The price of the US Dollar, Treasuries and Gold have always been interlinked. US interest rate term structure is a key element to consider when looking at their price action and this is what we’re going to look at here.
Any USDxxx FX pair (spot and forwards) is driven by – and reflects – interest rate differentials which are priced into the future. 2017 began where the second half of 2016 left off, which is with decent optimism regarding the US Dollar. The Fed had hiked 25bps in December after a year of inaction, and the US economy seemed to be motoring along. The Fed Fund futures market was pricing three full hikes in 2017 and a further three in 2018. But then things started to change: Q1 GDP was revised a lot lower (though seasonality has seen consistently weak Q1 GDP readings), inflation seemed to plateau and the Trump administration started to falter on their pre-election promises. It’s worth noting that employment has remained very strong and although participation rate has steadily fallen to near 40-year lows, the job market remained buoyant. The March rate hike was duly delivered but the change in sentiment moved interest rate expectations: just three further 25bp hikes in the rest of 2017 and 2018 combined. The DXY index completed a false breakout on the monthly chart and looks like it may be heading for more weakness.
US Treasuries naturally are greatly affected by US interest rates (bonds 101: as rates fall price goes up and vice versa). The recent downturn in US rates expectations has kept 10 UST yields within the truly formidable 20-year downward channel. It’s very interesting to note that the recent peak in yield coincided with the December 2016 rate hike; a clear sign that the market believes that the Fed will not be able to sustain its planned hiking path. USTs also happen to be one of the most popular flight-to-quality targets and as a result global uncertainty has given them a steady bid.
Finally, we turn to gold. This is also driven by long-term yields, in fact it’s most correlated to long-term real yields (nominal yield minus inflation). When real yields drop, gold price tends to rise and vice versa. Unsurprisingly, since the end of 2016 gold has been on a steady and consistent bull run. Its price is also greatly driven by money / credit supply and it’s obviously a popular safe haven asset. Gold has relatively little use beyond its store of value capacity – it is of course used in industry, jewellery etc but the majority of physical gold in existence lies idle in a vault or a safe. So, its value is effectively defined as what someone is prepared to pay for it. It’s a controversial asset but one which has withstood the test of time, being used as currency for thousand of years.
So, to summarize all the above, the Dollar – Treasuries – Gold trinity is greatly affected by the term structure of US interest rates. If someone trades one of the three instruments it’s always useful to monitor the other two, as they can provide telltale signs for market direction. Very often and depending on general market circumstances, one of these instruments leads the other two.
The “Technical” view
Gold is close to breaking out, what else could move too?
When you get a major asset class that is close to breaking a major level, and could make a major move in the market, we like to look around and see what else could move as well. Often on our daily webinars, we mention how the market is like a set of “dominoes” and as one asset class makes a move, sometimes it can provoke others to do the same.
Gold is at a major inflection point, and with big risks looming at the end of the week, the risk is that gold breaks a multi year trend line. Take a look at the chart below:
Gold has broken the $1280 level, but has rejected the horizontal resistance (thus far) at the $1295 level. A breakout above $1300 is really going to put some upside momentum on the beleaguered shiny yellow metal.
So what if gold manages to breakout? The natural place where traders are going to look is the DXY. The US Dollar index has been beaten down since the beginning of the year. Some major false breakouts as many traders/institutional players thought that the US Dollar was going to soar as interest rate differentials diverged between central banks. At this point, it’s tough to say why the US Dollar is underperforming. Some would pin it on the current administrations possible stance on a weaker dollar to enhance trade. Perhaps that other central banks may start to normalize monetary policy, or perhaps the markets are less sanguine on the idea that the current US Administration will be able to push through some of the economic agenda that was previously hoped. Whatever the reason, the US Dollar has been weak, and you can see below, near key support:
The DXY is almost at the major 61.8% Fibonacci retracement level which seems to be holding price at the moment. But what if gold breaks higher? The risk to the US Dollar is that we could take out this support, which would be interesting as it seems many traders have been attempting to play a “dead cat bounce” in the US Dollar in recent days and weeks.
So let’s talk bonds. Typically, you can see the correlation between gold, the US Dollar, and bonds. The correlations are very strong. So, with a breakout in gold, the US Dollar could come down, and bonds? They may go higher!
The consensus of the market has been in recent months that a major top has been put in for the bond market. Although this may be true (I personally happen to believe it too), does that mean that the bond market is set to move straight down from here and bond yields rip higher? Looking at the chart below, I question that idea as we have just overcome the 200dma and are testing the 38% retracement. Take a look below:
If you look at the correlations between the three asset classes, they are very strongly correlated. The main chart is the DXY (US Dollar index) and gold is in red, 10yr treasuries in yellow. I put the bond market and gold together as line charts since they tend to move together, and the US Dollar is inversely correlated.
The point being, that gold is nearing a breakout point. If it breaks and closes above the $1300 level at the end of the week, the DXY may come under pressure as bond yields drop. Bonds would be higher as a result.
However, this is such a big level for gold, the exact opposite could happen, which could lead to a very manageable risk short on gold, long US Dollar and short bond trade as well.
The dollar Index DXY has reached important confluence of Fibonacci support on a weekly time frame. In harmonic patterns the 0;236 retrace level is extremely important, it is the first retrace level to be tested and a good indicator if the swing you have drawn is valid; The 0.236 retrace from the 2011 lows in the DXY lines up exactly with the 0.618 retrace from the 2016 lows at 96.47 but 0.618 retrace levels can be messy and the 0.236 retrace level from the 2009 lows in the DXY is a little lower at 96.00. There is a lot of Fibonacci confluence between these two levels so much so that we can say we expect a significant bounce if not a reversal from the 96.00-96.47 level in DXY which at the minimum returns to 99.27.
The importance of the 0.236 retrace level also means that if it breaks we can confirm we have a top or important high in the US dollar. A daily close be.low 96.00 would confirm the end of the 8 year uptrend and point to at least another 5% decline to 91.00
The Elliott Wave perspective
EURUSD is trading nicely higher since French election in April when EURUSD broke above 1.0900 level and continued higher in impulsive fashion all the way up to 1.1300 area. Technically speaking this can be an important zone for some pullback lower since we know that after every five waves market turns the opposite in three waves. So from an EW perspective we anticipate a three wave set-back this month. Also, notice that pair is approaching an important swing level back from Nov 09 at 1.1300 that I call it as a »Trump level« which may play an important role if we consider that a lot of stop orders can be placed up there. So a spike above that swing and turn down would not be surprise for me at all.
At the same time, we are looking at 10 year US notes which holds a tight correlation with EURUSD. On 10 year we see wedge pattern that can face limited upside. A reversal down into a three wave decline will help EURUSD to came slightly down as well.
Another market which is on the rise in-line with 10 year US notes and EURUSD is gold. On metal we have seen a nice move up in May from 1215 and above an important resistance line from 1375. At the same time we can see a retest of 1295 levels which is a high of the year. Normally these are important zones so technically a pullback lower may show up from around 1300 level and back to that broken trend which may become a good support later this month.
You can also watch the following video which I uploaded a couple of days ago as a “Mid Week Video” update for ForexAnalytix in which I am analyzing the EURUSD and the US 10 year Treasury.