Opportunity Amid the Myopia

Markets go through episodes of myopia from time to time.

The current one has everyone fixated on one trade – “long AI.”

That’s not to disparage the proliferation of AI and its growth. NVIDIA (NVDA) obliterated revenue projections last week, becoming the first trillion-dollar chipmaker.

(I should have listened to my 10-year-old – even he knew to buy AI stocks.)

But when a $4 billion market cap stock like C3.ai (AI) takes center stage before its earnings release yesterday – with anticipatory headlines and trader positioning – it’s a sign the market has lost focus.

After all, C3.ai is the same company that dropped 26% in one day back in April because of claims of inflated income metrics by short seller Kerrisdale Capital.

C3.ai was down -13.92% on Thursday, with NVDA ironically up 5.12%.

With that said, there’s one opportunity outside AI that is flying under the radar…

Pausing Rate Hikes

Lost in the excitement for the next melt-up stock were comments from Fed officials, now coming out in droves.

The Fed is opening the door wider for a pause on hiking rates.

It started with Jay Powell’s hints during the last FOMC meeting.

And this week’s comments from two Federal Reserve members blew the doors wide open.

First, it was Philadelphia Fed president Patrick Harker:

I am in a camp increasingly coming into this [upcoming FOMC] meeting thinking that we really should skip, not pause.

That was followed by Philip Jefferson:

Indeed, skipping a rate hike at a coming meeting would allow the Committee to see more data before making decisions about the extent of additional policy firming.

And Harker doubled down yesterday, saying, “It’s time to hit the stop button for one meeting and see how it goes.”

Treasury yields dropped from their recent highs on the news, which begs the question – Why have they been rising so much lately, to begin with?

The chart below of the 30-year Treasury yield shows that rates dropped after the Silicon Valley Bank (SVB) collapse. Then they traded in a tight range until legging up on recent fears of a U.S. debt default.

The notion that the U.S. will default on its debt was improbable. McCarthy and Biden decided to play nice, negotiate in good faith, and get a bipartisan deal over to the Senate floor.

Neither political party wants to be blamed for the chaos that would ensue if there was no deal, especially coming off a slew of banking failures.

But yields on U.S. Treasurys rose nonetheless, going all the way back to pre-SVB levels.

It was a clear setup to buy call options on the iShares 20 Plus Year Treasury Bond ETF (TLT), which we did in The Opportunistic Trader options advisory on May 23. (As a reminder, call options gain value when the underlying asset rises.)

But the market is beginning to understand that the Fed may be done here.

And that’s where I see an opportunity.

Gold’s Sweet Spot

As I explained in a previous essay, the combination of falling rates and a rising yield curve could get gold to break through its recent highs in a big way.

After all, that combination is the sweet spot for gold and other dollar-sensitive commodities. 

The table below shows the average weekly returns for gold spot prices going back the last 20 years.

During that time frame, 147 weeks saw the 30-year yield falling with a steepening yield curve. During those weeks, gold returned 0.9% on average.

The opposite case, when yields rose with a flattening yield curve, had gold falling -0.3%.

And in all other cases, gold reverted to its average weekly return of 0.2%.

That means if we see a rate pause and then actual rate cuts down the line – which the market is already pricing in, according to the Fed Fund Swaps market – then rates will plummet.

And shorter-term yields will fall much harder than longer-term yields. That would push the yield curve back up and probably un-invert it.

In that case, assets like gold will likely start to melt up.

We saw the effect of this in March, as you can see from the chart below. This confluence caught the market by surprise – with the bank failures pushing gold up by more than 10%.

Today’s nonfarm payroll (NFP) report, if weak, will re-ignite the same dynamic we saw in March.

Short-term yields will fall harder than long-term yields, thereby steepening the yield and getting gold to explode.

It would also serve as confirmation of what Fed officials are anticipating… that unemployment will rise in the coming months as the lag effects of tighter monetary policy take shape.

Regards,

Eric Shamilov
Analyst, Trading With Larry Benedict