The Fed under Yellen and the gold trade

The gold run isn't over yet: Traders
The gold run isn't over yet: Traders

Gold, which has been on a remarkable run so far in 2016, pulled back this week before the Fed statement, and then did an about-face.

Jitters ahead of the Wednesday statement from the Federal Reserve Open Market Committee likely sent some investors who have been lucky enough to be in on gold trade early this year to take some profits. Although no changes to rates were expected, many investors and traders were treating the Fed like a wildcard to which the market as a whole might overreact. And with a 16-percent plus run up in gold so far in 2016, why take short-term chances? In this instance, they could have. The market overreacted in a way opposite to what some gold traders were expecting.

Gold Bars
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On Wednesday afternoon in trading immediately after the Fed statement — in which it left rates unchanged and said it expected only two rate hikes this year, not four — gold and the stock market moved higher, while the dollar declined. Gold bugs were not surprised. But historically, the recent post-FOMC trading pattern for gold hasn't shown major swings, just slightly negative returns.

Axel Merk, president and chief investment officer at Merk Investments, which runs the Van Eck Merk Gold Trust (OUNZ) ETF, said the reaction from investors immediately after a Fed statement is not how a trade will ultimately play out, so he takes the immediate reaction with a grain of salt. "You can interpret it any way you want," Merk said. He still believes the stock market is due for a dip and if that occurs gold is supported as a risk diversifier. "We've had a rally now for weeks and the Fed wants what they say to have the least amount of damage," Merk said.

In Merk's opinion, the key in these statements doesn't change for gold, and it's that while growth and inflation are expected to go closer to what is historically normal, rates will remain below normal, even if rising. "I don't think the Fed can hike real interest rates. It's all just a show," he said.

"My own view is that hawkish posturing will induce a risk-off environment, equities will do poorly, and gold has been a good diversifier when the risk-off view is in place," Merk said before the FOMC statement was released.

On Wednesday, the market interpreted a more dovish Fed behind the wheel of the economy and both gold and equities rose in tandem. Merk said the FOMC minutes may induce short-term volatility, because investors and traders move to the sidelines ahead of the event, which reduces liquidity and increases the ability of the markets to be "yanked around."

There's been reason in recent history to stay out of gold — or, in the least, sit on the sidelines — in the immediate aftermath of an FOMC statement during the Yellen era.

Data from Kensho, which runs historical analysis of trade scenarios, showed in the one, two and three trading days after an FOMC statement since Janet Yellen became Fed chair, gold exchange-traded funds (ETF) and gold miner exchange-traded funds traded negative to a limited degree.

The major gold etfs, SPDR Gold (GLD) and iShares Gold (IAU), were both negative by on average 0.50 percent in the three days after FOMC statements dating back to March 2014. For gold mining ETFs, such as Market Vectors Gold Miners (GDX) and iShares MSCI Global Gold Miners (RING), the post-FOMC immediate return was roughly three times as bad, at negative 1.4 percent, which is not surprising, since this niche is more or less a leveraged bet on the performance of the precious metal.

As Merk said, trades can get "yanked" around, and the gold trade was yanked into positive territory on Wednesday afternoon (even after a gain of as much as 2 percent after the FOMC statement, gold was at best brought back to flat for the past 5 trading days).

While gold has not done great further out from Yellen-era FOMC minutes, with the gold ETFs trading positive less than half the time in the 15 trading days after a statement, the trading return of both gold shares ETFs and gold miner ETFs has been, on average, positive. Gold miner ETFs were up more than 4 percent on Wednesday afternoon.

Peter Hug, global trading director at Kitco, said this isn't surprising, because Yellen is in the unenviable position of trying to normalize U.S. interest-rate policy after years of expansionary monetary policy.

The Fed remains at least rhetorically inclined to push the higher rate argument, but given the current global growth malaise, raising U.S. rates against a backdrop of negative rates in the EU and Japan would swing massive capital flows to U.S. dollars and be counterproductive to U.S. growth, Hug said.

The ETF Trade: Gold ETFs shine
The ETF Trade: Gold ETFs shine

"At every Yellen Fed meeting, she parrots the phrase that the United States is committed to higher rates, which creates a knee-jerk sell-off in the metals, and then when the rhetoric is analyzed, the markets assess the limited options opened to the Fed," Hug said. He added that it is important to note that recent Yellen jargon is now focusing not only on the Fed's domestic targets (employment/inflation) but also global issues (deflation/negative rates).

"Yellen has to promote optimism, which then leaves a rate hike open, but is not likely to raise rates under current conditions. So 'sell jargon and buy the reality' has been the posture for gold traders," Hug said.

Hug said the the first rate hike "was not a function of economic strength but more a matter of saving face."

On Wednesday, the gold trade seemed to cut through the jargon, and global woes may keep the gold bugs optimistic as far as gold's fear- trade premium. But gold bugs have not come out ahead, at least so far, in the brief Yellen era. Notwithstanding this year's big gains, GLD is down roughly 2 percent since Feb. 3, 2014, when Yellen was sworn in as Fed chair, while the Dow Jones Industrial Average and S&P 500 have gained considerably, thanks to sizable 2014 gains.

Merk said in a world in which cash that doesn't pay any interest is competing with other cash that pays no interest, "The long-term story for gold is in place."

CORRECTION: Axel Merk is president of Merk Investments, which runs the Van Eck Merk Gold Trust ETF. His name and the fund's name were misspelled in an earlier version of this article.