Michael Every from Rabobank is bearish on Gold in his recent video:
“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”
Several readers have written, asking if this changes our view on Gold.
The short answer is NO, for three reasons:
1. The Fed can only hike rates until something breaks
Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.
The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.
Bank credit still grows at a healthy rate.
The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.
Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.
Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).
Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.
A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.
2. A strong Dollar is destroying US industry
The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.
This has allowed the Financial sector to grow to a point where it dominates the US economy.
Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.
In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.
The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.
The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.
The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.
Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.
The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.
3. US debt above 120% of GDP would destroy the bond market
Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.
Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.
That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.
The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.
The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.
China & the Dollar
After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.
China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.
The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.
In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.
The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.
The Belt-and-Road initiative
In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).
China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.
The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.
Funding the federal deficit
China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.
But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.
The US is faced with a difficult choice:
- Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
- Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.
It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.
Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.
Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.
This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:
- Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
- The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.
Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.
There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.
Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.
It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.
The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.
The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.
Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.
10-Year Treasury yields have climbed in response to the December FOMC minutes which suggest a faster taper of QE purchases and faster rate hikes. Breakout above 1.75% would offer a medium-term target of 2.3% (projecting the trough of 1.2% above resistance at 1.75%).
The Dollar Index retreated below short-term support at 96, warning of a correction despite rising LT yields.
Do the latest FOMC minutes mean that the Fed is serious about fighting inflation? The short answer: NO. If they were serious, they would not taper but halt Treasury and MBS purchases. Instead of discussing rate hikes later in the year, they would hike rates now. The Fed are trying to slow the economy by talking rather than doing — and will be largely ignored until they slam on the brakes.
Average hourly earnings growth — 5.8% for the 2021 calendar year — is likely to remain high.
A widening labor shortage — with job openings exceeding total unemployment by more than 4 million — is likely to drive wages even higher, eating into profit margins.
The S&P 500 continues to climb without any significant corrections over the past 18 months.
Rising earnings have lowered the expected December 2020 PE ratio (of highest trailing earnings) for the S&P 500 to a still-high 24.56.
But wide profit margins from supply chain shortages are unsustainable in the long-term and are likely to reverse, creating a headwind for stocks.
Warren Buffett’s long-term indicator of market value avoids fluctuating profit margins by comparing market cap to GDP as a surrogate for LT earnings. The ratio is at an extreme 2.7 (Q3 2020), having doubled since the Fed stated to expand its balance sheet (QE) after the 2008 global financial crisis.
Stock prices only adjust to fundamental values in the long-term. In the short-term, prices are driven by ebbs and flows of liquidity.
We are still witnessing a spectacular rise in the M2 money stock in relation to GDP, caused by Fed QE. The rise is only likely to halt when the taper ends in March 2022 — but there is no date yet set for quantitative tightening (QT) which would reverse the flow.
Gold continues to range between $1725 and $1830 per ounce with no sign of a breakout.
Expect a turbulent year ahead, driven by the pandemic, geopolitics, and Fed monetary policy. Rising inflation continues to be a major threat and we maintain our overweight positions in Gold and defensive stocks. A soft landing is unlikely — the Fed could easily lose control — and we are underweight highly-priced growth stocks and cyclicals, while avoiding bonds completely.
10-Year Treasury yields remain soft despite the recent CPI spike. The Fed is weighting purchases more to the long end of the yield curve. Breakout above 1.75% (green line) would signal a fresh advance.
10-Year TIPS yield sits at -0.78%, unaffected by the $369bn in overnight Fed reverse repurchase agreements which remove liquidity but mainly affect short-term interest rates.
Gold broke through resistance at $1850/ounce. A rising Trend Index indicates medium-term buying pressure. Long tails on the last three daily candles indicate retracement to test the new support level; respect signals a test of $1950/ounce.
Silver is testing resistance at $28/ounce. Rising Trend Index indicates medium-term buying pressure. Breakout above $28 is likely and would offer a target of $30/ounce in the short/medium-term.
The Dollar index is testing primary support between 89 and 90. Rising Trend Index (below zero) suggests another test of the descending trendline. Respect is likely and breach of primary support would offer a medium/long-term target of 851.
From Luke Gromen at FFTT:
When you are an externally-financed twin deficit nation with insufficient external funding (as Druckenmiller pointed out), there are three potential release valves:
- Higher unemployment.
- Higher interest rates.
- Lower currency (inflation.)
With US debt/GDP at 130%, Options #1 and #2 aren’t an option……
We expect long-term Treasury yields to remain low while inflation rises, causing the US Dollar to sink and Gold and Silver to advance.
Our long-term target for Gold of $3,000 per troy ounce2.
- Dollar Index (DXY) target of 85 is calculated as the peak of 93 extended below support at 89.
- Gold LT target calculation: base price of $1840/ounce + [TIPS yield of -0.87% – (nominal Treasury yield of 1.64% – real inflation rate of 5.30%)] * $400/ounce = $2956/ounce
Inflation is a hot topic at the moment. For good reason: higher inflation would drive up interest rates, affecting both bond and equity prices, as well as commodities and precious metals.
