- Interim Update 30th November 2016

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The Oil Market

Anticipation of and then reaction to the outcome of an OPEC meeting caused significant two-way volatility in the oil price over the past few days, with oil first dropping back to its 200-day MA due to scepticism that the OPEC members would manage to strike a deal on production cuts and then rising sharply after it was announced that a production-cut deal had been done. The volatility hasn't, however, altered the price pattern.



This week's OPEC news actually hasn't changed anything. To avoid losing its remaining credibility OPEC had to announce some sort of production-cut deal, but the deal that has been announced probably won't have a significant effect on overall oil supply even in the unlikely event that all parties to the deal meet their commitments. The reality is that OPEC is no longer the swing producer in the oil market. That honour now belongs to the US shale-oil industry.

In any case, the currency market is the most important driver of the oil market and the currency market continues to point to a lower oil price. Of particular significance, the C$ has done nothing to suggest that its short-term downward trend is over.

The C$ would have to achieve a daily close above 75.25 to generate the first sign of an upward reversal in its short-term trend.



We view the OPEC-inspired price surge as an opportunity to buy some more USO put options, both as a speculation and a way of hedging long exposure to commodity-related equities.

The Treasury Market

The following daily chart shows that the iShares 20+ Year Treasury Bond ETF (TLT) has not yet begun to rebound from its 'oversold' extreme, although it lost downward momentum a couple of weeks ago and is possibly building a base.



The on-going weakness in the Treasury Bond is the main obstacle to a short-term rebound in the gold price. It will be difficult for the gold price to manage anything more than a modest multi-day bounce until the T-Bond price reverses upward.

The Stock Market

The NASDAQ100 Index (NDX) tested its September-October highs on Tuesday of this week and then pulled back on Wednesday. It has therefore still not confirmed the breaks to new highs by other important US stock indices.



We expect at least a 6-month extension of the equity bull market, but at the same time we expect a significant 1-2 month correction.

Gold and the Dollar

Gold

Gold and Inflation Expectations

We've covered the relationship between the gold price and inflation expectations in many TSI commentaries over the years, but it now makes sense to revisit the topic. This is because a sharp rise in inflation expectations since mid-September went hand-in-hand with a sharp decline in the gold price. According to conventional wisdom, this is not supposed to happen. A sharp rise in inflation expectations is supposed to be bullish for gold.

In the financial markets it's not unusual for "conventional wisdom" to be wrong, although in this case it is not so much wrong as incomplete. It is certainly the case that all else remaining the same, an increase in inflation expectations will be bullish for gold. However, all else never remains the same.

Here is a more complete and correct statement of the relationship between gold and inflation expectations: It is bullish for gold when inflation expectations rise relative to nominal interest rates and bearish for gold when inflation expectations fall relative to nominal interest rates, regardless of whether inflation expectations are rising or falling in absolute terms.

With the aforementioned statement of the relationship in mind, let's take a look at what happened in the recent past.

The following chart shows the gold price (the blue line) and the yield difference between the 10-year T-Note and the 10-year Treasury Inflation-Protected Security (TIPS). We refer to this yield difference as the "Expected CPI", because it is the average annual rate of CPI growth that the market expects the US government to report over the next several years. Although almost everyone knows that the CPI tends to understate the rate of currency depreciation, the Expected CPI is a useful proxy for the financial markets' inflation expectations.

If gold consistently performed well during periods of rising inflation expectations and poorly during periods of falling inflation expectations then the two lines on the following chart would move in the same direction almost all of the time. However, over the past 12 months they have actually spent more time moving in opposite directions than moving in the same direction. It is especially noteworthy that sharp declines in inflation expectations during the first 6 weeks of the year and during June were accompanied by a strong gold market and that a sharp rise in inflation expectations since late-September has been accompanied by a weak gold market.

It is therefore fair to say that changes in inflation expectations cannot explain gold's performance over the past 12 months.



Gold's performance over the past 12 months can, however, be explained by changes in the nominal 10-year yield minus the Expected CPI. The difference between these quantities is the 10-year TIPS yield, a proxy for the real interest rate.

The following chart shows the gold price (the blue line) and the above-mentioned proxy for the real interest rate. Notice that a) the gold price has consistently trended in the opposite direction to the real interest rate, b) the gold price traced out a topping pattern and the real interest rate traced out a bottoming pattern from early-July through to late-September, and c) the sharp decline in the gold price from late-September through to the end of last week coincided with a sharp rise in the real interest rate.



The upshot is that the gold market was very weak in the face of sharply-rising inflation expectations over the past two months because nominal interest rates rose even faster than inflation expectations, leading to a higher real interest rate.

