correction Continues - 23rd Apr 17
Robert Prechter Talks About Elliott Waves and His New Book - 23rd Apr 17
Le Pen, Melenchon French Election Stock, Bond and Euro Markets Crash - 22nd Apr 17
Why You Are Not An Investor - 22nd Apr 17
Gold Price Upleg Momentum Building - 22nd Apr 17
Why Now Gold and Silver Precious Metals? - 22nd Apr 17
4 Maps That Signal Central Asia Is at Risk of War - 22nd Apr 17
5 Key Steps For A Comfortable Retirement From Former Wall Street Trader - 22nd Apr 17

Market Oracle FREE Newsletter

Why 95% of Traders Fail

Dovish Fed to Send Gold Higher

Commodities / Gold and Silver 2016 Jan 26, 2016 - 12:04 PM GMT

By: Sam_Kirtley

Commodities

Gold and US real rates have long had an inverse relationship. Gold rallied to all-time highs while monetary policy was being made historically accommodative through quantitative easing. Then, as these measures were reduced and the Fed moved towards the beginning of a new tightening cycle a bear market in the metal began, leading the metal to almost halve from its prior highs.


However, gold failed to break to new lows when the Fed announced their first rate hike in December. When new employment data in January showed continued strength in the economy, making future hikes likely to come sooner, the metal again failed to break lower. Financial market mayhem has now made it highly unlikely that there will be more hikes in the medium term, which means that gold has no catalyst drive it lower. Instead, we believe that gold is in fact likely to have a major bullish catalyst this week: The Fed.

Why The Fed Will Not Hike

The rate hike last month was regarded by many, including us, as the beginning of a new tightening cycle for the Fed. However, since then we have seen market concerns around China’s currency devaluation and the future of the inflation situation escalate significantly, leading to mayhem in the financial markets.

This turmoil alone is enough to stop the Fed from hiking again. During the correction last year the Fed chose to not hike rates at their September meeting. The Fed reinforced that the tightening of monetary policy would be with respect to market sentiment with this decision. Investors were assured that the Fed would keep monetary policy highly accommodative and that tightening would be gradual.

This means that the Fed cannot hike during times of tumult in the markets as to do so would cost them credibility, and thus their ability to signal to their intentions. Therefore, it is near certain that the Fed will choose to leave interest rates unchanged at their meeting this week.

Disinflationary Pressures Will See a Dovish Fed

While China’s currency devaluation should not directly affect the Fed’s monetary policy decision, the effects of the devaluation will. The weakening of China’s currency means that other currencies, and in particular the US dollar, are now stronger. This means that US exports are more expensive, which makes them less competitive. The result is that economic growth in the US has the potential to be severely hurt. If growth begins to slow, inflationary pressures will fall also.

The continued decline in oil is having an increasingly negative effects on the energy sector. A lack of expansion in the energy sector means that support companies, such as the industrials, are similarly hurt. The total flow on effects of this mean that the decline in oil is now having a considerably negative effect on the economy.

Without concerns around the future of the inflation situation the Fed has the option to take a dovish stance. However, this is not the only reason that they are likely to do so. Credit spreads have widened, which means that interest rates are effectively higher without a hike. This means that the need to raise rates now to combat future inflationary pressures has been significantly reduced, as the higher borrowing costs will have a similar effect that of a January hike by tightening financial conditions.

Considering the combined impact of both a disinflationary outlook and wider credit spreads increasing borrowing costs, we can see that the Fed is likely to take more dovish action than simply leaving rates unchanged. To ease concerns around inflationary pressures and to lessen the negative impact that wider credit spreads will have on inflation, the most prudent monetary policy action is to provide a dovish statement following this meeting.

What this Means for Gold

Given the long term inverse correlation between gold and US real rates and our view that the Fed will release a dovish statement this week, we gold is highly likely to rally. The question is, by how much?

