- Gold has declined due to the rise in real interest rates associated with the ongoing crash in Treasury bonds.
- As inflationary forces continue to mount, gold and Treasuries will continue to decouple and may soon go in opposite directions.
- Since CPI overweights urban consumption and does not account for key factors, "CPI inflation" will likely continue to rise regardless of Federal Reserve policy.
- A crash in stocks and bonds may fuel a rally in gold as money flows out of financial assets into real assets and goods.
- With gold's downside risk limited by dovish monetary policy, it may be a good time to consider accumulating gold or gold miners.
The past few weeks have seen an increase in concern among gold investors that the bull market has ended prematurely. Gold has been a top bet for many investors who are concerned about rising inflationary pressures and monetary instability. These pressures have continued to mount, so it seems the price of gold should be rising, but gold has declined by over 10% so far this year.
Indeed, we're expected to see a $1.9T stimulus package soon which should hypothetically boost aggregate demand, or at least keep it from declining. Food inflation is also very high by historical standards and oil prices are rising. These "supply-side" inflationary pressures combined with extreme fiscal deficits have historically caused large inflationary waves which have benefited gold.
While the long-term outlook for gold is very strong, short-term interest rate pressures are pushing the yellow metal lower. In my view, this may actually be one of the last strong buying opportunities for the metal. Gold declined in value quite dramatically exactly a year ago as investors exited all assets and many feared deflation. However, those that used the opportunity to accumulate were paid handsomely.
Gold and other precious metals may see more declines in the short-run as interest rates rise. However, the interest rate pressures which have pushed gold lower are shifting which means the bottom may be near. Additionally, evidence suggests a large portion of last year's monetary base expansion (i.e. Q.E.) went into stocks and bonds and not gold. As stocks and bonds decline, I believe that we'll see trillions of dollars move into the real-asset market which could spur one of the largest bullish moves in gold yet. Let's take a closer look.
The "Interest Rate Effect" of Gold
Fortunately, gold is a largely mechanical asset. Its value at any moment is almost entirely determined by interest rates and inflation expectations. Gold is a non-yielding asset that is expected to keep up with the money supply over the long-run. In the short-run, gold's value is largely determined by real interest rates otherwise known as interest rates minus inflation. This can be thought of as the "real return" of a U.S. Treasury bond after accounting for inflation (measured using inflation-indexed Treasury bonds).
Last year, inflation expectations actually declined while the price of gold rose. This is because real interest rates collapsed to all-time-lows which improved the "present value" of gold since it has an effective real-interest rate of 0%.
The opposite is true today. Inflation expectations are rising at a rapid pace, but interest rates are rising even faster. In other words, the real interest rate is rising. This can be seen through the 10-year Inflation-Indexed Treasury rate and inflation expectations below:
It is the decline in real interest rates (blue line above) that has been driving the gold bull market since 2018. More accurately, interest rates have been declining at a faster pace than inflation expectations. This is largely due to Federal Reserve rate cuts and Q.E. which, until recently, has been artificially boosting the value of Treasury bonds (i.e. keeping long-term rates low).
This can also be visualized through the strong correlation between the gold and the 20-year Treasury bond ETF (TLT):
Put simply, gold has been a proxy for long-term Treasuries so falling Treasuries equals falling gold. However, mounting inflationary pressures will force the decoupling of gold and Treasuries since inflation is positive for gold and negative for fixed-income. Unless the Federal Reserve decides to shock the market through quantitative tightening or aggressive rate hikes, real interest rates will likely stop rising and may decline soon.
The CPI Will Rise Because Inflation is High
Most Wall Street gold analysts use the 10-year real yield to assess the fair value of gold. Since the TIP bond was launched in 2003, there has been a very strong negative correlation between its yield and the price of gold. See below:
(Data Source - Federal Reserve)
The current 10-year inflation-indexed yield is -0.66% which implies a gold price of $1747/oz based on the linear regression model. Gold is currently at $1700/oz, so it is slightly undervalued using this model but only by around 3%. In order for gold to rise, we will need to see the 10-year inflation-indexed yield decline back below 1%.
The 10-year inflation-indexed bond yield which is used in this model is based on TIP bonds (Treasury inflation-protected securities). Importantly, these bonds are indexed to the consumer price index or CPI. Usually, the term "inflation" is based on either the difference between this bond's yield and a "normal" Treasury yield which is the expected forward CPI inflation rate. "inflation" also refers to past YoY CPI growth or annualized month-over-month CPI. These figures are all around 2% today.
