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At the FOMC meeting last week the Fed raised interest rates for the first
time since 2006. This was a historic moment marks the first rate hike after
the Fed engaged in massive quantitative easing programs to combat the Global
Financial Crisis and the Great Recession. However, we are not economists or
economic historians. We run a trading service and are therefore concerned
with where the markets will go next. This means that our key point of
analysis is around where rates will go next, rather than what they did last
week.
We were short gold going into last week’s FOMC meeting, but reduced our
short exposure following the hike and consequent fall in gold. What happens
with interest rates over the next year and beyond will determine how gold
trades going forward. Therefore our analysis of the future of interest rates
will be the most significant component in calculating the risk reward
dynamics on potential new gold trades.
Connecting the Dots
The FOMC meeting last week also included the release of the dot plot
projections. These show where members believe key economic data series will
be going forward, but also, and more importantly, show where members believe
interest rates should be. These dot plots are thus vital for speculators in
determining the future of interest rates.
The chart above shows how FOMC members believe interest rates over the
coming years. The current implication is that rates will rise to 1.40% by the
end of 2016, which would take four hikes of 25 basis points each. It is also
implied that rates will rise another 100 basis points in 2017. If we believed
that these projections would be realised, then we would be limit short gold.
However, we instead hold the view that rates will in fact rise more slowly
over the coming years.
Oil & ECB
These are two factors that will lead the Fed to tighten at a slower pace
than the dot projections currently imply.
Lower oil has led to falling energy prices, but this is not the only
reason falling oil prices have caused disinflationary pressures. Energy
companies under financial stress have seen credit spreads widen and selling
across the board in High Yield debt. This has increased the borrowing costs
for the US corporate sector.
When this is combined with the fact that oil prices are lower, it is clear
that new projects, particularly involving high cost shale, are becoming more
and more unviable. This has hurt the jobs sector, which means that the
multiplier effect must be considered. When the energy sector lays off or
cannot hire a worker, that worker may not buy the new house they were looking
at, which would have involved credit and a mortgage. This means that it is
not just the salary that is lost, but future spending using borrowed funds as
well.
The higher borrowing costs also in of themselves are likely to cause the
Fed to hike at a lower rate. The widening credit spreads effectively increase
interest rates for US businesses, which means it has the same effect as rates
being higher. Therefore the Fed will not need to hike as fast as the effect
of the hike will already be in play.
Moving across the Atlantic to the Eurozone, we believe that the ECB will
have to embark on an expansion of their current QE program. Although the ECB
recently lowered rates further, there is still a lack of inflation with core
inflation also printing lower in the Eurozone. This means that further QE is
likely to be needed and we believe that this will come early next year.
Such action will further weaken the Euro while strengthening the US
dollar. This will generate more headwinds for the US economy by increasing
the costs of US exports for foreign buyers, which will hurt the exporting
sector and thus growth. A dampened growth rate will mean that inflationary
pressures will be further limited, and therefore there will be less urgency
for the Fed to hike.
Therefore it is likely that 2016 will see far less need for hikes than the
Fed currently expects, so it is unlikely that we will see the projected 100
basis points of hikes.
No Christmas Catalyst
Now that the FOMC has passed and rates have risen, gold needs a new
catalyst to move lower. However, there is little that can act as such a
catalyst. The next payrolls print is not until January 8th, more
than two weeks away, while other data prints are unlikely to move the metal
lower. This means there is a significant amount of trading time wherein gold
will be without a bearish catalyst.
There is instead the potential for bullish factors to push gold higher.
Any type of risk off event will likely trigger safe haven buying in gold.
Without a major bearish factor in play to counteract this, such an event
would likely see gold rally.
We Sold The Rumour And Bought The Fact
There is an old market saying of “buy the rumour, sell the fact”. Often
assets trade higher ahead of significant positive events, but then begin to
selloff afterwards. Since the beginning of the bear market in gold the metal
has often rallied ahead of FOMC meetings or payrolls releases, but then sold
off once the event passed and was shown to be bearish for gold.
Earlier in the year some speculated that the Fed hike would come with
dovish connotations. During this time we increased our short gold exposure,
gaining very favourable entry levels. The speculation that the Fed would be
more dovish led gold to rally up until the October meeting when the Fed
signalled that they would hike in December, after which it began to selloff.
This decline continued until the rate hike was announced. Following this
gold initially moved lower, but then began to recover and regained ground on
Friday, and has the potential to continue this recovery with no bearish
catalyst to keep the price falling. However, we reduced our exposure on the
day of the rate hike by taking a 70.21% profit on a short GLD call spread
position. This ensured that we avoided Friday’s rally and the risk of it
continuing.
Enjoy The Holidays
Following a tough year for financial markets we will take a brief break
over the holiday period before returning in 2016. Currently our portfolio is
running light with a considerable 75% in cash. This allocation gives us
sufficient dry powder to action new trades in the upcoming year and ensures
that we do not have any unwanted exposure on the books.
Our model portfolio returned 28.86% on closed trades in 2015. While this
has not our best year and we have come in below our 52.31% annualized return
since inception, we are content to have outperformed both long and short
positions on the markets we trade. 2016 will no doubt hold another round of
fresh challenges and we look forward to the opportunities next year will
bring. If you wish to become a subscriber to receive trading signals as and
when they are issued, please subscribe via either of the buttons below.
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