Why Goldman Sachs Is Wrong About The Gold Bull Market Ending In 2013

by: Ben Mountifield

Goldman Sachs has issued a report stating that the price of gold is likely to peak in 2013, ending the yellow metal's 12 year run. The investment bank is assuming that stronger US economic growth will lead to a rise in US real interest rates, however this article looks at why Goldman is wrong.

In the short-term Goldman is bullish on gold, with Jeffrey Currie, an analyst at the bank, saying that "the combination of more easing [QE from central banks] and weaker growth should prove supportive to gold". However the investment bank believes that an improving US economy will lead to rising real interest rates which will prove negative for gold.

Over the medium-term the outlook for gold "is caught between the opposing forces of more Fed easing and a gradual increase in US real [interest] rates on better US economic growth. Our expanded modelling suggests that the improving US growth outlook will outweigh further Fed balance sheet expansion and that the cycle in gold prices will likely turn in 2013" Goldman said.

Without additional easing by the Fed in the second half of 2013 Goldman predicts that gold may fall from today's price of around $1,706 per ounce, to $1,625 by the end of 2014.

What's driving the gold bull market?

The gold bull market is being driven by powerful structural forces such as currency debasement (which shows up as inflation), and negative real interest rates, i.e. interest rates that are below the rate of inflation. Only when central banks around the world halt their efforts to stimulate economic growth via quantitative easing, and allow interest rates to rise will the bull market in gold come to an end.

The risk free rate of return, i.e. the rate paid on a 10-year US Treasury, is currently 1.60%, however the CPI inflation rate (using figures from the BLS) is currently running at 2.16%, meaning that adjusted for inflation interest rates are negative to the tune of 0.56%.

Why real interest rates will remain negative

Under their "improving US growth" scenario Goldman is either forecasting a rise in Treasury yields, or a drop in the inflation rate, or both. However the Fed is pursuing aggressive monetary policy to ensure this doesn't happen.

It is widely expected that in its efforts to boost growth, the Federal Reserve will soon add around $45 billion a month of Treasury purchases to the $40 billion in mortgage debt it is already buying. This would mean that the Fed will effectively be absorbing about 90% of new dollar-denominated fixed-income assets.

As Bloomberg reported on Monday, "Even after U.S. public borrowings outstanding grew from less than $9 trillion in 2007 as the US raised cash to pay for spending programs designed to pull the economy out of the worst financial crisis since the Great Depression, rising demand coupled with a drop in net supply means bonds will be scarce".

A Bloomberg survey of 18 primary bond dealers found that the US government will reduce its net sales of Treasuries and other dollar fixed- income securities by $250 billion from the $1.2 trillion of bills, notes and bonds issued in fiscal 2012 which ended 30 September.

Zach Pandl, a senior interest-rate strategist at Columbia Management Investment Advisers LLC, pointed out 30 November, that "The shrinking amount of bonds in the market is lowering rates and not just benefiting the Treasury, but providing lower rates for private-sector decision-makers as well."

Essentially the US central bank now IS the market for US government debt. I.e. the US government issues new debt (currently more than $1 trillion a year) and the Federal Reserve buys it, thereby almost entirely bypassing the international bond market. As a result the Fed can (at least for the time being) keep a lid on interest rates.

Longer-term this policy of debt monetisation is unsustainable and know one yet knows how the Fed's so-called exit policy might work, or even if there will be sufficient buyers for the assets they hold.

Not only would rising US interest rates be extremely damaging to industries such as autos and housing, they would be crippling in terms of debt repayment costs. During fiscal year 2011 interest payments on US debt amounted to more than $450 billion. However in March 2012 the CBO (Congressional Budget Office) calculated that a 1% rise in interest rates could add around $1 trillion to interest costs over the next decade.

It seems clear that the US government and Federal Reserve will do whatever it takes to keep interest rates suppressed and as a result we can expect real interest rates to remain negative for some time yet.

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. I have no business relationship with any company whose stock is mentioned in this article.