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Hey Hey, Powell Jay, How Many Rates Did You Cut Today?

Topic: Gold
Publication Type: Viewpoints
Hey Hey, Powell Jay, How Many Rates Did You Cut Today?

What 3 Market Shocks Mean for Gold

In barely the span of a week, financial markets and gold in particular were subjected to three successive shocks—proliferation of the coronavirus, forced selling of gold on Friday the 28th, and finally, emergency cuts by the Federal Reserve on Tuesday.  Individually formidable and yet mutually reinforcing, these events precipitated some of the most extreme market conditions seen since the financial crisis. 

Examining the fallout provides an empirical illustration of gold’s role in the portfolio during market stress, illuminating not only surprises but outright oddities emanating from the market tumult.  Let’s evaluate the short-term impact of each shock on gold—beginning with the mid-session cut—as well as the ultimately favorable signals each may connotate over the long-run.

Shock 1: What An Emergency Cut Means for Gold

It is genuinely striking how rapidly a situation can irrevocably change.  The hurricane cone of market uncertainty radically expanded from where it had stood only moments early at Tuesday 9:59 am, with the emergency cuts raising previous obscure possibilities to the forefront.  Most striking about this 50-basis point mid-session cut is not it occurred, but the fact that this treatment is typically reserved for major macroeconomic crises—the likes of the Lehman Brothers collapse and the Russian sovereign default.  In other words, an emergency cut raises the question: what economic risk is so pervasive that two weeks time cannot be spared until the next Fed meeting?

Source: Bloomberg and GraniteShares Research

While two rate cuts would normally bullishly excite equity markets, the severity of this action may have more unnerved than calmed stocks with the S&P 500 closing 2.8% down.  With the implication of the Fed seeing destabilizing conditions over the horizon, safe haven assets including fixed income and gold unequivocally rallied.  Indeed, the Fed’s response Tuesday not only bolsters the probability of further accommodation, but it signals a marked departure from any attempt to normalize monetary policy.

Related: The 60/40 May Be Broken, But Not for the Reasons You Think

Historically, emergency rate cuts have been a strong predictor of upward movement for gold, this extraordinary measure amplifying the benefit of conventional rate cut. As the chart above depicts, over its 49-year period as free floating asset, gold gained on average 17.2% over 18 months following an emergency cut, and 26.1% after 24 months.  While the Fed may have limited ability to directly address the coronavirus, this rate cut can palliate some market symptoms, shoring up asset prices and staving off a potential liquidity crunch.

Shock 2: Equity Losses Prompt Forced Selling of Gold

The Tuesday surprise cut certainly benefited gold, with the real asset gaining $65/oz following this market shock, more than recovering the preceding Friday’s bout of forced selling.  Responding to this key second shock in the gold market, the headline report is that gold had its steepest single-day decline since April 2013, falling $60/oz. to close at $1585/oz.  The common refrain issued was that gold joined other assets in the COVID-19 market selloff, failing as a “safe haven” investment.  This headline, however, is rather myopic when considering the broader financial context and the unique circumstances that precipitated this event. 

Beyond taking a broadened economic perspective, the nuances behind gold’s price action Friday warrant attention.  The marked selling of gold Friday emanated not from profit taking, or even from a loss of confidence in the asset, but instead from forced selling.  Institutional managers who had accrued massive losses in equities markets, and to a lesser extent in commodities as well, were forced to unload positions and risk overlays in gold futures to cover their losses and meet margin calls. 

Beyond Headlines: Anatomy of a Forced Sale

In essence, market traders had accumulated such staggering losses in such a quick timeframe, they had to offload their gold positions to bail themselves out and rapidly deleverage.  This dynamic resulted in a one-day sell off in gold, as traders outstripped the market’s capacity to absorb their losses. The magnitude of loss, but even more striking the rate of loss, were key factors at work.  To be clear, these were not traders opting to reduce or even short gold exposure in arm’s length transactions; the trading dictum of selling what you can, not what you want, reigned supreme. 

Source: Bloomberg, Total Known Gold ETF Assets

To further underscore this point on market technicals, gold ETF assets in the aggregate continued to climb though this sell off, now standing at all-time highs of over 85 million ounces (depicted above). What this trend may further corroborate is that the selling occurred in the gold futures market, reinforcing the view the price action was driven by institutional traders caught exposed on the margin.  Furthermore, many gold ETF structures may not authorize rehypothecation of shares, thereby indicating these assets may not be used to gain short exposure.

In many respects, the monetizing of gold positions on Friday was analogous to behavior witnessed during the 2008 financial crisis, albeit on a smaller scale.  Once the forced sales were completed, safe haven buyers of gold produced a powerful positive trend for the asset, with gold ending in positive territory for the year in 2008. In other words, large scale forced selling events may have the effect of front-loading available selling activity, and can potentially ease selling pressures on a forward looking basis. Indeed, this effect has already been playing out in dramatic gains gold realized after the emergency cuts; many potential sellers had already exited the market.

Shock 3: Coronavirus Proliferation and Mass Market Selloff

The market selloff that began Friday 21st produced some of the most volatile and dynamic trading sessions since the financial crisis.  Essential is to evaluate gold’s performance not on the basis of a one-day market panic, but within the framework of a mathematical as opposed to a mythological context as would be done with any other asset.  Quite simply, no single day will make or break nearly 50 years of non-correlating performance; empirics not emotions should govern portfolio decisions.

Foremost, gold has been in a trend of near uninterrupted gains over the last 18 months, advancing $400/oz. from $1,200/oz. to $1,600/oz. For perspective, that equates to a monthly advance of $22/oz., or 1.6% gains compounded monthly (for those who think geometrically).  So remarkable has this pattern been that gold has served as a more effective diversifying asset than fixed income, even amidst a historic year for bonds in 2019.  Furthermore, even with this pullback, gold remains up over $80/oz. (+5%) this year, compared to equities’ -8% YTD rout.

Significantly, the macroeconomic factors that have propelled gold over the past 18 months have not weakened, but intensified over the last week.  Global central banks have indicated a strong willingness to not only accommodate markets, but to extend a coordinated response to this supply shock.  This movement began Friday afternoon with Fed Chair Powell issuing an unprecedented statement signaling rate cuts, followed by the Bank of Japan and further announcements from the ECB Monday. The emergency cuts Tuesday by Powell and other central bankers all but coronated these events.

The Balance of (Market) Power

All of these developments are favorable for gold, even independent of the asset’s historic store of value during financial crises.  Moreover, the 10-Year Treasury has broken well below all-time lows to under 0.900% as uncertainty builds over the spread and economic impacts of COVID-19.  These sustained flows into fixed income, as well as the heavily inverted yield curve, illustrate a remarkable clamor for safe-haven assets; gold may be expected to benefit from this demand.   

Learn More: 31 Flavors of Yield and Rethinking Income

Panic buying and selling will often produce unexpected distortions across asset classes, and broader context and understanding of these market forces are more important than the headline itself.  The very fact these market gyrations are occurring, even in the gold market, may be a compelling rationale for gold’s potential ahead.  Moreover, Powell’s emergency cuts may only underscore this point yet further.  It is precisely these markets, characterized by equal measure panic and fleeting euphoria, that gold can serve as a safe haven asset and moderate the volatility of stock and bond markets alike.

Past performance is not a guarantee of future returns. One cannot directly invest in an index.

Diversification does not assure a profit or protect against loss.  The assets referenced are not a recommendation or solicitation to buy, hold or sell. There are no guarantees that a strategy of holding or nor holding certain securities will produce favorable results.