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CNF Focus| Gold&Bond price drop together, worthy of vigilance

Gold&Bond price drop together, worthy of vigilance

On January 6, the price of COMEX gold futures fell 1.75%, and fell another 3.39% on January 8, with the price of gold per ounce dropping over $120 in 3 days!

At the same time, the U.S. 10-year Treasury bond yield exceeded 1% on January 6. Then it rose for 6 consecutive days, standing above 1.17% and hitting a 9-month high. Before the outbreak of COVID-19, the 10-year U.S. Treasury yield was about 1.5%.

Exhibit.1 Comparison of COMEX Gold Futures Price and US 10-yesr Treasury Nominal Yields

Background

On January 6, Georgia's final election results were released, and two Democratic candidates won their Senate seats at the same time, which was not expected by the market. Democrats successfully control the Senate and resistance to the adoption of Biden's policies fell significantly. Investors began to seriously consider the impact of "blue wave" on the market.

In the short term, with the uncontrollable epidemic and the congressional riots reflecting huge social contradictions, strengthening fiscal stimulus has become the most effective and immediate response. Earlier, Democrats and Republicans argued about whether citizens should be given $600 or $2,000 for months. Now there is no longer a suspense, the Democrats can pass the bill they want after the handover of power on January 20. Besides, Biden said on Jan. 8 that he planned to formulate a stimulus package of up to trillions of dollars, an amount much higher than the previous draft of $900 billion. [1]

In the medium term, Biden plans to provide benefits to the bottom layer, restart Obamacare, undertake international obligations of the United States, restore relations with traditional allies, and build new energy and other infrastructure. All of these requires money, and where does it come from? The first is printing money. The US government’s deficit may further expand and the total national debt will continue to increase. The second is tax increases. The main idea is to raise the corporate income tax from 21% to 28% and increase taxes on high-income groups to regulate class conflicts.

Biden's short-term and medium-term policies have different market impacts. Short-term fiscal stimulus is highly influential and certain, requiring only a simple majority in both houses of Congress to pass. The medium-term non-fiscal bills such as raising Medicare and expanding infrastructure investment would require 60 votes in the Senate to pass. Although tax increases, as fiscal bills, can be passed with a simple majority, it is difficult to enter the actual agenda for the next 1 year, considering that the current economy has not yet recovered and Biden's tax increases are more tied to non-fiscal policies.[2] The market's main attention is now focused on the immediate fiscal stimulus that far exceeds expectations.

Reasons for the drop of bond price

There are two main reasons for the rise in U.S. bond yields. First, with the passage of mega-stimulus bill, the U.S. economy will undoubtedly get back on track more quickly. Therefore, the market's risk appetite continues to rise, with funds flowing from gold and bonds, which have a strong safe-haven function, to stocks and commodities. Second, the Fed's bond purchase rate has remained stable in recent months. If the U.S. government increases the scale of debt issuance, the massive supply of Treasuries will inevitably lead to lower bond prices.

Reasons for the drop of gold price

Gold's rise in 2020 was supported by the steady decline in real interest rates. In the first half of the year, nominal interest rates were depressed mainly by the Fed. In March when the epidemic hit the world, the Fed rapidly expanded its balance in response to the liquidity crisis under the panic, bringing the 10-year U.S. bond yield from 1.8% to below 0.6%. In the second half of the year, the 10-year U.S. bond nominal yield remained stable and the decline in real interest rates was mainly due to the rebound in inflation expectations. With the vaccine approved for the market, public’s fear of the epidemic subsiding and the economy gradually recovering, inflation expectations moved further during this phase.

Exhibit 2. Comparison of US 10-year Treasury Real Yield and US 5-year Treasury Real Yield

The biggest reason for gold price's decline is the rise in U.S. bond yields so far this year. However, it is easy to observe that the real interest rate on 10-year U.S. bonds has started to rise, while the real interest rate on 5-year U.S. bonds has not followed up, indicating that there is a big difference between the market's expectations for the short and long term.