Most markets have already priced in a no hike from the Fed this week. However, while other markets may price in key action from the Fed ahead of time, gold generally does not react until after these expectations have become reality. This means that although rates staying unchanged this week is largely priced in for financial markets, gold still has the potential to have this action priced in after it has been announced.

If the Fed releases a dovish statement, as we expect that they will, then the rally in gold is likely to be substantial.

Adding to this bullish effect from the Fed is the fact that gold is underpriced relative to bonds at this point. SHY, the ETF that tracks 1 to 3 year Treasury bonds, last closed at $84.75. This level corresponds to roughly $1150 gold, but the yellow metal is currently trading $40 lower. This means that even without a dovish statement from the Fed, gold has the potential to rally to at least $1150. Therefore we believe that gold has considerable upside potential from here and high probability of achieving it.

How to Trade the Rally in Gold

There are multiple vehicles available to take advantage of a post-Fed rally in gold. GLD is an ETF that tracks gold, but this lacks any leverage to the metal. There are many who are calling to get long gold stocks to gain leveraged exposure to the yellow metal, but we believe that this would be a poor use of capital.

If one held a bullish view on gold and believed that the metal was likely to rally following this week’s Fed meeting, then it would be near contradictory to also hold the view that gold stocks will rally. The Fed will make a dovish statement if they believe the economic outlook is threatened. In this situation, stocks are likely to continue to fall, or at the least underperform, and gold mining stocks are much more likely to be sold off with equities than rally with gold.

We hold the view that the best way to gain leveraged exposure to gold is through the use of options. One strategy that we believe has particularly attractive risk reward dynamics is selling downside protection on gold. To execute this we are looking at selling March and April vertical put spreads with strikes around $100, which corresponds to approximately $1050 in gold.

These trades return between 15% and 25% if gold is above $1050 at expiry. Now, these returns are not astronomical, but the downside risk is very low here. If gold rallies after the Fed meeting this week as we believe it will, it is likely that the metal will move above support at $1150 to challenge resistance at $1180 and the long term downtrend. This movement makes it extremely likely that gold will remain above support at $1050.

Therefore we believe the risk reward dynamics on this type of trade are highly favourable at this point and as a result are our vehicle of choice. Should gold continue to rally higher and break through the long term downtrend line, then we will look to take a much more aggressive position on the metal, such as buying calls on GLD.

If you wish to know the exact details of our trades and when they are executed, please visit www.skoptionstrading.com. For those considering subscribing to SK OptionTrader, please be aware that we are closing to new clients on February 20th to ensure that the quality of our service is not diluted. Therefore if you wish to become a subscriber, we recommend doing so sooner rather than later.

We are also considering much more bullish plays if market dynamics continue to become more bullish for the metal. Should gold break through the long term downtrend line, currently just below $1200, then we will look to take advantage of the new bullish trend by opening much more aggressive positions. If you wish to see exactly when we execute these trades and how we trade rising gold prices in the future, please visit www.skoptionstrading.com.

Sam Kirtley

Email:bob@gold-prices.biz

URL: www.silver-prices.net
URL: www.skoptionstrading.com

To stay updated on our market commentary, which gold stocks we are buying and why, please subscribe to The Gold Prices Newsletter, completely FREE of charge. Simply click here and enter your email address. Winners of the GoldDrivers Stock Picking Competition 200

Disclaimer:  www.gold-prices.biz   makes no guarantee or warranty on the accuracy or completeness of the data provided. Nothing contained herein is intended or shall be deemed to be investment advice, implied or otherwise. This letter represents our views and replicates trades that we are making but nothing more than that. Always consult your registered adviser to assist you with your investments. We accept no liability for any loss arising from the use of the data contained on this letter. Options contain a high level of risk that may result in the loss of part or all invested capital and therefore are suitable for experienced and professional investors and traders only. Past performance is neither a guide nor guarantee of future success.

Sam Kirtley Archive

© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife