Gold: What's Not To Like

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Includes: AAAU, BAR, DGL, DGLD, DGP, DGZ, DZZ, GLD, GLDI, GLDM, GLDW, GLL, IAU, IAUF, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Bang For The Buck
Summary

Gold just made a new multi-year high in U.S. dollar and all-time highs in several other currencies.

We are seeing a record amount of debt with negative nominal rates.

U.S. interest rates have declined significantly in 2019, the 10-year real rate is just barely positive.

Central Banks bought a record amount of gold in 2018 and many have continued to buy into 2019.

Investment Thesis

I have been writing about the importance of precious metals over the last year on Seeking Alpha. Given the recent multi-year high for gold (GLD) in U.S. dollar, it felt appropriate to reiterate why I feel precious metals and gold, in particular, has a bright future ahead.

I think the risk-reward for gold is far more attractive compared to bonds and the market seems to be coming around to that conclusion.

Chart

Figure 1 - Source: YCharts

New Highs in Many Currencies

Since the U.S. economy is the largest in the world and the currency is by far the most important, it is natural that we often focus on the dollar. While we just broke a multi-year high in dollars, we have seen the price of gold reach all-time highs in several other currencies.

This might be expected in extremely volatile currencies like Argentinian peso or Turkish lira, but it is not just happening in countries with less stability. We have seen all-time highs in Australian dollar and Swedish krona as examples. We are also not far away from seeing all-time highs in Japanese yen, British pound, and Canadian dollar.

Yields

That gold is making new record highs makes sense given the fact that we recently saw a new record amount of negative yielding debt. The Fed also indicated that this might be a possibility in the U.S., even though we are still some way from that today.

Figure 2 - Source: Eric Pomboy on Twitter

Gold is often compared to bonds as the safety trade. We have seen negative rates in both the short end and the long end of the curve for many currencies. However, with the recent drop in U.S. rates, we are not far away from the U.S. 10-year yield turning negative in real terms.

Interest-Rate Peg & Fiscal Situation

A few months ago, the Fed raised another possible intervention that can be used during the next recession. That the Fed will peg longer-term interest rates, effectively offering to buy an unlimited amount of bonds or QE infinity. The reason given would be to stimulate the economy. However, I think this is far more likely related to the deteriorating U.S. fiscal situation.

We are looking at a $1T deficit in perpetuity using conservative assumptions. When we get to the next recession, the deficit will likely be closer to $2T than $1T. We also know that the federal debt increases by more than the deficit on average. Over the last decade, we had an average deficit of $873B, while the debt on average increased by $1,149B. A minor difference of $276B per year.

Figure 3 - Source: TreasuryDirect

The above graphs show interest expense over time, which has remained relatively muted despite the increase in debt, thanks to declining interest rates. Given the above data, I would argue that pegging the interest rates is simply because there is no way the U.S. government can afford to pay the interest on the debt if we see longer-term interest rates climb.

Treasury yields can never return to an average of 5% across the curve because that would mean that interest expense climbs above $1T per year. Interest expense in the amount of $1T would effectively eat up any GDP growth. The U.S. could then be compared to zombie companies that can't afford to pay for interest expense from earnings.

Risk-Reward vs. Bonds

I fully acknowledge that treasury bonds have a significantly lower risk in nominal terms. However, given the state of the U.S. government and many other countries around the world. I struggle to see how anyone with a slightly longer time horizon would hold bonds when the equation simply doesn't tie out.

I view gold as having a 20-25% downside in nominal terms. The downside would be more likely if politicians stopped making promises which will not be kept, and we all start taking haircuts on debts and other longer-term liabilities. Needless to say, this is something I view as unlikely.

The real downside in bonds is far more significant, in my view, and I think the risk is increasing in a parabolic shape as we move further out in time as well.

Conclusion

Central Banks have been putting their money into gold instead of the dollar. We have had many outspoken investors like Dalio, Gundlach, and more recently Paul Tudor Jones highlight their affinity for gold.

U.S. has been one of the few remaining developed markets that have offered positive real yields on bonds. As that now looks poised to change, I expect further upside to gold.

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.

Additional disclosure: I am still long GDL, but I have moved the better part into physical gold.