Dollar, gold, commodities, stocks, and bonds dance to the same tune

What is the tune? It's a mix of declining risk aversion, rising confidence, less uncertainty, and continued growth. That's not to say that everything is just peachy. Rather, it is the result of things turning out somewhat better than the market's gloomy expectations. This tune has repeated in dozens of blog posts here over the past 5 years.

The dollar is rising because the outlook for the U.S. economy is improving, and the U.S. economy is doing better than most other developed economies, and that in turn inspires confidence where before there was despair. Gold is falling because inflation remains under control, the dollar is strengthening, and civilization as we know it remains intact; gold had been priced to all sorts of calamities (e.g., massive monetization of debt, a collapsing dollar, geopolitical turmoil, double dip recessions) which have failed to materialize. Commodities are falling because the dollar is rising, and because commodity prices had risen to such a degree that increased exploration and production kicked in. Bond yields, particular the real yield on 5-yr TIPS are rising, as the market gains more confidence in the economy's ability to grow, and as investors become less risk averse—unwilling to accept negative real yields in exchange for protection against rising inflation and a slumping economy. Rising real yields and falling gold prices tell us that the world's demand for safe assets is declining, because risk aversion is declining and confidence is rising.

The prices of gold and 5-yr TIPS have been moving in unison for many years (I use the inverted real yield on TIPS as a proxy for their price). Both are "safe" assets in the sense that they offer protection against certain kinds of risk. Gold is a traditional safe harbor for those who worry about currency debasement and geopolitical risk. TIPS are guaranteed by the U.S. government, and they offer explicit protection against inflation. Moreover, they are the only instrument that can promise a guaranteed real rate of return. Gold has declined from a high of $1900/oz to now just under $1200. It's still trading way above its long-term, inflation-adjusted price of about $600, so it's still "expensive," only less so now that it was a few years ago. Real yields on 5-yr TIPS are about zero, which means investors are willing to give up any hope of a real rate of return in order to be compensated for inflation. This tells me that the market is still quite risk averse, only less so than it was a few years ago. Declining prices of gold and TIPS are a direct indication of declining risk aversion and rising confidence.

The dollar and commodity prices have been negatively correlated for a long time. Commodities are a proxy for real (tangible) assets that tend to preserve their value in times of currency weakness (as is gold). So when the dollar weakens, commodities (and gold) tend to strengthen. Recent dollar strength has contributed to a moderate decline in commodity prices, and as the chart suggests, commodities may continue to soften. But they are still well above the levels of 13 years ago, and the dollar is still well below its former highs.

Gold and commodity prices have been positively correlated for decades. But gold tends to be much more volatile: note that the range gold prices (the right y-axis) is about about 2 ½ times the range of commodity prices (left y-axis). Gold "overshot" commodity prices a few years ago, and has been gradually coming back into line with commodities. This suggests to me that gold could decline to $900/oz or a bit less over the next year or two.

The ratio of the Vix index to 10-yr Treasury yields (the red line in the above chart) is a good measure of the market's fear, uncertainty and doubt regarding the future of the U.S. economy. Bouts of fear have been the driving force between stock market corrections, not any actual weakness in the economy. But the market is still somewhat nervous and cautious. 10-yr yields are still very low, which tells me that the market does not believe the economy can grow much faster than it has in recent years (2 - 2.5%), and is more at risk of slowing down, than speeding up.

This chart of consumer confidence sums things up nicely. Confidence has been rising for the past five years, but it is only now about equal to its long-term average. Conditions have improved, but it's hard to find evidence of exuberance. Consumers are still concerned about the health of the economy. The recent elections confirm that people are unhappy with the way things are going. The economy could be a lot stronger, and incomes could be a lot higher, if only government would get out of the way.

UPDATE: I should have included the chart below before. It also confirms what is going on. PE ratios are up from very low levels (a sign of a great lack of confidence in future earnings), but they are only slightly higher than average. There is no sign as yet of any "irrational exuberance." Stocks are doing well because earnings are doing very well and investors are gradually regaining their confidence in the future.