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The October statement from the Fed made one thing very clear; December is
a live meeting and Fed is ready to hike rates if it sees fit. Yellen was more
hawkish than the market was expecting, sending gold prices lower and bond
yields higher. The critical focal point from here will be if the Fed’s
hawkish stance will be validated by the upcoming economic data, most
importantly the two employment releases we get between now and the December
FOMC.
Employment data had been solid for the last few years, indeed the Fed
shifted its focus from employment to inflation, reflecting that their mandate
of achieving full employment was nearly accomplished. However the last two
prints of +136k and +142k have put a spanner in the works. Are these one off
points like the +119k we got earlier this year? Or is this a change in the
health of the economy which could see the first rate hike delayed?
As mentioned above, we read the statement as a clear attempt by the Fed to
keep a December hike on the table. Given that market pricing had been leaning
towards only a 20-30% chance of a December hike following the NFP data, if
the Fed had been any less hawkish they would likely have pushed December out
of consideration. Since this is the first hike in such a long time, and part
of unwinding the biggest easing of monetary policy the world has ever seen,
the Fed would likely be hesitant to raise rates with very low market implied
probabilities of policy action. The market is now pricing much closer to a
50% chance of a December hike, giving the Fed flexibility to raise rates if
they wish. If the markets are still only pricing 20-30%, the Fed would likely
not hike for fear of causing instability.
50% is probably fair pricing for December, given the uncertainty over
data. If the next two payrolls figures are solid (+200k), the Fed will
increase rates in December. If they are weak (+100K) then the Fed will delay
hiking, and rightly so, as they will be cautious and concerned that the
employment market is seriously softening. Those are the two easy solutions,
but the grey area will come if the employment prints are mediocre.
What If Data Prints Grey
If the data is simply average from now until December, in our view the Fed
will hike rates. Our reasoning for this is due to creditability and stability.
On credibility, the Fed has been saying all year that they plan the raise
interest rates in 2015. Every dot plot has shown this, and the Fed has
delayed and delayed again for a number of reasons over the past few years. In
the absence of a smoking gun reason not to hike, the Fed would lose
credibility if they remained on hold. The market would doubt that the Fed
will ever be able to get off zero. Even if the Fed stressed that they could
hike in early 2016, the market would not believe it.
On stability, the Fed would prefer a meeting with a press conference and
projection materials to deliver their first hike. December is such a meeting,
but January is simply a statement with the next press conference being in
March. Whilst Yellen has stated that they could hold an impromptu press
conference, it is highly unlikely that after a record time on zero, the first
hike would be delivered with an impromptu tone. This would risk causing
unnecessary volatility in markets. In addition to this January meeting on the
27th would only give the Fed a minor amount of additional data compared to
December, for example there is just one more employment print between the
meetings.
Therefore if the Fed does not go in December, they will have to wait until
March to hike. That could be too long. In our view, if Fed is this close to
hiking, then they are best to execute the first hike in December, with
minimal surprise to markets.
Fed speakers between now and the December meeting will be key. The Fed
will want to ensure the market is fully prepared. Therefore expect pricing to
drift towards 75% if the data is solid, encouraged by hawkish Fed speakers.
What does this all mean for gold?
The simple answer is that a hike is bearish for gold prices, as it will
reduce the need to hold gold as a financial asset and the USD strength
resulting from a hike will see gold fall in USD terms. To demonstrate this
the chart below shows the price of the front Eurodollar futures contract
(Currently December) and gold prices. The futures price is quoted as 100
minus the 3mth Libor rate. Therefore a lower price means a higher expected
3mth yield. So as the chance of a Fed hike increases, the Eurodollar price
falls. It is clear that generally gold has been falling and rising with the
Eurodollar price, indicating its sensitivity to Fed policy.
If market pricing increases past 50% and towards 75% as we expect it to,
as a result of solid employment data and Fed speakers talking up the chance
of a December hike, the Eurodollar price will fall to new lows. Therefore we
would expect gold to also fall to fresh lows.
Technically on the downside $1125 is the next support, and should that
break we would expect gold to fall swiftly towards $1080. A catalyst will be
needed for this to break and that catalyst will likely be the NFP data this
Friday.
Trading Gold on the First Rate
We currently have short position in gold, via a few different option
strategies. However we are not aggressively short the yellow metal here, and
have not been since the start of 2013, when we turned our long term bullish
stance to a bearish one, reflecting that the easing of monetary policy in the
US had come to an end.
The reason we are not aggressively short gold at this stage is due to the
data risk. Monetary policy and therefore gold prices are massively leveraged
to the next few data prints. Employment data is a lottery and therefore
having too large a position is similar to taking a coin flip. That is not a
prudent way to manage capital and take risk.
Our current position will lose us a small amount of money if we are wrong,
but could pay off considerably should we be correct. If this payrolls print
is strong, we will add to gold shorts. Any kind of positive backward
revisions would see us shorting gold aggressively with $1030 (the pre QE2 resistance
that is now a major support level), as an initial target.
Holders of gold mining stocks are unfortunately in for yet more of the
same under this scenario. Whilst we are without a position in gold stocks at
present, we are looking for opportunities to establish short positions.
Despite October being the best month since 2009 for equities, gold stocks
barely outperformed the S&P 500, even though gold gained 2.25% over the
month. We are concerned that a pullback in stocks, combined will a fall in gold
prices in a December hike situation would see gold stocks fall to yet another
low, even though the HUI index is already down 25% in 2015.
For now the next stop is this US Employment data this Friday. Following
that we will reassess the situation, but as things stand a December hike by
the Fed is more likely than not, which is bearish for gold prices in the
short term. Our full trading
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