Contributed Commentaries
The Gartman Gold Trade Revisited
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
Headframe, Lone Mountain, Eureka, Nevada
A profitable trade when central banks go in different directions
February 13, 2018
Dennis Gartman, renowned commodity investor and author of the Gartman Letter, often advises investors to buy gold in currencies that are most likely to weaken relative to the U.S. dollar (USD). Japan and Europe’s divergence in central bank monetary policy from the U.S Federal Reserve has made this a very profitable strategy. In late-October 2014, the Federal Reserve ended the third and final phase of their expansive quantitative easing program or QE3. Shortly thereafter, the Bank of Japan and European Central Bank greatly expanded their monetary stimulus – the U.S. tightened while Japan and Europe stepped on the gas pedal. This caused the Japanese yen (USD/JPY) and euro (EUR/USD) to weaken setting up the “Gartman gold trade” in terms of one or both currencies . Fig. 1 illustrates how this divergence in central bank policy has driven gold/currency spreads since 2014:
Figure 1 – Comex gold in currencies USD, euro & yen
For the purpose of percentage comparisons, gold in terms of each currency is shown with respect to its 2013 low. This a reasonable benchmark for comparing the "value of gold" relative to currencies. Although gold in U.S. dollars (USD) made lower lows in 2015 and 2016, the yellow metal lost value across a broad set of assets in 2013 and established lasting lows in terms of euro and yen. The downdrafts of 2013 boiled away of much of gold’s inflated dollar value after making all-time highs in 2011. By the summer of 2014, gold had recovered roughly 10% in all three currencies.
After the end of QE3, gold in terms of euro and yen soared higher, initially outpacing gold in USD – divergence well underway. As the USD grew stronger, the Gartman trade picked up momentum. For example, Mr. Gartman told CNBC's ‘Squawk Box’ on June 9, 2016, “I think you can get both sides. I think you can get gold in dollar terms rising, and I think you get the euro falling, so gold in euro terms gets very strong.”
At that time, the trade favored the euro over yen as shown by the spread chart in Fig. 2:
Figure 2 – Comex gold spread in terms of euro & yen
On this chart, key monetary decisions by the Federal Reserve, Bank of Japan (BoJ) and European Central Bank (ECB) are color coded: green for policy expansion, red for tightening and orange for transition. Several days after QE3, the BoJ aggressively expanded their already accommodative policy. The ECB followed in January with a “shock and awe” QE program. After the European move, the euro fell in value faster than the yen causing gold in terms of the former to accelerate. This spread divergence peaked in July 2016 with gold in euro gaining 41% from its 2013 low while gold in USD posted only 16%. At that time, gold in yen trailed both at 13%.
The Bank of England (BoE) joined the party in August 2016 with their “Brexit Bazooka” expansion blunting the advance of gold in terms of euro. The year ended with U.S. elections triggering a trend of higher lows for gold in yen. As gold in euro drifted lower, the spread in Fig. 2 narrowed and gold in all three currencies started to converge (Fig. 3).
In terms of monetary policy, the Federal Reserve tightened further with rate hikes starting in December 2015. Four more followed in 2016 and 2017. In the meantime, expansionary central banks at least began to contemplate an eventual unwinding of their balance sheets. While not tightening per se, ECB’s Mario Draghi reduced Europe’s QE rate but stretched out the planned duration in October 2017. This transitional “lower for longer” approach signaled global accommodative policy finite and less desirable as major economies moved from recovery to growth.
Value Parity and the EUR/JPY cross rate
By Friday’s close, gold in terms of euro still topped the net gains from 2013 lows at 22% with gold in yen at 17%. Both currencies outscored gold in USD which only rose to 11%. Of course, the Gartman gold play is a trade and not a passive investment. For instance, one could hold gold in euro from post-QE3 until mid-2016, take profit and transition to gold in yen after the U.S. election to improve net return.
The EUR/JPY cross rate is a useful indicator for determining when to switch or blend currencies in a Gartman trade. This cross rate is negatively correlated with the gold euro/yen spread shown in Fig.2. This is by mathematical outcome rather than market condition. In fact, value parity (i.e. spread = 0%, Fig. 2) occurs at 139.24 EUR/JPY. This cross rate had been trending higher, peaking at 136.96 on February 5. This is consistent with a narrowing spread. EUR/JPY has since reversed closing at 133.06 Friday suggesting that value parity is not in the cards for the time being.
Mechanics of the Gartman gold trade & an alternative
The mechanics of the Gartman trade don’t necessitate buying physical gold in actual currencies. Mr. Gartman has shown “buying gold in euro terms” can be accomplished by taking a USD position in a gold exchange traded fund (ETF) such as SPDR® Gold Shares GLD and then shorting EUR/USD in the forex market.
Although this is a nimble and efficient way to trade gold there is a third alternative. Some investors allocate a percentage of their portfolio for safe haven protection and are more inclined to hold than trade gold. For this case, taking a position in an ETF based on the U.S. Dollar Index (US:DXY) offers some of the advantages of the Gartman gold trade. PowerShares DB US Dollar Bullish ETF (UUP) is one such instrument.
The US:DXY is weighted index of six major currencies that favors the euro (57.6% by weight) and to a lesser extent, the Japanese yen (13.6%) and British pound sterling (11.9%). In a strong dollar environment, the value of UUP increases as some combination of these currencies weaken relative to the U.S. dollar. Therefore, a pairs strategy of holding GLD and UUP removes some of the downdrafts and volatility of holding GLD alone as shown in Figure 3.
Figure 3 – An ETF pairs strategy for gold (GLD) positions
This chart compares two $10,000 ETF accounts opened the day of the 2013 GLD low. The accounts are held passively to date. The first is GLD alone; the second is an initial 50/50 position in GLD and UUP. Note at the onset of monetary divergence, the combined account preserves the highs, mitigates the gold lows and provides lower volatility. For this period, the maximum gain of both accounts occurred on July 8, 2016 when the gold euro/yen spread was greatest (EUR/JPY cross rate lowest). The strategy performs best during the strong U.S. dollar period (dark gray area) with more than 2-times less volatility than holding gold alone.
The pairs strategy began to show some weakness (lighter gray area) in September 2017 as the DXY started its trend lower to levels now roughly the same as late-2014 (DXY 89-90). For perspective, the DXY peaked at 102 in December 2016.
What Next?
Years of extraordinarily loose monetary policy worldwide are now being slowly dismantled. An era of quantitative tightening will eventually replace QE as central banks unwind their burdensome balance sheets. The collapse of gold/currency spreads in Fig. 1 illustrate that change is in the wind.
Has the Gartman gold trade run its course? For nearly 3-1/2 years it has yielded a very profitable way to trade gold against currencies that weakened relative to the U.S. dollar. Now that spreads are narrowing some of that opportunity has diminished. However, volatility in markets has returned and the risks of overheated economies, inflation and growing deficits in the U.S. will no doubt create future opportunities for trading safe haven gold against major currencies. Key directional indicators to watch are the DXY and the EUR/JPY cross rate as noted. For longer-term holders of gold that employ a GLD/UUP pairs strategy, it is sensible to occasionally change the mix ratio as a function of dollar weakness or strength.
On Mardi Gras Day – Laissez les bons temps rouler!
