By Valentin Schmid
An employee of Caviar Phones holds a special gold-plated iPhone 7 bearing the likeness of President-elect Donald Trump, costing over 2,971 dollars in the company's boutique outside Moscow on Nov. 14, 2016. The price of gold dropped from $1,278 before the election to $1,183 at the end of November. (VASILY MAXIMOV/AFP/Getty Images)
"If Trump wins, gold will go through the roof." That was the popular narrative before the election and the first move right after it became clear that Donald Trump won the presidential election on Nov. 8.
However, what happened afterward befuddled many market observers. Despite the hype about the uncertainty and perceived recklessness of a Trump presidency - essentially positive for gold - the yellow metal tanked from $1,278 just before the election to $1,183 at the end of November.
Soon after it became clear that Trump would have a Republican Congress to approve his spending plans, and the first names for the post of Treasury Secretary started to make the rounds, the uncertainty gave way and analysts started to price in tax cuts and deregulation.
Both of these elements of Trump's economic agenda are good for companies, small and large, and should boost innovation and productivity. If productivity increases and the economy grows, stocks are a better bet than gold, so gold was sold off and stocks rallied.
Furthermore, Trump and Republicans have vowed to repeal the Dodd-Frank regulations, which severely limit the risks financial firms are allowed to take.
If Dodd-Frank is repealed, banks and other financial companies will likely expand debt in the financial system through new lending or proprietary trading. This expansion of financial assets is usually bad for gold because it is a monetary, physical, and nonfinancial asset.
A Second Reagan?
Contrary to popular opinion, gold is also not a commodity and won't benefit from Trump's infrastructure plan, another point the stock market is loving.
Spending $1 trillion over 10 years will boost commodity prices and wages, and eventually productivity, but not the price of gold. The same goes for military spending, which Trump may also increase.
In short, the market is looking for a repeat of Ronald Reagan's two terms, where stocks, bonds, and the dollar soared. Gold crashed from its early 1980 peak and didn't recover until 2007. The federal debt increased greatly during Reagan's terms, and the market expects the same to happen with Trump.
However, Reagan's starting point was much different from Trump's according to Dan Oliver, principal at the hedge fund Myrmikan Capital: "Reagan's program came at a particular moment in time: the trough of a credit cycle. Interest rates were at cycle highs, exceeding 20 percent, and the sum of government and private debt added up to only 150 percent of GDP," he wrote in a note to clients.
Even the Federal Reserve had more gold than other assets at the time, with gold making up 92 percent of its assets.
Trump's economy is much inferior to Reagan's. Total debt to GDP (government and private) is at almost 340 percent, interest rates are at zero or negative, and the Fed has only 7 percent of its balance sheet in gold.
During Reagan's presidency, not only did gold fall, but also so did interest rates and inflation. This is unlikely to happen during a Trump presidency, and the market already gave us the first clue why it won't.
Rising Interest Rates
As soon as the market settled on Trump winning, the bottom fell out of Treasury bond prices, and yields started to rise, almost half a percent on the 10-year note.
In the absence of the United States' going bankrupt, higher yields represent market expectations of higher inflation down the road as bond investors want compensation for the erosion of their purchasing power.
This calculation makes sense because all of Trump's policies are inflationary: Restricting immigration reduces the pool of available labor and should increase wages. Reining in free trade reduces the number of goods in the country and should lead to an increase in the price of goods. Boosting infrastructure spending should increase both prices for inputs and wages.
Higher interest rates, however, destroy the value of existing debt and also hurt stocks because corporate cash flows are discounted using the prevalent risk-free rate. The higher the rate, the lower the value of the cash flows and thus the lower the value of the stock. Gold exists outside the system of financial assets determined by interest rates and wins in this scenario.
So why hasn't gold been rising along with rates as it has in the past? Dan Oliver thinks this is a temporary phenomenon brought about by a short squeeze in U.S. dollar assets. "When rates rise, the foreign demand for dollars intensifies, strengthening the dollar instead of weakening it."
Foreign entities may perceive relative safety in dollar assets compared to their own even more uncertain asset markets. They may also face margin calls on losing positions and need to procure dollars to make good on their liabilities. In some cases, it may involve the selling of Treasurys as we have seen with China and Saudi Arabia recently, so the price falls, and the yield goes up.
In other cases, this process involves the selling of gold for dollars, so the price of gold in dollars drops. Foreign institutions own large quantities of Treasurys as well as gold, and both markets are more liquid than the stock market, which makes both a preferred choice of assets to sell.
So will this trend of rising yields and falling gold prices continue? Oliver thinks we should look at another Republican presidency for reference.
"Even with the Fed buying every bond in sight, the enormous deficits caused the dollar to buckle, and the yield on the 10-year bond surged to 15 percent as investors demanded inﬂation protection. Gold would soar twenty-five times from 1970 to 1980, wiping out debt in real terms, and setting the stage for Reagan," he wrote. The president for most of the 1970s, of course, was Richard Nixon.