Over the past 10 years a correlation of sorts, albeit inverse, can be observed between the movements of long rates and the gold price. To be fair, there have been periods of exceptions, such as when post the Bernanke taper announcement in 2013 the gold price retreated on the back of a sensible indication of monetary policy normalisation but, unexpectedly for the mainstream pundits, Treasury yields continued to also fall after a shock reaction.
Before this anomaly however, which in the end it wasn’t, because growth had still not picked up to a level that could be described as a healthy economic rebound, as well as inflation continuing to lag, and from the end of 2015 again, gold fell when rates rose, and vice versa, like clockwork. We saw this during the massive risk market correction in the first half of 2016, in the aftermath of Trump’s election win, and most recently coming out of the summer.
We should again remind ourselves what the price of gold actually stands for. Some still continue to argue that gold is solely an inflation hedge, which isn’t entirely correct. Granted, gold as the best proxy of a non-inflatable good having on average been able to purchase roughly the same basket of goods for centuries does give us an indication at what kind of value inflatable goods revolve around it. This obviously includes fiat money.
But there is a bigger purpose. The precious metal is essentially a hedge against the demise of the money system as we know it. Why do we think central banks are eager to hold part of their reserves in gold? Ben Bernanke certainly didn’t know an answer to it, as when asked at a Congressional testimony he speculated that central banks were holding gold for reasons of tradition, whereas Alan Greenspan hadn’t shied away from calling gold money.
So, in other words, when the investing community feels the fiat money system is at risk, it will buy gold as a hedge and the price of it will go up. We have witnessed this impressively during the heat of the financial crisis, when in 2011 the Fed introduced QE as an unprecedented policy tool to avert a 1930s depression. The system was certainly deemed to be at risk then, and the gold price was catapulted to the 1,900 dollar mark.
From then, it has receded amid a systemic stabilisation of sorts. When Trump got elected, the political shock quickly subsided in favour of the Trump-is-good-for-business mantra. In anticipation of a massive economic boost by tax cuts and infra spending long rates blew up and gold fell. Systemic risk was no longer perceived to be high, at least for a while. Gold tumbled from 1,300 to 1,100 dollars and 10-year rates spiked from 1.80% to 2.60%.
Ever since however, we have seen 10-year Treasury yields gradually decline again and drop to 2% recently, and the gold price made its way back up to 1,350 dollars. Obviously, the Trump effect was not to be, at least so far. Tax reform remains elusive, and spending on infrastructure isn’t even talked about much anymore. As this space has contended since early spring, neither tax nor infra effects will come into play before 2018.
At the same time, the hopes about an elevated economic activity have largely been disappointed and macro numbers have come in mostly below expectations. Despite that, the Fed did raise rates, as they had more or less promised, but there was a sense of caution developing around Yellen being steadfast on an increasingly hawkish stance, her superficial views on the labour market, as well as her ignorance of sluggish inflation numbers.
In the absence of further assurances out of the Fed camp, and even the infamous Jackson Hole central banker gathering in August turning out to be a non-event, the market felt that Yellen & Co might misread the economy and stubbornly hold on to the normalisation course as a matter of political correctness. It amplified the reversal of this inverse correlation shortly after the US election, which has lasted for the better part of this year.
But then came the September FOMC last week, an obvious and historically seasonal point of attention. The Fed did not blink and held on to both rate hike and balance sheet unwind plans. Yellen in her testimony still admitted she couldn’t get her head around the low inflation phenomenon but pressed ahead anyway. Much like a mechanic reaction to the Fed’s direction, 10-year rates moved up 25bp and gold dropped 50 dollars…
… yet again strikingly confirming this inverse relationship. However, the smart money needs to decide now. Is it going to put its trust into Janet Yellen and the Fed well knowing that the nature of the US central bank and the fabric of its members is likely to be entirely different post the impending Trump appointments across coming 6-9 months? Or is it smart and doesn’t trust the economy’s health and the Fed’s hawkish saber-rattling?
As readers know, I’d rather find myself in the latter camp. The macro numbers have consistently shown that we are by no means out of the woods. Disinflation is here to stay, and the labour market has a long way to go to be judged sound. Let more volatility play out if it must, but you are aware of this space’s sense on long rates and that they are headed south rather than north. Consequently, and trusting the inverse correlation, gold has only one way to go.
An amplifier effect to this move, god forbid, may be caused by a significant weakening of the economy, let alone a slip into recession territory. The Fed would have to perform the mother of all u-turns, ease and probably apply a renewed version of QE, which would heighten systemic risk and the need for a hedge again and almost certainly push gold up much further. In such case, the 10-year rate targets of 1.75% and then 1.50% would be hit much more easily and possibly undershot.
