What’s Driving Precious Metals in 2019?

November - 2019

Although commodity markets have generally been difficult for managed futures in 2019, precious metals have been something of a bright spot with some markets breaking out of multi-year ranges.

The move in gold, in particular, has provided a good opportunity for trendfollowing and momentum strategies. Although precious metals can sometimes trade off common factors, this year, diverse themes appear to be driving the markets.

The strong rally in palladium has been the most notable move in precious metals in absolute terms in 2019. At the end of September 2019, palladium futures were up over +250% from its 2016 lows and over +40% in 2019. As Chart 1 shows, the strong rally in recent years followed a prolonged period when palladium traded in a $420-$850 range from 2010 to 2017.

It’s not unusual for markets to experience strong moves after a long period of ranging as investors sometimes anchor to the recent prices and then have to adjust to a shift in the supply-demand dynamic.

Chart 1. Palladium over 30 years, front month futures contract: Oct-1989 to Sep-2019

Source: Abbey Capital & Bloomberg. The front month futures contract refers to the contract which is the nearest to expiry at any point in time. Past results are not indicative of future returns.

In recent years there has been a fundamental shift in the supply-demand equation in palladium as supply has been constrained but demand has grown strongly amid strong demand for palladium for catalytic converters given tightening emission standards for automobiles.

Notably, futures markets have moved into backwardation** with near-month futures trading at a premium, often a sign of a market experiencing a shortage. However, liquidity in palladium futures is not as deep as in other precious metals and typically gold and silver will be more significant return drivers for many managers in managed futures.

The rise in gold year-to-date to September 2019 (up +14.4%) has not been as strong as palladium in absolute terms, but it has a similar pattern in that it resulted in a breach of a multi-year range between approx. $1,130 and $1,450. The sharp decline in global bond yields, uncertainty over the US and China’s trade war and dovish policy action by global central banks, have been key drivers of the rally since May 2019.

Notably gold accelerated higher after the ECB heavily hinted in June 2019 that it may restart quantitative easing. The shift in the macroeconomic backdrop appears to have prompted an asset allocation shift from investors as, so far in 2019, we have seen strong inflows into gold ETFs, and evidence of greater demand for gold from central banks as a reserve holding.

Chart 2. Gold price over 10 years, front month futures contract: Oct-2009 to Sep-2019

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Source: Abbey Capital & Bloomberg. Past results are not indicative of future returns.

Historically gold has been negatively correlated to the USD and the S&P 500 Index and positively correlated to US Treasuries. In recent months, the correlation between gold and the US Dollar Index has become less negative, while the negative correlation with equities and the positive correlation with bonds have increased, suggesting that gold’s safe haven status may have been the primary driver of it’s price in recent months.

Chart 3. 60-day gold correlations with the S&P 500, US Dollar Index and US bonds: Mar-2018 to Oct-2019

Source: Abbey Capital & Bloomberg. Please note that US bonds are represented by the JP Morgan US Government Bond Index.
See the “Index Definitions” section at the end of this piece for a description of all indices used. Past results are not indicative of future returns.

Although silver is also up in 2019, it has lagged the moves in gold and palladium.  Silver was still negative year-to-date as of the end of June 2019 possibly reflecting the different fundamental drivers of silver versus gold. While gold is mostly considered a store of value, silver’s main use is for industrial purposes.

However, the strong rise in gold in June appears to have influenced sentiment in the silver market triggering a catch up move in silver during July and August. That rally in gold resulted in a widening of the gold/silver ratio to its highest level since the early 1990s which appears to have attracted value buyers to silver.  As the graph below shows, this ratio has begun to narrow somewhat in recent months.

Chart 4. Gold/silver ratio: Jan-1970 to Sep-2019

Source: Abbey Capital & Bloomberg. Past results are not indicative of future returns.

However, the lagged move in silver in 2019 has not been as attractive from a Trendfollowing perspective as the move in gold.

In the early part of the year silver chopped around in a range whereas gold has trended more consistently particularly since May (although gold and silver have both experienced counter trend moves in the last two months).

This is reflected in Abbey Capital’s proprietary market indicators.  Whereas gold has trended approximately 48% of the time in the last 260 trading days, silver has been in a trend only 37% of the time*. Past results are not indicative of future returns.

*Note on percentage of time trending indicator 

The analysis categorises each market as either (i) Trending, (ii) Consolidating/Reversing or (iii) No Trend using 20-day and 120-day moving average crossover analysis. We then calculate the percentage of time the market has been in a trending phase over the last 260 trading days. If the 20-day moving average is between the price and the 120-day moving average, the market is Trending.  Otherwise the market is consolidating/reversing or not in a trend. Past results are not indicative of future returns.

**Note on backwardation

Backwardation is the term given to a commodity futures market when the current spot price of a commodity is higher than the futures price.

Index Definitions

S&P 500 Index: The S&P 500 Index is an index of 500 US stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

JP Morgan US Government Bond Index: The JP Morgan US Government Index is a leading measure of US government bond market performance. The Index measures the total return of US Treasury securities across the whole yield curve

US Dollar Index: The US Dollar index, which was introduced in 1973, measures the value of the US Dollar relative to a basket of developed-market foreign currencies. The foreign currencies included in the index are as follows: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and the Swiss Franc.

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