Everything You Need To Know About Gold In 2021

Summary

• 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.

(Pexels)

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:

Data by YCharts

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):

Data by YCharts

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:

Data by YCharts

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.

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.

Comments

[Sage of Remnant Cove]

What factors determine interest rates ??? What is an interest rate composed of ???

[straw walker]

With the fall of the US dollar one would expect gold prices to rise..but the opposite has occurred..
The main reason.. much of real gold is held by foreign individuals, as gthey use gold as a depository for US dollars, and they have been selling gold..

[Paul T. Lambert]

If only it were this simple... but what this article neglects to mention is that for the most part, no real gold is actually traded. Nonetheless, no-gold paper gold pricing controls what you pay at the coin store. It's a travesty of actual market price discovery. Nothing new, here, of course; it's just that it's a mistake to pretend that gold "prices" have much to do with its actual value.

[r igo]

It all makes sense, especially the notion of nominal rates rising faster than inflation. But it is not the only factor affecting the price action in Gold. Stocks and cryptos took a big bite from the gold pie. If not that, I think Gold would be higher, perhaps not at the top at 2050, but more like 1900. Yes, a lot of money is being infused into the system, and lots of people have no better use of it but investing in the stock market and the bitcoin. That causes a positive reinforcement loop when even more money is attracted to this wave and taken from other places, like Treasuries and Gold. Both stock market and the BTC may crush and probably will, but until this bonanza continues, Gold will have hard time to get shining. But the thesis in my opinion is right and Gold should become an attractive investment first and insurance policy (physical) second.

[Maurice M]

What about SBSW? Exposure to gold, palladium, platinum, rhodium, etc.

[Stratocaster17]

@Maurice M south africa

[Notlim Shot]

@Maurice M Doubled my money in a year with SBSW - Thanks to James Dines, The Dines Letter

[Miners to the Moon]

@Notlim Shot, @ Maurice M, SBSW is at 52-week highs - are you lightening up your position?

[Bud03]

Just added a full position in a #1 jurisdiction (Australia) for Karora Resources Inc. (KRRGF OTC; KRR TSX). Just became a solid junior with recent proven finds; strong financials and all-in production < $1000. Trading at @ U$ 2.50 and should be at U$ 6 in a year.

[BlueTower5000]

The way to play this right now with equity valuations in the sky is to buy the safest miners paying fat dividends. Newmont is about a 4% yield right now with a PE near 17 last I checked. Agnico Eagle and Kirkland Lake are another 2 safe miners paying dividends in excess of 2%. Limit your buying of the juniors in case of a severe downturn and try to keep some cash for dip buying in case we go lower. Maybe pick a streamer like FNV or WPM. Buckle up though, we’re approaching another liquidity event.

[Miners to the Moon]

@BlueTower5000, Amen. Do you have an opinion on SBSW or KL?

[BlueTower5000]

@Miners to the Moon I own both. KL is supremely undervalued and my biggest single miner position. SBSW has a massive dividend and stands to profit hugely when platinum starts rallying.

[Miners to the Moon]

@BlueTower5000, but is SBSW fully valued? Hate to chase a miner at its 52-week highs.

[Dinjax]

@Harrison Schwartz good article and thanks for the education explaining gold's recent drop.
Agree with your assessment on CMCL and would also add BTG as another undervalued miner with solid performance. Long both.

[Agbug]

Considered the argument here, and decided to dump my GDXJ and go for a ride with GUSH. Higher oil prices seem a much better bet short term.

[birder 4000]

I am sort of a skeptic, well more than sort of. I am of the opinion that the dollar is going to be worth virtually nothing. Just consider the latest legislation--give everybody free money. I suppose if you are a politician who does not expect to last much longer that makes some sense. Won't be around to pay the reckoning. And long term for a politician is four years. Well, I do believe that a hedge in this situation is appropriate and gold, silver, collectibles, and mining equities do provide that. Same goes for foreign equities although it appears that most foreign governments seem to be in lock step with the US. Even Switzerland ran a deficit last year. Although assets based in Switzerland are perhaps safer than those based in the US. Think Nestle, Roche, and Novartis for instance.

