For many months the price of gold has been inversely tracking the rise and fall of the dollar. When the dollar trends higher gold has tended to trend lower, and visa versa. So examining how the fiscal cliff will impact gold is really an examination on how the fiscal cliff will impact the dollar versus other major world currencies such as the euro and the yen. There are many factors that go into movements in the dollar besides just what is happening in the U.S. In the last couple of years, events in Greece have rocked and rally the euro more than once. No matter what happens with the fiscal cliff, other outside forces could cause the dollar to move in a different direction than anticipated just from the outcome of the fiscal cliff negotiations.
The good news is both Democrats and Republicans are making conciliatory gestures and both seem interested in cutting a deal. The odds of going over the cliff with both sides entrenched in irreconcilable differences seems unlikely. However, if they plunge over the cliff it will be very bearish for the U.S. economy and global growth. Last year during the debt ceiling crisis leading up to the downgrade in U.S. debt by S&P on August 5, 2011, the dollar was weak and gold rallied to an all time high by September of 2011. Once the crisis passed and the world focused on other events the dollar rallied and gold fell. While a plunge over the cliff is unlikely, it could be very short term bearish for the dollar and short term bullish for gold. Under this scenario, gold longs should consider some profit taking as both sides will eventually come to some sort of agreement.
The most likely outcome based on comments from both sides at this time is that tax rates for the wealthy will not rise, but they will lose deductions raising their effective tax rates to generate revenue. In exchange, Social Security will be off the table, but the rate of growth of health care spending by Medicare and Medicaid will be reduced in one way or another. Other programs will also see some spending reductions. If this is the deal, then it could be long term bearish for the dollar, which would be long term bullish for gold. Healthcare has been the fastest growing sector of the U.S. economy for several years. Healthcare spending continued to increase and healthcare employment continued to grow even during the economic downturn in 2008 and 2009. This deal would cut future GDP growth by slowing the growth of the healthcare sector and prolonging the amount of time until unemployment returns to normal levels. The Federal Reserve will then be projected to wait an even longer amount of time before it raises interest rates and returns to a normal monetary policy. The dollar is expected to strengthen when the Federal Reserve ends its extraordinary policies such as near zero interest rates and quantitative easing. If markets perceive the Federal Reserve will extend quantitative easing for a longer period of time it will be bearish for the dollar.
While not currently on the table the negotiations could take a surprising turn as detailed in the article How to Redefine the Terms of the "Grand Bargain" to Avoid the Fiscal Cliff and Provide Growth. A Keynesian style deal would actually lead to a shift in higher expectations for U.S. growth and employment. Under this scenario the debt and the deficit would rise in the short term. But because the U.S. economy would be expected to return to normal employment levels more quickly, then the Federal Reserve would be expected to return to more normal monetary policies more quickly. This could actually be bullish for the dollar and bearish for gold. It would be counter-intuitive to the thinking of many gold investors because they think gold is higher on inflationary expectations. But gold has been tracking the movements of the dollar much more closely than the swings in the monthly CPI reports. While gold may trade versus inflation reports at some time in the future like it did in the 1980's, gold is currently trading in a contra fashion to the dollar.
The most likely expectation is for an austerity light deal that will turn out to be long term bearish for the dollar and bullish for gold. But there is a small chance Washington will either plunge over the cliff or find a creative way to avoid tax increases and spending cuts. Investors in the SPDR Gold Trust (NYSEARCA:GLD) will want to pay careful attention to the final negotiations of the fiscal cliff. So will investors in gold mining stocks like Newmont Mining (NYSE:NEM), GoldCorp (NYSE:GG), Barrick Gold (NYSE:ABX), Anglico Eagle Mines (NYSE:AEM), Jaguar Mining (JAG), Yamana Gold (NYSE:AUY), and Harmony Gold (NYSE:HMY).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.