Something Big Is Coming…

It’s been an interesting couple of days.

The S&P 500 fell into correction, falling over ten percent, since its all-time high January 26th. The velocity of the crash shocked most, but if you were into reading tea leaves, then you weren’t surprised.

On January 28th, I wrote a note that pointed out all is not well in the short-volatility space while focusing on the inverse volatility ETN XIV. (after continuously warning throughout 2017). There were clear and present signals that suggested the short-volatility trade was deteriorating. It then fell 96.18 percent almost instantaneously with the VIX seeing its largest one-day surge ever.

I bring that up because not everything is obvious, and sometimes a little digging is required. Despite the increased volatility, gold is under-performing most expectations. Gold is nearly down one percent in the week and snapped a four session losing streak – the longest since December; and there is a reason for this: real yields.

Real yields have broken their post-crisis resistance of 50 bps and been moving higher.

Real yields are the differential between nominal yields and inflation. When real yields are negative, that is historically very bullish for gold. When they are positive, it is conversely so. Since nominal yields bottomed in 2016, real yields have been steadily rising from -44 bps to 67 bps. As real yields become even more positive, it tends to make the base currency attractive.

If we look at the dollar index-gold ratio, it tends to track real yields. It’s not perfectly correlated, but it is notable. As real yields increase, so does the dollar index-gold ratio and vice-versa.

But leading into 2018, there has been a huge divergence. Gold has been able to shake the trend in real yields.

Something is big is brewing, and the new bout of volatility and de-risking is making this precarious. The whole risk-off event could exacerbate the situation, causing real yields to continue higher pulling the dollar along with it. Gold could sell off in short order circa 2008 style (gold crashed while VIX and real yields spiked). Gold is liquid, and you sell what you can in a panic not what you want.

The opposite scenario is a possibility too. If the volatility increases along with the asset deflation, it could force the Fed’s hand. If the Federal Reserve steps away from their relatively stern stance, real yields may fall and gold goes higher.

It may be too early to be 100 percent certain, but I guarantee you’ll have to keep this on your radar.

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