Dollar Reversal: What It May Mean For Gold and Bonds
A follow up to our discussion on a coming dollar rally.
Yesterday’s Commentary noted that the dollar is very oversold and likely due for a reversal. To wit:
The dollar is deeply deviated from its longer-term mean, oversold on multiple levels, and has been basing since April. As noted last Friday, the incredibly negative bias and position against the dollar are excellent contrarian signals for a counter-trend rally at some point.
The Commentary also noted that foreign central banks most often hold reserves in dollars, bonds, and gold. Thus, weakness in one or two of the reserve options can lead to strength in the other(s) as the banks try to maximize their returns. Per the Commentary:
Central banks and foreign holders of reserve currencies have three primary choices to store foreign reserves: US Stocks, US Treasury Bonds, and Gold, as each is traded in US Dollars. Gold has been a primary choice for reserves over the last two years due to the weakness in the dollar. However, if that reverses, we could see a shift out of gold into stocks and bonds, which should perform better as the dollar strengthens—just something to watch.
So, if we are correct about a dollar reversal, how might gold and bonds perform? To appreciate the recent relationship between the dollar and gold, as well as the dollar and bonds, we share the graph below. For this exercise, we are focusing solely on the relationships since early April, when Trump first announced the Liberation Day tariffs, and markets became extremely volatile. As shown in the top graph, bond prices and the dollar fell while gold remained strong. The charts beneath the price graph display the 50-day running correlation between gold and bond prices versus the dollar. As the graph alludes, gold and the dollar are strongly negatively correlated, while bonds and the dollar are generally positively correlated. Therefore, if the recent correlation holds, and a dollar reversal occurs, higher bond prices (lower yields) and lower gold prices could be in store.
What To Watch Today
Earnings
No earnings reports today.
Economy
Market Trading Update
Yesterday, we discussed the dollar’s deep oversold condition and why a rally could be forthcoming. While the dollar has been under a lot of pressure, bonds have been rallying very quietly. As shown, yields have fallen and broken below the 200-DMA. While this isn’t the first time we have seen such a technical break, it does suggest that lower yields could be on their way as recent economic and inflation data all show weakness.
With a sell signal in place, lower yields are likely. However, in the near term, yields are pushing two standard deviations below the 50-DMA, so a higher bounce in rates is expected before another push lower. The most recent economic data, as noted, indeed suggests lower yields later this year, and, as stated above, if the dollar rallies, such would also contribute to a bond rally as foreign reserves move back into Treasuries to benefit from the yield and rise in dollar appreciation.
Furthermore, as with the dollar, there is a massive short position against US Treasuries. If yields decline, we could see an acceleration in bond prices as shorts are forced to cover. However, right now, this is the last thing that investors expect to happen, which increases the probability that a bond rally is becoming more likely.
Funding The Deficit With Regulatory Changes
On May 16th, we noted: “Many analysts suspect that the SLR will change by this summer. However, the pressure to change them sooner could arise if Treasury yields continue to rise. With Treasury yields approaching 5%, we suspect banks will be licking their chops to buy Treasuries once the SLR restrictions are eased.”
A month later, it appears even more likely that the Federal Reserve will relax capital restrictions on the largest banks. Per Reuters:
A Federal Reserve plan to relax leverage rules could free up $185 billion in capital and unlock nearly $6 trillion in balance sheet capacity for large U.S. global banks according to Morgan Stanley.
A 5-2 vote approved the Fed’s proposal. Assuming it is enacted, there will be plenty of incentive for banks to expand their balance with low-risk assets such as US Treasury securities.
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What happened to the pullback in stocks you were talking about to add more exposure???