In our previous commentary on gold, we wrote that gold prices would keep falling for three reasons: (1) accelerating US inflation, (2) decelerating growth outside the United States and (3) an ongoing slowdown across emerging markets. Ultimately, all three factors were supportive for the US dollar, gold’s ultimate nemesis. Since that time (May 17), gold prices have weakened from around $1,290 to $1,197 on August 14.

Predictably, we were heavily criticized for our outlook thanks to a small, but vocal, number of gold bugs. Looking ahead, gold is likely to find some support from US inflation, which we expect to begin decelerating in the near future. The precious metal is also likely to run into resistance based on excessively bearish sentiment, as shorting gold has become a consensus trade in the speculator community. Unfortunately, it’s still too early to call the bottom for gold, as the US dollar is likely to keep strengthening. As a result, we expect gold to keep weakening.

Stars lining up for the US dollar, and that’s bad news for gold

In the past, we wrote that the US dollar would keep strengthening thanks to accelerating US growth and inflation. More recently, we have changed our view on US economic conditions going forward. Specifically, we now forecast that both US growth and inflation will begin decelerating in rate-of-change terms. Paradoxically, an economic downturn (even in the US) is typically great news for the US dollar. This is because of the US dollar’s safe haven qualities.

An overview of recent trends in US inflation and year-over-year GDP growth are shown below for reference:

US economic data: upcoming shift

(Click on image to enlarge)

Source: US BEA, EIA, BLS, MarketsNow

Thanks to weakening commodity prices (our outlook on crude oil is now bearish), the primary driver behind year-over-year inflation is already softening. At this time last year (see indicated area in red), inflation began meaningfully accelerating. As a result, continued growth in year-over-year inflation for the rest of 2018 will become increasingly challenging going forward. Thus the combination of weak commodity prices and steepening base effects is likely to weigh on future inflation data.

Our outlook for US growth follows a very similar logic. As forward-looking US economic indicators (such as ISM sentiment figures, industrial production, etc.) peak, the primary driver for future growth is softening. At the same time, the US economy has to contend with particularly tough comparables going into the second half of 2018. These comparables have also been outlined in red.

As both US growth and inflation begin decelerating (matching the ongoing slowdown occurring in most major economic regions), the US dollar is likely to strengthen. This is particularly the case thanks to an acute US dollar shortage in emerging markets, a topic we have covered extensively in the past. Unsurprisingly, the US dollar has moved up sharply following the latest Turkish lira and emerging market currency sell-off.    

Decelerating inflation helps, but Fed has historically gone too far

The combination of a global downturn coupled with an upcoming US downturn is great news for the dollar. While gold’s inverse correlation with the US dollar is one of the strongest relationships across all financial markets, the precious metal also trades as a function of US Treasury bond yields.

Given our forecast for decelerating inflation, it follows that US Treasury bond yields are more likely to head south. All else held equal, this is positive for gold. An overview of 10-year US Treasury yields are shown below:

Treasury bond yields: A lower-high

Source: TradingView, MarketsNow

Looking at the chart above, 10-year yields recently made a lower-high (3.016%) relative to its 2018 high of 3.129% in mid-May. This is an early sign that Treasury yields are likely to begin moving lower.

While falling bond yields are positive for gold, there is a risk that the US Federal Reserve goes too far in hiking rates. This is particularly the case as Fed Chair Powell has already indicated that US monetary policy will not be influenced by weakness in emerging markets. Specifically, he said that "Fed policy normalization has proceeded without disruption to financial markets, and market participants' expectations for policy seem reasonably well aligned with policymakers' expectations."

Historically, the Fed has ignored the problem of a dollar shortage in emerging markets (to its peril) and has hiked rates into a global downturn. The clear market-based signal from gold today is that the Fed’s intentions are too hawkish relative to global economic conditions.  

Short gold has become a consensus trade, and this is a risk for the shorts

Another factor influencing gold worth mentioning is the significant consensus short position in futures and options contracts. An overview of the net speculator position in gold is shown below:

Short gold: everybody on board?

Source: CFTC, MarketsNow

As can be seen above, net speculator positions in gold are now net short to the tune of 6,995 futures and options contracts. Over the last five years, the net position in gold has always remained in positive territory, despite a significant bear market that began in 2012. In standard deviation terms, the trailing 12-month speculator position is two and a half standard deviations from the historical average. The 36-month trailing average is two standard deviations from the historical average. This is a clear sign that short positioning in gold is starting to look excessive.

Still too early to call a bottom in gold

While gold will enter a bullish trend when economic conditions change in the future, all signs point to continued strength in the US dollar. This is particularly the case thanks to (1) changing economic conditions in the US amid a global slowdown, (2) an increasing shortage of US dollars particularly in emerging markets and (3) the Fed continuing to hike rates into a downturn.

While falling long-term Treasury bond yields and an excessively crowded short position in gold are positive signs, it’s too early to call a bottom for the precious metal today.