March CPI jumped to 2.64% but the increase is partly attributable to the low base from March 2020. Core CPI (excluding food and energy) came in at a more modest 1.65%. The main difference between CPI and core CPI is rising energy and food costs.
The annual inflation rate in the US ……is the highest reading since August of 2018 with main upward pressure coming from energy (13.2% vs 3.7% in February), namely gasoline (22.5% vs 1.6%), electricity (2.5% vs 2.3%) and utility gas service (9.8% vs 6.7%). Prices also accelerated for used cars and trucks (9.4% vs 9.3%), shelter (1.7% vs 1.5%) and new vehicles (1.5% vs 1.2%) while inflation slowed for medical care services (2.7% vs 3%) and food (3.5% vs 3.6%). Cost of apparel continued to fall (-2.5% vs -3.6%)……..a jump in commodities and material costs, coupled with supply constraints, are pushing producer prices up and some companies are passing those costs to clients. (Reuters)
10-year Treasury yields eased to 1.62% with the breakeven inflation rate at 2.33% — weakening the real 10-year yield to -0.71%.
Inflation and the Money Supply
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
But experience since the 1980s shows several surges in money supply growth without a corresponding rise in inflation. While an increase in money supply may be a prerequisite for a spike in inflation, it is not the cause.
More direct causes of inflation are increases in input costs for suppliers of goods and services. The two largest input costs are commodities and wages. Rises in commodity prices will mostly affect the manufacturing sector, while increases in wage rates impacts on all employers. Also, commodity prices tend to be cyclical, so price fluctuations will be more readily absorbed, while wage increases tend to be permanent and more likely to be passed on to customers.
The chart below shows a much closer correlation between hourly wage rates and CPI since the 1970s, with surges in hourly earnings accompanied by a rise in inflation.
Rising commodity prices are driving higher inflation at present. While some of the pressures may be transitory, due to supply interruptions, underinvestment in new production over the last decade is likely to act as a supply constraint for both energy and base metals. Rising demand fueled by short-term stimulus and longer-term infrastructure investment would act as an accelerant.
Wage rate increases are so far restrained, but that is likely to change as the economy recovers, boosted by decoupling from China and on-shoring of critical supply chains. Shortages of skilled labor are expected to drive up wage rates, maintaining upward pressure on inflation in the longer-term. Training and education of suitable staff will take time.
We have all the ingredients for an inflation spike. A massive boost in the money supply, accompanied by record stimulus payments, much of which has been channeled into savings. This will help to fuel increased demand in the longer term, while restricted supply will drive up commodity prices and wage rates for skilled labor.
Interesting question from Steve:
Bitcoin has broken through $50k, so there is now some USD940 billion in circulation. What would be the impact on the Gold price? It seems to me that many Bitcoin purchasers are buying as an alternative to buying Gold as a store of assets.
Bitcoin may be diverting some investors from gold but we believe this is marginal. Global gold reserves ($9.6T according to Perth Mint) are still 10 times the size of Bitcoin.
If we look at 2018, when Bitcoin fell from $19,000 to $3,200….
There was little benefit to Gold which also fell for most of the year.
Again in 2020, when Gold peaked at the beginning of August….
Bitcoin remained flat for 3 months before commencing an up-trend in November 2020. And broke $20,000 on Dec 17th, while Gold was rallying.
The rise in Bitcoin is not the cause of recent weakness in Gold.
We see Bitcoin as speculative and would not hold it as a store of value — any more than Dutch tulips.
Gold has served as a store of value for thousands of years and this is unlikely to change.
There is no reliable benchmark for assessing performance of different markets (stocks, bonds, precious metals, commodities, etc.) since central banks have flooded financial markets with more than $8 trillion in freshly printed currency since the start of 2020. The chart below from Ed Yardeni shows total assets of the five major central banks (Fed, ECB, BOC, BOE and BOJ) expanded to $27.9T at the end of November 2020, from below $20T at the start of the year.
With no convenient benchmark, the best way to measure performance is using relative strength between two prices/indices.
Measured in Gold (rather than Dollars) the S&P 500 iShares ETF (IVV) has underperformed since mid-2019. Respect of the red descending trendline would confirm further weakness ahead (or outperformance for Gold).
But if we take a broad basket of commodities, stocks are still outperforming. Reversal of the current up-trend would signal that he global economy is recovering, with rising demand for commodities as manufacturing output increases. Breach of the latest, sharply rising trendline would warn of a correction to the long-term rising trendline and, most likely, even further.
There are pockets of rising prices in commodities but the broader indices remain weak.
Copper shows signs of a recovery. Breakout above -0.5 would signal outperformance relative to Gold.
Brent crude shows a similar rally. Breakout above the declining red trendline would suggest outperformance ahead.
But the broad basket of commodities measured by the DJ-UBS Commodity Index is still in a down-trend.
