The talk of recession is getting louder. In the space of just 6 months, consensus has gone from expecting two rate hikes in 2019 back in December, to now a 51% chance of a rate cut by July. Markets aren't expecting just a 25-basis point either. Fed funds futures are trading at a 32% chance of a 100 basis point cut from current rates by the end of the year. Six months ago, only the permabear hard money crowd was saying that the rate hikes were over. Now, the mainstream acquiesces to this and bond markets look like they're trying to anticipate this as we are seeing collapsing yields past 6 months on the yield curve.
With signs of an impending decline abounding, President Trump is doing his part constricting the supply of imports to the US by raising tariffs left and right, in apparent homage to Senator Reed Smoot and Rep. Willis Hawley, who incidentally both lost reelection after their infamous Smoot Hawley Tariff passed in 1930. Tariffs necessarily shrink an economy by constricting the supply of goods in a country. This is not a great idea when the yield curve is inverting, which it is now. Every recession for the past 50 years has been preceded by an inverted yield curve. It doesn't mean the economy will collapse tomorrow, but it does mean the case against a recession within the next 18 months is a tough one to make. If we avoid one through next year, it'll be the first time in 50 years that we've avoided one for so long after a negative 10Y - 3M yield spread.
I don't want to spend too much time arguing for an imminent recession. Whenever it happens, it happens, and even the most permabull of permabulls on the economy admits that eventually, it will. The Fed has not succeeded in outlawing recessions yet. The question I want to ponder here is, what happens to gold (GLD) the next time a recession comes around?
During the last recession, gold was smashed. Sort of. At least that is the echo that is left in the collective memories of investors. Ask your average fund manager what happened to gold during the Great Recession and he'll say it went down, and that gold doesn't perform well in recessions. True, gold went down during the last recession, but only for the first few months of it. If we are to consider the entirety of the Great Recession, gold actually performed very well compared to other commodities.
Just take a look at this Yahoo Finance chart below, comparing GLD with the Invesco DB Commodity Index Tracking Fund (DBC). The latter was down nearly 50% from April 2008 to March 2009. Gold was flat, with its recovery taking place in the context of a collapsing commodities complex. If gold can withstand such intense selling pressure in the commodities sector, image what it can do when commodities are rising.
The really remarkable thing though is how gold was performing in the face of a skyrocketing dollar index. Gold was able to regain its old highs and rebreak $1,000 an ounce by February 2009, at the same time that the dollar index was making new recession-era highs. So, an alternate read on gold's price action during the 2008 financial crisis is that it was extremely resilient, even in the face of a skyrocketing dollar, while other commodities were not.
Even if we go back to the Great Depression, this situation ultimately led to the devaluation of the dollar against gold from $21 an ounce to $35 in 1933. President Roosevelt's devaluation isn't normally seen as a "gold bull market" because it was done by executive order, but it was an executive order that was estimating what the gold/dollar ratio would have been if decided by the free market. So, in essence, it really was a gold bull market. In other words, during the Great Depression, gold really had a 66% bull market. That's enormous. The only problem was, owning gold was illegal, so nobody could benefit but the government as it simply confiscated it all and put it in Fort Knox to back the dollar.
So, the question is not whether gold can rise in a recession or not. Clearly, it can and often does. The question is, what will the initial reaction to the next recession be for gold? Let's consider three things.
- The gold/dollar/commodities backdrop against which gold was trading back then versus now
- The global trade environment
- The global bond market environment
Commodities and Dollar Backdrop
Back during the first part of the Great Recession in 2008, the US dollar index was at an all-time record low at around 71, at a time when US money supply (M2) was shrinking in absolute terms on a quarterly basis. It was due for a strong bounce. Meanwhile, gold was at all-time record highs having just broken through the psychological stronghold of $1,000 for the first time ever, cutting through 28-year resistance like it was nothing. This spurred an extremely rare period of positive press for the metal rather than the standard everyday mainstream ridicule of the barbarous relic.
This was happening while the commodity complex as a whole was at all-time highs. The CRB commodity index had reached an astronomical 470. Oil was at all-time record highs. Natural gas was near all-time record highs. The whole commodity complex was soaring.
These were the prevailing established trends for 7 years before the initial 2008 gold pullback. The CRB commodities index had climbed 160%, and the dollar index had fallen a massive 40% over the same time frame. A sea-change in the economy was bound to trigger a reversal in these trends. (True, we can say that now in hindsight, but it wasn't so obvious then.)