As others have said, CPI inflation is not necessarily equal to the actual inflation experienced by consumers. This is illustrated by the fact that energy, food, rent, and home prices (which are not in the CPI) have all been rising at a faster pace than CPI. See below:
Another major issue with CPI is that it overweights urban consumption even though a very large portion of the U.S. population lives outside urban areas. Last year, COVID caused record numbers of people to leave urban areas for suburban and rural areas. This created a supply-demand imbalance wherein urban areas saw unnaturally low demand while non-urban areas saw both a spike in demand (due to new entrants) and artificially low supply (due to production/supply-chain issues).
Overall, it is fair to assume that this caused prices to rise faster outside of areas where the CPI is measured. Over time, the price imbalance will close as workers demand higher wages in order to account for rising consumer prices. However, this means that CPI inflation will likely continue to rise over the coming years even if the Federal Reserve attempts to hike rates. Even more, the rapid increase in energy prices will also cause inflation to rise since virtually all companies must increase prices to account for higher utility bills. This situation is extremely similar to the stagflationary environment of the 1970s which saw a tremendous rise in the price of gold. The only difference is that the monetary situation today may be more extreme than it was in the late 1960s.
The Money-Supply Impact
This argument goes even further when you account for the skyrocketing money supply. Most investors expected last year's multi-trillion dollar money-supply increase to cause a larger spike in inflation than has been experienced. However, many individuals and businesses put their stimulus money into financial assets and not real assets. Indeed, securities trades and savings were the top choices for most who received stimulus checks last year.
The M2 Money Stock, the long-run inflation determinate, rose from $15T to nearly $20T since COVID began and is still rising at 0.5-1.5% per month even as Q.E. slows dramatically. In general, the price of gold and the market capitalization of stocks has a mean-reverting relationship to the M2. However, the gold/M2 and Wilshire 5000/M2 ratios have a generally negative relationship. See below:
(Source - Federal Reserve)
From 1980 to 1990, the ratio of money in gold was abnormally high while the ratio of money in stocks was abnormally low. The opposite was true by the peak of the dot-com bubble in 2000 which proceeded a substantial bull market for gold and bear market for stocks. Today, an abnormally high amount of extant money is in stocks while a generally low amount is in gold.
If we're indeed at the precipice of a crash in equities as I believe, then a wave of money will soon leave financial assets. Some of this money may put back into savings, but a large portion may go to real assets and goods. Interestingly, this would imply that a crash in stocks and bonds would actually cause inflation to rise. This did actually occur following the 2000 bear market from 2002 to 2007 which saw the highest inflation rates in years.
Based on the long-term average ratio between gold and M2, it is possible we see gold rise to $2300/oz - $2800/oz. Gold could rise even higher if the M2 continues to increase as is likely given Q.E./deficit policies. Importantly, this may still take a few years since inflation will need to catch up.
The 2021 Gold Outlook
Gold has been a disappointing asset for most investors since last August. This has grown in recent weeks as the collapse in Treasury bonds has caused a significant sell-off in gold. In the short-run, I believe it is possible we see the 10-year inflation-indexed Treasury rate (i.e. "real yield") rise to -0.40% which was its pre-COVID level. This implies a minimum gold price of $1640/oz (based on regression model) which would likely be seen within a month or two. Real-rates could rise higher if there is a liquidity shock, but I believe it is unlikely considering rising inflationary pressures and the strong possibility the Federal Reserve restarts Q.E. or pursues direct yield curve control.
The long-run outlook for gold is much stronger. Once the real-yield stops rising, I believe it will decline back to new all-time lows as inflation rises up to the 3%+ level. While this would be above the Federal Reserve's target, I believe it has enough inertia due to non-CPI inflationary pressures (or poorly weighted measures) that will make it so rate hikes do will stop inflation from rising. There is precedent for this as the Federal Reserve had to hike rates for well over a decade from the late 1960s to 1982 before inflation and gold finally stopped rising. By the time the rate hikes were done, gold had risen by over 13x in value.
Given the strong possibility that money flows out of financial assets back into real assets and goods this year, I would not be surprised to see gold end the year at or over $2500/oz. The hiccup which occurred exactly a year ago was a buying opportunity and I believe history is repeating. If we do see a crash in stocks, then a surge in quantitative easing will likely follow which will likely catalyze another large wave higher in gold.
This would be great news for gold ETFs such as (GLD) and (GLDM). It would also boost gold miners (GDX) and junior miners (GDXJ). There are many ways investors can gain exposure to gold, but personally, I believe it is a good time to accumulate miners - particularly junior miners who have a greater upside. My favorite of these is Caledonia Mining (CMCL) since it is trading at a large discount at its August peak and has arguably the lowest valuation among miners. All miners carry more risks than the physical metal, but with the price drop as large as it is, their downside risk today is considerably lower than it was months ago.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CMCL,GLD over 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.
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