Last week I wrote that “downside risks remain” and specifically cited the chart below showing what happened to gold in 2008. What occurred then was real yields rose (TIPS fell) significantly on plummeting inflation expectations in line with the crash in the stock market, even though nominal bond yields remained relatively stable and the Fed was cutting short-term rates aggressively towards zero. Being highly correlated to real yields, gold dumped ~30% at the same time.
The risk now is that we get a similar spike in real yields when gold is near perfectly correlated to real yields on an inverse basis, but for slightly different reasons.
I posted the following tweets on September 9:
The 10 -Year (“10Y”) yield hasn’t been lower since. In fact, it looks like it is in the process of an ABC correction to at least 1.98%, where C=A, or perhaps as high as 2.28%, where C=A*1.618.
Higher nominal bond yields mean higher real yields, assuming inflation expectations are constant. We have seen this recently since the triple “B” bottom at 1.51% and the rise to 1.65% so far. Real yields have climbed from a low of zero this past weekend to 13 basis points today. If the 10Y does continue to rise to 1.98% or higher, real yields will also continue to rise.
But didn’t Fed Chair Powell just announce plans to buy U.S. Treasury securities? Shouldn’t that reduce yields? Powell’s announcement of permanent open market operations to address recent volatility in repo rates only focuses on short-term rates. In fact, we are seeing a steepening of the yield curve as short-term rates fall and longer-term bond yields rise.
Note how I said “assuming inflation expectations are constant” above. What if they fall at the same time as nominal yields rise? The truly awful ISM data on October 1 and 3 dramatically increased fears of recession, and the S&P has dumped from 3000 since. Recessions combined with stock market sell-offs (or worse, a crash) are deflationary, so it is fair to assume that inflation expectations could fall too. A combination of rising nominal yields and falling inflation expectations could cause a spike in real yields just like that in 2008. I don’t expect this to happen, but it is a risk and real yields could certainly rise further.
Real yields are equivalent to the yield on Treasury Inflation-Protected Securities, “TIPS,” as shown above. This means that real yields are the inverse of TIPS prices, i.e., if TIPS fall, real yields rise and vice versa. Below is the chart for TIP, an ETF that tracks TIPS prices. Note how it bottomed in November last, the same time gold and silver began their spectacular rallies. Now it is on the verge of breaking trendline support (purple line) since November. This could cause TIPS to fall hard and real yields to spike higher. My targets on the downside for TIP are more modest. Like the 10Y Bond but a mirror image, I believe TIP is undergoing an ABC correction with targets on the downside at ~114, where C=A, and ~112, where C=1.618*A. Then we head higher again. Only a decline below 112 would increase the probability that a scenario like 2008 is playing out again.
Why am I talking about bond yields and real yields instead of gold and silver? Because gold is near perfectly correlated to TIP, which is perfectly correlated to real yields on an inverse basis. Silver is also near perfectly correlated to gold. Simply put, unless the correlation between gold and TIP breaks down (and it has on occasion in the past), then higher real yields, lower TIP prices, mean lower gold and silver prices. This is why this is so important.
My primary scenario is for a continued rise in nominal and real bond yields and further declines in gold and silver to targets I provided weeks ago at ~1423 and ~16.50, respectively, then a new rally to begin to higher highs. A 2008-type spike in real yields and dump in precious metals is far less likely at this point, but it remains a risk to monitor, especially if the 10Y yield breaks 2.30% and TIP falls below 112.
Even if the 2008 scenario does play out, this just means that you get to buy gold and silver at even cheaper prices given the monetary insanity that will follow, in my honest opinion. Gold rose almost 200% in less than three years from its low in October 2008, silver closer to 500%. I believe the gains after the next low in both will exceed those numbers, especially in the mining stocks.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.