The Gundlach Conundrum: $1,000 Gold by Year's End?
Kitco Commentaries | Opinions, Ideas and Markets Talk
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Diamond Range, Eureka, Nevada
Range bound copper prices and rising yields may signal danger ahead for gold
June 20, 2017
In his 2017 forecast, bond guru Jeffrey Gundlach of DoubleLine Capital made a prescient observation about gold, copper and U.S. 10-year Treasury yields. More recently, he called for those yields to be in a range of 2.7% to 2.8% by year’s end. Can we make a call on gold prices for late-2017 if Mr. Gundlach is correct?
The answer is yes.
If copper remains range bound between its year-to-date (YTD) high and low, a very bearish decline in gold prices may lie ahead. Should we be bracing for a return to $1,000 per ounce gold? A solution to a puzzle will reveal the answer.
Here is the Gundlach Conundrum in three easy pieces.
Piece #1: A “fantastic” coincident indicator
In his forecast, Mr.Gundlach stated that the copper-to-gold ratio is a "fantastic" coincident indicator of interest rates. Last April, I tested this hypothesis by constructing a 2-year regression model of the U.S. 10-year Treasury yield given daily Comex gold and copper prices. The results were stunning.
My April 18th Kitco commentary presented this data in chart form. Figure 1 is an update of that chart through last Friday’s closing prices and shows that the Gundlach indicator has grown even more fantastic.
Figure 1 – U.S. 10-year Treasury yield model based on Comex copper & gold prices
Figure 1 compares my model output (Model-2) to actual 10-year Treasury yields. I chose the gold-to-copper ratio (GCR) for this analysis since we think in "pounds-of-copper-per-ounce-of-gold" in Northern Nevada - Gundlach correlations are positive; mine are negative.
Recent political and geopolitical concerns plus uncertainty about the timing and efficacy of the new administration’s domestic policies have caused the GCR to rise and U.S. interest rates to fall YTD. As market participants run to safe havens gold and U.S. Treasurys, they typically retreat from “risk-on” assets like copper. Rising gold and declining copper prices raise the GCR while higher bond prices produce lower yields. At Friday’s close, the GCR was at an elevated 491 pounds per ounce and the 10-year Treasury yield plumbed 2.157%. On the heels of the “Trump Rally” in mid-March, yields peaked at 2.60% and the GCR was much lower at 464.
The error standard deviation between the model and actual yield is now only 10.5 basis points (bps) versus 15 bps in April. The goodness-of-fit, or “R-squared,” has improved from 0.78 to 0.89 - the closer to 1.0 the better. The correlation of the 10-year yield over this two-year period is an even tighter -0.94 versus an earlier -0.88.
Piece#2: Comex gold versus copper prices year-to-date
Figure 2 is a scatter plot of gold and copper prices for 2017; 114 market days with daily price pairs shown by triangular markers. On such a plot, straight lines denote a constant GCR. The upper green line represents the Model-2 computed GCR for the YTD 10-year Treasury yield low of 2.11%. The lower red line corresponds to the GCR for the highest yield of 2.60%.
Figure 2 – Scatter plot of Comex copper & gold prices YTD
Reassuringly, all price pairs fall within these two lines in agreement with the tight correlation between the model and actual data of Figure 1. Last Friday’s close is indicated closer to the upper bound, lower copper price and lower yield: Comex gold $1,256.5 per ounce, Comex copper $2.5640 per pound and 10-year yield of 2.157%.
Piece #3: Corner analysis suggests lower gold prices
In addition to assuming the validity of the Gundlach correlation and yield predictions, the third assumption for this analysis is that red metal prices will remain range bound for the remainder of 2017. In moment, we’ll look at cases for much higher/lower copper prices.
Figure 2 is Figure 3 redrawn with upper (green) and lower (red) boundaries corresponding to Mr. Gundlach’s yields of 2.7% and 2.8% respectively. Connecting the corners defined by YTD copper highs and lows with the two new boundaries defines an area (blue) for likely copper and gold price pairs at year’s end.
Figure 3 – The Gundlach Conundrum – is gold headed lower by year’s end?
As shown graphically, this suggests 2017 gold closes in a range of $922 to $1,093 per ounce.
Putting these three pieces together presents a puzzle: no Comex gold price this year has fallen below $1,146 per ounce but the blue box indicates no higher gold price than $1,093 and only if copper reaches the top of its present range by the close of 2017. To date, the $1,200-level has proven solid support, only 11% of the data points in Figure 3 have fallen below this level.
Correlations come and go in markets. So far, the Gundlach relation has proved very good over two years and improving since April. Will it break down in the next six months? Hard to say but this cross-asset correlation has survived the reelection and first six months of a new administration intact. Figure 1 shows a slightly larger tracking error in the November to March time frame than most of 2016, but model and actual data have again converged in the last several months. So far, Piece #1 appears to be on solid footing.
If the Gundlach boundaries are extended to include much higher copper prices, it would take $3.00-$3.25 per pound copper to just sustain the key $1,200-level. If copper prices plummet below the current YTD low, the blue box of Figure 3 extends into deep triple-digit territory for the yellow metal. Neither of these extremes are in most expert’s outlook for copper. The red metal faces the same challenges as oil of potential oversupply and tepid real demand. However, robust rallies or violent crashes are considered tail events in a slowly improving global economy that moves to balance supply and demand. Range bound copper prices are a reasonable assumption for Pieces #2 and #3.
From Mr. Gundlach’s viewpoint there is a low probability of a recession but his Treasury yields for late-2017 do not represent much domestic growth either – certainly not the levels projected by some in the heady days after reelection. Mr. Gundlach has further warned to expect higher bond yields and lower stock prices this summer. This, together with a more hawkish Federal Reserve and recently lowered inflation expectations, is a bearish headwind for gold. Lacking further political or geopolitical shocks, there may indeed be a substantial gold correction ahead.
I want to avoid a visit to the blue box. Maybe Mr. Gundlach will be proved wrong…just maybe.