[Agbug]

What's missing is unable to be measured or easily quantified with a FRED chart in order to get the PM market moving upwards. The fear factor. Something unexpected and typically unpleasant. Some global political turmoil or other black swan type of event that generates a fearfull response. For example, I knew Trump had won the election when gold spiked $50 an ounce on election night 2016. That's just an example mind you, not a judgement on the result.

Holding $GDX, $GDXJ and $NEM right now. $GOLD would be next on my list if I find the cash.

[SuperAwesomeDude]

@Agbug The most powerful man in the world holding his first press conference. THAT will be a black swan event!

[Agbug]

@SuperAwesomeDude I don't want to be anti-elderly, so I'll leave the world to be the judge of your observation. I had an extreme pivot investment wise and dumped my GDX and GDXJ and went all in on GUSH. Another pro-gold article convinced me that gold and silver weren't my best bet right now. I'm a little late to the crude party, but the music is just getting cranked up.

[Steve in TN]

@SuperAwesomeDude That hilarious statement should be given by late night comedians but will never happen due to their leftist bent.

[adriano321]

Silver will outperform in the near- mid term. New physical buying pressure is stretching an already thin market.

[BooBooGao]

Most people don't need gold and they don't need plastic garbage from China anymore. They do need oil, gas and food. Some silver coins would come in handy.

[NimbleTrader]

It seems clear Gold will selloff in an equities selloff, as investors sell gold for cash to cover margin calls. There will be nowhere to hide. However, Gold and other PMs will recover first. No way do PMs just take off righy if stocks crash.

[gusrhymeswithbus]

@NimbleTrader Most people getting margin called in an equities selloff are unlikely to have gold in their portfolio.

[Zero Set]

I am very exited about the future of Caledonia Mining. I am also very exited about getting the opportunity to buy shares in the mid 13's. And more excitement found in these two recent articles.

Zim has perfect business operating environment – Caledonia Mining Corporation
www.zbcnews.co.zw/...

Expansion Prospects Excite Caledonia
miningzimbabwe.com/...

[RandyFloyd]

i'm adding slowly. maybe i'm getting greedy "hoping" for a deeper correction, but regardless this has got to be a good place to get in. but could it get better...?

[Doug Scher]

I think mining in the U.S. makes a big comeback in general. The last 20 years have washed out the old prospectors and ushered in a new group of tech savvy, sustainability minded newbies, while the in ground mineral resources have remained largely untouched. I just bought a little PPTA for fun and, hopefully, profit. Run by a woman mining engineer from the Sierra Club with Native Americans on the BOD! . Gold and rare earth( antimony) miner. Silver will run even faster than gold, as the renewable electrification of everything will increase demand for the next couple of decades. Most of the legacy deposits in N.A.are in Mexico, Endeavor Silver, a great name in the space. Also coming, sustainable development of Idaho cobalt. Jervois will be the dominant player. Thanks Harrison, good analysis

[Aureus Denarii]

@Doug Scher
The Stibnite project for PPTA, formerly Midas Gold is still years away if it even moves forward. With massive upfront capex as it is a previously impacted site with considerable contamination. Which likely means dilution and debt to get to production.
Even if Laurel Sayer were "from the Sierra Club" I'm not sure she would have any influence on the many other conservation entities against the proposed mine. If your comment, "Native Americans on the BOD!" is a reference to the native Idahoans on the Board, that's quite different than an Indigenous person.
In fact, the corporation is being sued by the local Indigenous tribe to stop the project.
All that being said, it is a huge high-grade resource in mining friendly Idaho. With what could be a boon to one industry (mining), it would be disastrous for another (tourism) as this is located in a particularly pristine area of central Idaho. An open pit mine here just doesn't fit. But they have packed the board with miners, Idahoans and lobbyists so who knows.
Good Luck

[Agbug]

@DRE Retired , That seems like a tough one to gain permits for, but stranger things have happened. Funny coincidence, I worked on a survey crew in 1980 that was for a mine in that valley of old Stibnite. A true ghost town then. It's the East Fork of the South Fork of the Salmon River, right up against the Frank Church River of No Return Wilderness. Seems a tall order for a mine in that locale.

[KarlStox]

Very interesting! Once the monetary dam breaks... the flood will shock many