Current Market Situation

With the T-Bond remaining weak and the Dollar Index remaining strong it is not surprising that the US$ gold price has not yet managed a rebound of any significance. However, we continue to anticipate a short-term rebound, mainly due to the extent to which the gold market and the markets that exert the greatest influence on the gold price are stretched on a short-term basis.



As noted in the latest Weekly Update:

"A rebound could begin as soon as this week and probably won't begin any later than mid-December (within a few days of the 14th December FOMC announcement), but for a rebound to have longer-term significance it must, at a minimum, achieve a weekly close above $1210. It must also be accompanied by a fundamental shift in gold's favour."

As also noted in the latest Weekly Update, the Commitments of Traders (COT) report that gets published at the end of this week will be very interesting in that it will reveal the effects on speculative sentiment of gold's break below $1200. The larger the decline in the speculative net-long position in reaction to the break below $1200, the more constructive (for the bullish case) it will be.

Gold's COT situation will of course be covered in the next Weekly Update.

Gold Stocks

Aside from the fact that the gold-mining indices have continued to show subtle signs of strength relative to gold, nothing of significance happened over the first three days of this week.

Over the past three days the HUI traded in a narrow range near its low. This price action could be part of a small base prior to a multi-week rally or it could be a consolidation prior to a plunge below the 14th November low. We suspect it's the former, but we aren't betting on any particular short-term outcome for this sector.



The Currency Market

The euro is still holding the line

The euro remains precariously positioned slightly above major support as two important political events and one important monetary event loom in Europe.



The two important political events are a referendum in Italy and a presidential election re-run in Austria (the results of the Austrian presidential election early this year were thrown out due to counting irregularities), both of which are scheduled for Sunday 3rd December.

Italy's referendum is about the changes to the size and power of the Senate (the upper house of parliament). A "yes" result, which would reduce the Senate's size and power, has been vigorously advocated by Italy's Prime Minister Renzi.

The polls point to a "no" result, but not decisively. The outcome is therefore 'up in the air', especially considering the poor recent track record of the political polling industry.

A "no" result could -- but not necessarily will -- prompt Renzi to resign, thus superficially making Italy's political situation less stable.

The polls are also not decisive with regard to the likely winner of Austria's presidential election, although the Freedom Party's Hofer has a small lead. From the little we know about the situation, the Freedom Party appears to be more anti-immigration than pro-freedom. Austria's presidential election could therefore be viewed as a referendum on the EU policy that allowed hundreds of thousands of Middle-Eastern immigrants into Europe over the past two years.

The outcomes of these political events could create currency-market volatility next week, but it should be understood that regardless of the outcomes the probability of either country leaving the EU within the coming 12 months will be close to zero (zero in the case of Austria, slightly above zero in the case of Italy).

The important monetary event is the ECB meeting scheduled for next Thursday (8th December). It's likely that the ECB will announce an extension of its asset monetisation program at the conclusion of this meeting, thus highlighting the contrast with a Federal Reserve that is set to take a tiny step towards a tighter monetary stance a week later.

In the euro's favour are its 'oversold' condition and the fact that almost everyone expects a rate hike from the Fed and extended monetary easing from the ECB. This could enable the euro to rebound from support over the weeks ahead regardless of the events mentioned above, although we think it's too risky to bet on a euro rebound at this time.

The Chinese Yuan continues to slide

The first of the following charts shows the performance of the Yuan/US$ exchange rate over the past 10 years using monthly average prices. The second of the following charts zooms in on the Yuan's shorter-term performance using daily closing prices.

                                   Chart source: Pacific Exchange Rate Service

The Yuan has been weak relative to the US$ for almost 3 years. This weakness was predictable based on the Yuan's over-valuation and will probably persist for many more months. What hasn't been predictable is the financial-world's reaction to the Yuan's most recent bouts of weakness.

We are referring to the fact that the financial world outside China pretty much ignored the sharp declines in Yuan/US$ that occurred during May-July and over the past two months. Pronounced weakness in the Yuan was widely viewed as very important last year, but this year it has generally been viewed as irrelevant.

China's government, however, is worried by the relentless decline of its currency. It has been selling-off its US$-denominated reserves to offset the downward pressure on the Yuan resulting from capital outflows and is now readying new restrictions on outbound foreign investment in an effort to relieve the downward pressure.

This strikes us as a significant short-term threat to stock and bond markets in the major economies, with stocks being at greater short-term risk due to being 'overbought'.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://research.stlouisfed.org/