BMO’s $1.24 million leveraged notes on gold ETF a bet on rate cuts, government stimulus

By Emma Trincal

New York, July 7 – Bank of Montreal’s $1.24 million of 0% market-linked buffered and leveraged notes due July 7, 2025 linked to the VanEck Gold Miners ETF are a bullish bet on gold, which may materialize after a recession, when monetary and fiscal policies inject liquidity in the economy, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par plus 150% of any ETF gain, capped at $1,340 per security, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF falls by up to 20%, the payout will be par plus the absolute value of the ETF’s return.

Otherwise, investors will lose 1% for every 1% that the basket declines beyond 20%.

“Gold prices have fluctuated a lot. The ETF hit a low at $21.16 on Sept. 26. It was its lowest point since the spring of 2020. Since then, the fund has rebounded a lot,” said Kaplan.

The initial price, or the ETF’s closing price on the trade date, was $30.11.

Inverse relationship

Understanding the price swings of gold and gold miners is not aways easy, said Kaplan. Some indicators can help, for instance the U.S. dollar.

“GDX bottomed at a time when the U.S. dollar hit a 20-year high,” he said referring to ticker of the ETF, which is listed under the ticker “GDX” on the New York Stock Exchange.

“The dollar is a barometer of the global economy. People buy the greenback when they’re concerned about global growth,” he explained.

“If they anticipate deflation, the U.S. dollar will rally in a classic flight to safety. But gold tends to anticipate inflation and moves up when inflation rises or when the government injects liquidity in the system.”

In March 2020 at the onset of the coronavirus pandemic, GDX “collapsed” as investors anticipated a deep recession, he added.

“Right now, we can say that that GDX is trading in a range even if it fluctuates quite a bit within that range.

“I would have preferred to do that trade in September, when GDX was so cheap. But we’re still at pretty decent levels,” he said.

At $30 a share, the ETF is trading 32% off its $44.01 high of August 2020.

A Fed bet

The VanEck Gold Miners ETF is likely to surge once the Federal Reserve begins lowering interest rates, he said.

“I think this note is in part a huge bet on the Fed cutting rates within the next two years. Right now, the Fed is delivering a very hawkish message. But they don’t even have to cut rates in order to have an impact on gold. They just have to start talking about rate cuts and GDX will be moving higher again,” he said.

Kaplan pointed to a difference in expectations between the equity market and gold futures.

“The stock market has already anticipated the Fed’s rate cuts. But the same expectations have yet to be priced in with gold. Any rate cut, or inflationary signal would give gold some good upside potential,” he said.

Futures insiders

Kaplan said he uses traders’ commitments to get price signals on gold futures. Traders’ commitments are published weekly by the Commodity Futures Trading Commission. The report discloses various holdings and trades from market participants that are closely involved in the industry for a specific commodity.

“You’ll get some trade signals from people who own gold or mine gold on the ground,” he said.

The information is similar to what stock market investors can decipher from insiders’ reports.

“Back in September, there was a lot of buying activity. Now it’s sort of neutral,” he said.

Cap

Kaplan found some of the terms of the notes attractive.

“The 20% buffer is a good thing. In general, I like notes with a buffer. With this one, you also have the absolute return. That’s a very useful feature,” he said.

“As far as the leverage, if GDX moves up a lot, you’re going to miss some of the potential gains,” he said.

The 34% cap over two years is the equivalent of a 15.75% annualized compounded return.

“On the other hand, it would be really helpful if we have a smaller increase,” he said.

The breakeven to hit the cap would be an annualized return of 10.75%.

Longer may be better

The tenor of the notes was not the best aspect of the product, he said.

“It’s a reasonably structured note. I like the buffer and the absolute return. But I probably would have preferred a longer maturity. We’re not at a point where insiders are buying yet. I think it’s less likely that we’ll have a huge increase in the share price until they start buying more,” he said.

“I would prefer a longer term like four or five years if I had the choice.”

Kaplan reasoned that the full expansion of inflation was likely to take some time.

Inflation vs. deflation

“Right now, asset prices are trading at very high levels. Tech is very high. Real estate is very high. There’s a serious risk that the asset bubble is going to pop, which would be deflationary,” he said.

This environment would not be favorable to gold. But in reaction to the economic crisis, governments would start cutting rates and deploying inflationary policies, he added.

“If you get to a situation like 2020 when the government spent billions in stimulus checks, brought back interest rates to zero, purchased massive amounts of debt, put in place a huge fiscal stimulus, you’re injecting a lot of liquidity into the system.”

When a recession precedes stimulative government measures, two conflicting forces emerge in the economy, he explained. The first one, which originates from a bear market and recession is deflationary; the second is inflationary and results from crisis-combatting government policies.

“The question is which of those two forces will be the strongest? Is one going to offset the other?” he said.

“It’s hard to tell, but in all likelihood, the inflationary impact will happen later. The bubble needs to fully burst first.”

This is precisely why Kaplan said he would have opted for a longer-dated note.

Terms

“Things can always be improved. A longer timeframe may have been better. Buying GDX in the fall would have definitely been better,” he said.

But as it was, the structure remained appealing.

“This is a pretty good note. Even if it takes longer for GDX to rebound, the leverage is going to help. If you’re wrong, you can still make money on the downside with the absolute return. If there is a big drop, the buffer allows you to cut some of your losses and to outperform.

“It’s a reasonably good trade,” he said.

Wells Fargo Securities, LLC and BMO Capital Markets Corp. are the agents.

The notes settled on Thursday.

The Cusip number is 06374VW93.

The fee is 2.575%.

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