Asset markets suffered some of their wildest swings over the past five trading days, as a widely ridiculed mini budget delivered by Chancellor of the Exchequer Kwasi Kwarteng in the United Kingdom sparked a sharp sell-off in the UK government bond (Gilt) market, and in the British Pound (GBP).

The sell-off was so profound that at one point, GBP fell below USD $1.04 (-8% in one trading day) while 10-year UK GILTS surged above 4.5% by September 27, a rise of 1.4% in just 5 trading days.

Backed into a corner as a result of the wild moves, the Bank of England (BOE) has since stepped in with emergency support to buy UK government bonds “on whatever scale is necessary”, in an effort to avoid what the BOE labelled as dysfunction in markets that poses “a material risk to UK financial stability”.

Precious metals, equities, cryptocurrencies and commodities were all caught up in the sell off, with several markets falling by multiple percentage points, before stabilising (for now) after the BOE’s intervention.

While the news out of the UK has dominated financial headlines, there have also been a range of developments on the other side of Atlantic that are driving markets, including precious metals.

US bond yields continue to rise, while the yield curve is now at levels of inversion last seen back in early 2000, when gold was trading below USD $300oz and AUD $500oz.

The chart below, produced by my colleague Nick Frappell in his monthly technical analysis report for ABC Refinery, speaks to rapid change that we’ve seen over the last few weeks as regards market expectations re US interest rates. The peak in the implied policy rate has increased by approximately 0.80% (from 3.80% to 4.60%) over this time period.

This data in part explains the continued surge in the USD, with the dollar index at one point trading as high as 114 this week, which put it up almost 20% YTD, and 60% from its GFC low back in 2008.

The spike in rates in the US is also having a profound impact on the economy, most notably the housing market, where existing home sales are now down 20% over the last year, having fallen for seven straight months. Values are being hit too, with the median price of an existing home sold in the US down almost 6% from its June peak.

Financial markets are also continuing to find higher rates a tough pill to swallow, with prices for most indices continuing to decline. Sentiment (though not necessarily allocations) remains incredibly depressed, with more than 60% of participants in a recent AAII survey suggesting they are despondent as regards their view on the market. That’s only happened 4 times in 35 years.

The spike in yields, and the surging dollar are also obviously continuing to impact the precious metals market, with silver giving up some its hard won gains this week, though a GSR of close to 90 will no doubt encourage some silver bulls to add to their positions.

Gold too continues to face short-term headwinds, though deeper analysis of its performance is suggestive of an underlying resilience that might not be immediately apparent if simply looking at the fact the price has fallen 9% in USD terms this year.

Underlying strength in bullion

As we’ve covered in recent updates, sentiment toward gold is currently very poor, witnessed through net short positioning in the futures market, strong outflows from gold ETFs, and media headlines bemoaning gold’s supposedly lacklustre performance in 2022.

This narrative has if anything strengthened in the past week, with a range of analysts stating they expect the precious metal to continue to fall, while one article ran with the kind of provocative headline; “gold will keep losing its irrational luster” that is typically only seen after prices, and especially sentiment, have seen significant declines.

Two primary factors drive this pessimism

• The fact that gold has fallen in USD terms this year, rather than increased, even though inflation rates have soared, at one point topping 9% per annum
• The expectation that inflation will decline quite quickly heading into 2023, while interest rates will not only move higher, but stay at more elevated levels.

While it’s understandable some may have lost faith in bullion given the above, it should be acknowledged that

• It remains an open question as to whether inflation really will fall as fast as markets expect, with research from Bank of America suggesting that since 1980, once inflation reaches 5% in an advanced economy (a level it has already exceeded in most of the developed world today), it takes on average 10 years for it to return to 2%, while the Cleveland Federal Reserve’s Inflation Nowcasting model still has inflation comfortably above 4%
• Relative to most other asset classes, from stocks to long-dated bonds and especially cryptocurrencies, gold has been an outperformer in 2022
• Gold’s weakness in 2022 is almost exclusively a USD story, with the precious metal delivering strong price gains in GBP (+16.1% YTD), EUR (+8.4% YTD), YEN (+14.7% YTD) and a range of other currencies.
• While higher inflation has been a tailwind for gold, it’s faced very strong headwinds, the most notable of which are the strength of the USD and rising nominal and real interest rates.

This is a subject the World Gold Council (WGC) recently addressed, with their analysis highlighting the fact that gold would likely have fallen by more than 30% if it were only driven by movements in the USD and real rates.

This can be seen in the chart below, which also comes from the WGC article, and shows an expected gold price based on a “simple model” (i.e., one that just looks at changes in real interest rates and the USD as factors driving the gold price) vs. the actual gold price.

The fact the actual price has held up as well as it has suggests there is an underlying resilience in the gold market today.
This, combined with current investor positioning and sentiment, mean it likely won’t take much for the market to find firmer footing, and for prices to rally meaningfully.