Although gold is entering the New Year in a corrective mode, after forming a major bearish reversal in the summer of 2016, investors should brace themselves for even bigger surprises in 2017. Gold (NYSEARCA:GLD) might experience sizeable swings in the months to come according to a couple of divergent macro scenarios. These scenarios span from the exacerbation of the USD funding shortage to progress in the great rebalancing of the Chinese economy, with each scenario producing its own reverberations for the yellow metal. In the former scenario, the anticipation of a full-scale USD funding crisis has the capacity to break up the long-standing negative correlation between the greenback (NYSEARCA:UUP) and gold, fueling a bid into the precious metal. In the latter case, selling pressures on gold could intensify especially if president-elect Trump sticks to his pro-growth agenda refraining from extreme protectionist measures. Irrespective of which scenario unfolds first, gold is poised to exhibit higher volatility than the one experienced so far, either to the upside or to the downside, since global macro tensions are getting bigger by the day. This means that gold investors should prefer tactical over strategic moves, given the potential for a truly volatile year in precious metals.
How A USD Funding Crisis Could Benefit Gold
The single most important factor which could fuel a bullish reversal in gold is the activation of the Fed's global swap facilities amidst an escalating USD funding crisis. Such a funding crisis originates from the fact that the price of the dollar is not the same across the world. In simple terms, the costs of borrowing dollars internationally (offshore) are higher and increasing in relation to their onshore counterparts. As domestic interest rates are readjusting upwards in line with Fed's new monetary tightening cycle, so do LIBOR rates, the benchmark offshore interbank lending rates. However, apart from the biggest global banks operating in London, no other corporate entity has direct access to the interbank lending market, with the only alternative to be the procurement of dollars through the foreign exchange market. In this light, the cost to procure dollars internationally through the foreign exchange market diverges from LIBOR rates in contrast to the traditional finance theory. This occurs because global banks cannot take the necessary risks to engage in arbitrage opportunities, i.e. to borrow dollars in the cheap interbank market rate and lend them in the expensive foreign exchange market rate, which could allow them to bridge the gap along the way.
US dollar-yen cross-currency basis swap spreads, and the difference between USD LIBOR rates and how much it costs to borrow dollars through currency swaps are headed to all-time lows. This means that non-US investors, companies, as well as global banks find it increasingly difficult to borrow dollars through the foreign exchange market in order to run their usual businesses. The deeper into the negative this gap goes, the more expensive the provision of USD lending and hedging to the emerging economies becomes. This increased cost of USD hedging forces several non-US institutional investors, like Japanese pension funds, to invest in USD assets without hedging their positions for the risk of USD depreciation, increasing the demand for the greenback.
Such a vicious cycle between a revaluing greenback and increasing costs of borrowing dollars offshore will at some point make the provision of dollars impossible, creating big stresses to emerging markets. At that point, non-US global banks will pause their USD lending and institutional investors will refrain from further buying of USD-denominated emerging markets' corporate paper. This will leave local companies and banks unable to refinance their USD-denominated obligations, threatening the world with an emerging market downfall.
Then the Fed will face a crucial trilemma. It will have to abolish the control of one of its three variables; the domestic interest rates, the control of domestic banks' balance sheets (under Basel III commitments), and the price of the dollar between the onshore and the offshore market. As a matter of fact, given the Fed's global commitments over the implementation of Basel III, there are essentially only two options left to choose from; give up the control over either its balance sheet or the domestic interest rates, i.e. the rate normalization effort. Irrespective of which option is selected, gold will benefit the most.
If, for example, the Fed decides to unleash its massive USD swap lines with the other central banks, the offshore dollar monetary base will balloon, and gold will benefit against an internationally inflating dollar. If, on the other hand, the Fed chooses a more introspective direction, i.e. to reverse its monetary tightening, gold will again benefit due the fall of USD interest rates and long-term real yields.
Having said these, the basic bullish scenario for gold has become clear. Should the gold market begin to price in the Fed's trilemma, as the USD funding shortage intensifies, investors will experience something unusual; gold will fluctuate in tandem with the US dollar, breaking its long-standing inverse correlation. Whatever the case might be for the resolution of the Fed's trilemma, gold may emerge as the ultimate winner and one of the biggest positive surprises for investors in 2017. The only prerequisite for gold to benefit is the escalation of the USD shortage crisis.
The Bearish Scenario For Gold
Now, what happens if the meltdown from a USD funding crisis never materializes and the Fed sticks to its rate normalization efforts? In such a case, there are two basic macro scenarios which could unfold, both of them unfriendly for gold. The most prominent among these scenarios is the acceleration of the current reflationary cycle of the global economy coupled with investors' delay in adjusting their long-term inflation expectations.
When investors are reluctant to increase their long-term inflation expectations at the speed with which nominal yields rise, then long-term real interest rates soar and gold drops. This well established cognitive bias of investors was in fact what dragged gold's price down since the US election and turned the precious metal into its current corrective mode. Having said this, there are a few reasons to expect the same patterns to continue in the New Year, and these reasons are related with policy choices at both sides of the Pacific. The acceleration of inflationary pressures could come as a pro-growth policy mix in the US coincides with a smooth rebalancing effort by the Chinese. In such a case, long-term bond yields would increase faster than the corresponding inflation expectations, making investors to expect higher long-term real rates and driving gold below its 2016 lows.
This scenario is supported by a recent Bloomberg report according to which Chinese leaders seem increasingly willing to accept lower than initially targeted growth rates in exchange for tackling the debt overhang of the state owned enterprises (among other corporate entities) and achieving a smooth rebalancing of their economy. This Chinese determination to prioritize domestic rebalancing over the demonstration of excessive growth could become a bearish game-changer for gold if it proves to be of substance of course.
On the other hand, if the capital flight out of China escalates to the point of an uncontrolled devaluation, then the reflationary scenario would turn into a deflationary one for the global economy. This time around, gold would suffer due to unexpected deflation. Long-term inflation expectations would drop much faster than the long-term nominal yields, pushing long-term real rates higher, and this would dampen investment demand for gold.
While gold is entering the New Year in a corrective mode, there might be a few surprises further down the line. Maybe the single, most important of them will be the breaking up of the long-standing negative correlation between gold and the US dollar, especially in the case that the USD funding shortage starts to strangle the global economy.
Will the global reflationary scenario materialize into a rising business cycle or end abruptly with a devaluation of the yuan? In either case gold has to lose, while in the case of a dovish Fed reaction to the US dollar shortage escalation, the precious metal could benefit the most.
Global economy's troubles are not always beneficial for gold, but one thing is for sure. The New Year will most certainly prove to be equally, if not more, exciting than 2016, and the gold market will offer investors sizeable swing opportunities. In this light and contrary to popular wisdom, tactical decisions will prove to be much more appropriate than strategic ones, especially in such a rapidly changing short-term macro environment. This time, gold investors will be more in need of strong reflexes and less in need of long-term strategic thinking. Speed of response will prevail over long-term considerations. This after all might prove to be the biggest surprise the New Year has in store for gold investors.
Disclosure: I/we 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.
Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.