Short-term fiscal stimulus will push inflation expectations upward. At the same time, the Fed has no plans to raise interest rates until 2023 and there is limited room for short-term nominal interest rate to increase. Therefore, the real interest rate of the 5-year U.S. Treasury has no reason to rise.

However, in the long term, compared with the upward trend of inflation expectations, the market believes that the normalization of the Fed’s monetary policy has a stronger momentum for rising U.S. bond nominal yields. In other words, the nominal interest rate of the long-term U.S. Treasury is ahead of inflation expectations, so the real interest rate of the 10-year U.S. Treasury is going upward. If this turning point is verified, it means that the market has now begun to incorporate the process of normalization of the Federal Reserve's monetary policy into market expectations.

Will the turning point of the market be now?

On January 6, in the minutes of the December FOMC meeting announced by the Federal Reserve, the word "taper" clearly appeared for the first time. Although the committee members only discussed the exit method initially without proposing any specific timetable, and emphasized that they would fully communicate with the market before reducing the scale of bond purchases, this minutes still became a major factor affecting the market. Among the committee members, Bostic, President of the Federal Reserve Bank of Atlanta, is the most aggressive. He said that if vaccine promotion and the fiscal bill can significantly improve the economy, the reduction of the scale of debt purchases can start as soon as this year, which greatly exceeds market expectations. Although no other Fed member supports Bostic's view yet, the emergence of such a voice is enough to influence the market. [3]

The point is not only on gold and U.S. bonds, but the issue is more on global financial markets. Whether it is the US or Japan, stock indices or commodities, the current bull market in financial markets is largely based on negative real interest rates on US bonds. This comes after the Federal Reserve pushed real interest rates into negative territory, which forced investors all over the world to look for products with certainty and safety.

For example, from the second quarter of last year, funds poured into the technology sector which had the highest certainty under the epidemic, pushing the Nasdaq index to a new all-time high. Since the fourth quarter of last year, restocking has become a definite trend, and funds have been hunting for upstream raw materials such as copper and iron. For another example, since China has the most effective control of the epidemic and the lowest uncertainty in economic operations, funds with safe allocation requirements have increased the allocation of RMB assets, and the RMB exchange rate has risen more than 10% to 6.4 last year.

The previous decline in real interest rates has pushed the valuations of the world's assets to unimaginably high levels. Once the global liquidity environment really reverses, the assets that have been piled up by liquidity at high levels will no longer be safe.

Conclusion

The magnitude of gold's 3 consecutive days of decline is actually not outstanding when placed in 2020. But the reasons for the decline in gold and US debt this time are worthy of investors' vigilance.The Democratic Party controls both the president and the two houses, and the smooth introduction of mega-scale fiscal stimulus may accelerate the recovery of the US economy and the upward trend of inflation. In this context, the Fed’s goal of "maximum employment and stable prices" may be achieved ahead of schedule and cause discussions on reducing the scale of bond purchases earlier.

If the inflection point of the real yield of U.S. Treasuries is established, most of the assets benefiting from liquidity may need to be repriced. Will overseas assets such as the RMB and the Euro, which were strong against the US dollar last year, face devaluation pressure? Is there any risk of a sharp pullback in 2021 for stock indexes that are already at high levels, such as Nasdaq and A50? Investors may track the progress of Biden's and the Fed's policy, and look for investment opportunities.

References

[1] 李园,新浪财经《拜登欲推数万亿美元新经济刺激计划,每人发放2000美元支票》

https://finance.sina.com.cn/world/2021-01-11/doc-iiznezxt1798576.shtml

[2] 黄文涛,格隆汇《参议院拿下50席,民主党如何利用?》

https://m.gelonghui.com/p/438746

[3] 杜玉,智通财经《美联储12月纪要:全体官员支持购债速度,谈及“缩减购债”将类似2013-14年》

https://www.zhitongcaijing.com/content/detail/390222.html

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2021/01/14
CN First International Futures Limited