As a reminder, reflation started to attract the attention of investors at the end of 2016 and was based on two pillars:
- Trump’s rally, i.e. rising expectations about the fiscal stimulus provided by the new administration, and
- Accelerating global inflation and economic growth. As a result, interest rates surged, while the price of gold plunged.
The problem is that both drivers of reflation trade have weakened recently. The failure of Trump to repeal and replace Obamacare undermined markets’ confidence in the quick and smooth implementation of the new administration’s pro-growth agenda. Some argue that the Trump care’s failure is actually a good thing because now the administration will quickly shift to the subject of tax reform. However, such a line of argument is totally wrong as it overlooks significant divisions among Republicans and the fact that healthcare reform was supposed to reduce government expenditures, enabling or at least facilitating the tax cuts.
Of course, the reflation trade is something bigger than Trump’s rally, as the uptick in economic activity started significantly before the U.S. presidential election.
GOLD ANALYSIS
The price of gold (left axis, yellow line, London P.M. Fix), the U.S. nominal interest rates (green line, right axis, as the 10-year nominal treasury yield, in %) and the real interest rates (red line, right axis, as 10-year inflation-indexed treasury yield, in %) from January 2016 to April 2017.
Given the negative correlation between the real interest rates and the gold prices, the recent pullback strengthens the bullish outlook for the price of gold. Moreover, the bond market is more liquid than the stock market, so treasuries are often ahead of equities. It implies that we may see some spring corrections on Wall Street, which should be positive for the yellow metal.
Let’s check other key gold price drivers, which are less bullish. As one can see in the chart below, credit spreads are very low. It indicates high economic confidence, which is bearish for gold. There was a pullback in the U.S. dollar in 2017, but greenback remains in the upward long-term trend – partially because the divergence in monetary policies between the Fed and other major central banks has been widening – which is also negative for the price of gold
Therefore, gold drivers send mixed signals. The U.S. dollar and credit spreads remain bearish, while the real interest rates have turned to be bullish recently, as the Trump rally has definitely softened. To be clear: it’s too early to herald the end of reflation, as the improving manufacturing sector in China should be enough to support the reflation trade in the medium term. There will be ups and downs, but the trend should be higher. What we are saying is that the macroeconomic outlook for gold has recently improved on the margin, as the reflation trade lost Trump’s leg.
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