Now, we have the exact opposite situation. Gold has been dormant for 8 years, range-bound, and gold stocks are still one of the worst performers over the last 8 years. The dollar is the so-called cleanest dirty shirt in the hamper, up 35% since the 2008 lows. The fundamental driver of dollar strength since 2008, in my opinion at least, has been the interest rate differential between deposit rates in the eurozone, which have been zero since 2012 and negative since 2013, and positive rates for the dollar. See below.
That means banks are incentivized to sell euros and buy dollars to capitalize on the spread and avoid the de facto tax of negative rates, driving the dollar higher and the euro lower. If a recession hits the US and the Fed starts cutting, that interest rate differential vanishes and the euro climbs, bringing down the dollar index. Keep in mind as I pointed out earlier, that past October 2008, gold rose strongly in the face of a strongly rising dollar. This time a falling dollar is more likely to be the backdrop.
As for commodities now, we are at historic extremes. The CRB Index is still right around lows not seen since prior to the Saudi oil embargo and energy crisis of the 1970s. A sea-change in the global economy once again is likely to trigger a reversal in these trends.
The Trade Environment
Just a brief word on this, as this is a mostly political phenomenon, but the last time we had high tariffs during a recession was 1930. Well, before the trade wars began with China, Mexico, and now even India, the World Trade Organization was already logging 9-year lows in quarterly trade indicators. This was way back in February. There is no way that the new tariffs and tariff threats have improved this situation. The less trade, the less goods get to where they are demanded, the higher the prices for these goods. The 2008 financial crisis was not coupled with any trade wars. The Great Depression was. Gold was steady overall in 2008 and rose 66% in the Great Depression against the dollar.
It can be said that this environment that constitutes more of a risk for gold than a benefit because any sudden easing in trade conditions would probably bring gold lower, at least briefly. This is probably true, but the counterpoint is that tariffs are not what will cause the next recession, only exacerbate it or make it start sooner than otherwise. The main issue for gold prices is the next recession with the backdrop of an already high dollar and record low commodity complex, not exacerbating factors like tariffs.
The Bond Market
Let's take a step back and analyze the phenomenon of negative interest rates. As pointed out by other prominent SA authors, the amount of negative-yielding debt in the eurozone is about $10 trillion. Now negative yields are leaking into European mortgage bonds. This is scary. What this means is that investors are guaranteed a loss on these bonds if held to maturity. If so, why are these bonds bought at all? Because people believe they can be sold to the next bidder for even deeper guaranteed losses/higher principle. It's a global psychosis that assumes bonds are safe havens no matter what price they're at. This is the only possible reason people own negative yielding debt.
We've seen how these hot potatoes stop, and it's never pretty. It's always volatile and ugly. The minute price inflation blips up to noticeable levels, there is going to be a tsunami of bond selling across the globe and the only major buyers will be central banks. That will mean effectively that the bond market bull will be monetized into currency, making the inflation problem even worse.
Gold, however, yields nothing. That's a lot more than negative. Imagine what would happen to the gold price if $10 trillion in negative yielding debt were moved to a new safe haven. (Hint: gold)
Back in 2008, Treasuries still yielded about 4%. At least, it made a bit of fundamental sense to pour into Treasuries initially as the financial crisis took hold. Better to hold a safe haven that yields something rather than gold, which yields nothing. The core inflation rate back then was about 2.5%, so Treasuries still actually had a positive yield at 4%. Not so now. Now, the 10Y yield is about equal to the core inflation rate, meaning the real yield for Treasuries is zero, and there's plenty of counter-party risk. Gold yields zero and have no counter-party risk.
Gold did not fall in 2008, on the net. It corrected, and then broke back up to new highs long before the Great Recession ended. In the Great Depression, gold jumped 66%, by executive order yes, but generally in line with what the free market would have demanded. Commodities have been so depressed for so long that they haven't been this low since prior to the energy crisis of the 1970s when the dollar was still on a gold standard! World trade is collapsing, which will only push up consumer prices faster than otherwise, and $10 trillion in negative yielding debt will need a new safe haven when the merry-go-round stops.
Recessions tend to reverse established trends. Gold has been basing, commodities falling, dollar rising, and bonds skyrocketing. All of this is likely to reverse when central banks fire up the printing presses once again. They're getting them warmed up as we speak. The time to go long gold is now.
Disclosure: I am/we are long GLD. 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.