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“Anything that endures over time sacrifices its ability to make an impression.”Robert Musil

Gold, interest rates and dollar correlations in front of the Fed

Lots of ink is being spilled by analysts and pundits world over in an effort to provide some clarity on what the Federal Open Market Committee will do and say tomorrow. Given that a quarter-point hike in the Fed Funds rate seems well-baked into the cake, emphasis on what Janet & Company say tomorrow will be most important.

Is inflation, at least in real goods, still dead? Has the forward growth outlook (the dot plot thing which I don’t understand) changed? How fast will the Fed’s balance sheet be reduced? Does the Fed need to worry about dollar denominated debt being held around the globe (read lots of embedded risk in emerging markets)? Will higher rates impact corporate profitability to any significant degree at the margin (read more money needed to pay debt load instead of investing into new products and development)? Is manipulation of money and credit still required to keep the stock market in rally mode? If stocks correct, will it have a significant corresponding impact on collateral values such that any positive Fed outlook would automatically be suspect? Why haven’t wages increased in this “recovery” if low rates are so effective for creating real growth? The questions are virtually endless. But so are the narratives.

It is likely the Fed Funds will be raised tomorrow. But beyond that, I’m not sure what else can be said with any degree of confidence. Such is where we are in this recovery; it’s officially 95-months old and yet for many if still feels like recession (that many defined as those who sell their labor and do not have access to capital). Proof positive economics, based on the rational man at the center of all assumptions, has failed us miserably.

So, best we watch what Mr. Market says about the Fed, then worry about what the Fed says about Mr. Market, methinks. And on that score, there are a couple of interesting and very tight correlations in play.

  1. 10-year US benchmark interest rates (red line) and gold (black bars).

    The chart below comparing gold and 10-year yield shows a whopping 92% 21-day negative correlation. That is considered extremely tight. Thus the bet, if 10-year yields move higher tomorrow, gold most likely moves lower; or vice versa.

  2. US benchmark 10-year minus 2-yr spread and the US dollar index

    A narrowing of the 10 vs 2-year spread is flattening of the yield curve; said flattening is the market’s way of saying investors are expecting future growth (and inflation) to be muted. Thus, lower yield means the US dollar looks less attractive for hot money speculators if this lower yield translates into a lower yield spread, or expectation the yield spread for the dollar will fall in the future (however that is defined). And as you know, currency investing is the most relative of games.

    The chart below shows as the 10 vs 2-year spread falls, so goes the US dollar. And in fact, there is a 78% 21-day positive correlation. That’s considered tight.

So, based on the ongoing correlations shown: If whatever the Fed says or does pushes up 10-year yields (faster than the 2’s) we should be selling gold and buying the US dollar…but if Janet once again shows her dovish face; i.e. the Fed chickens out, well, gold likely shines and the dollar gets whacked. Or…