Silver broke out of its downward trend channel relative to Gold. Completion of the recent pullback (at zero) confirms the breakout and signals future outperformance.
Comparing major stock indices, the S&P 500 has outperformed the DJ Stoxx Euro 600 since 2010. Lately the up-trend has accelerated and breach of the latest rising trendline would warn of reversion to at least the long-term trendline. More likely even further.
The S&P 500 shows a similar accelerating up-trend relative to the ASX 200. Breach of the latest trendline would similarly signal reversion to the LT trendline and most likely further.
Reversion is already under way with India’s Nifty 50 (NSX), now outperforming the S&P 500.
S&P 500 performance relative to the Shanghai Composite plateaued at around +0.4. Breakout would signal further gains but respect of resistance is as likely.
Looking within the Russell 1000 large caps index, Growth stocks (IWF) have clearly outperformed Value (IWD) since 2006. Breach of the latest, incredibly steep trendline, however, warns of reversion to the mean. We are likely to see Value outperform Growth in 2021.
The S&P 500 has made strong gains against Treasury bonds since March (iShares 20+ Year Treasury Bond ETF [TLT]) but is expected to run into resistance between 1.3 and 1.4. Rising inflation fears, however, may lower bond prices, spurring further outperformance by stocks.
The US Dollar is weakening against a basket of major currencies. Euro breakout above resistance at $1.25 would signal a long-term up-trend.
China’s Yuan has already broken resistance at 14.6 US cents, signaling a long-term up-trend.
India’s Rupee remains sluggish.
But the Australian Dollar is surging. The recent correction that respected support at 70 US cents suggests an advance to at least 80 cents.
Gold, surprisingly, retraced over the last few months despite the weakening US Dollar. But respect of support at $1800/ounce would signal another primary advance.
Silver is expected to outperform Gold.
Gold is expected to outperform stocks.
Value stocks are expected to outperform Growth.
India’s Nifty 50 is expected to outperform other major indices. This is likely to be followed by the Stoxx Euro 600 and ASX 200 but only if they break their latest, sharply rising trendlines. That leaves the S&P 500 and Shanghai Composite filling the minor placings.
Copper and Crude show signs of a recovery but the broad basket of currencies is expected to underperform stocks and precious metals.
The Greenback is expected to weaken against most major currencies, while rising inflation is likely to leave bond investors holding the wooden spoon.
Not to be confused with the ETF (AAAU) listed on NYSE Arca — which went by a similar name — Perth Mint Gold (PMGOLD) is a call option listed on the ASX that entitles the holder to delivery of 1/100th of a troy ounce of fine gold held at the Perth Mint.
Liabilities of Gold Corporation are guaranteed by the West Australian state government under section 22 of the Gold Corporation Act 1987, an Act of the WA Parliament.
Management fees of 0.15% p.a. are paid in physical gold.
Gold holdings of Gold Corporation are unallocated.
Further details regarding fees, custody and delivery are set out in their Product Disclosure Statement.
Published in ETF Strategy on December 14, 2020:
Goldman Sachs has completed its acquisition of the Perth Mint’s physical gold ETF.
Renamed the Goldman Sachs Physical Gold ETF (AAAU), the ETF’s fee is unchanged, at 0.18%, as is its listing on NYSE Arca.
The ETF also continues to provide the same fundamental function – namely physical exposure to gold bars meeting the specifications for “good delivery”, as defined by the London Bullion Market Association.
But while the fee, listing venue, and investment objective are all unchanged, the original custodian, the Perth Mint, has been removed and, along with it, the ETF’s unique guarantee from the government of the State of Western Australia.
Also out with the Perth Mint is the ETF’s novel convertibility feature that allowed shareholders of the ETF to exchange their shares for delivery of physical gold in the form of bullion bars and coins issued by the mint.
In its place as custodian is the London branch of JP Morgan Chase – one half of a duopoly of banks (the other half being HSBC) that is home to an increasingly large and arguably alarming concentration (approx. 2,500 tonnes) of ETF-owned gold……
China’s Yuan plunged on scares of a coronavirus epidemic spreading from its Wuhan epicenter.
The flight to safety took 10-Year US Treasury yields with it. Breach of support at 1.75% warns of another test of primary support at 1.50%.
Flight to safety is also likely to directly strengthen demand for Gold, while lower long-term yields provide a secondary boost by lowering the opportunity cost of holding precious metals. Respect of support at $1540-$1560 would signal another advance.
Silver is weaker but continues to test resistance at $18 to $18.50. Breakout would confirm a bull market for precious metals.
A stronger Dollar, also benefiting from the flight to safety, should only partially offset the rising demand for Gold and Silver.
Australia’s All Ordinaries Gold Index continues to test resistance at 7200. Breakout above 7200 would strengthen the bull signal from 13-week Trend Index and Momentum recovering above zero.
Prospects of retracement to re-test support at 6000 are diminishing. Accumulate on breakout above 7200.
Our pick of Australian gold stocks is available to subscribers to the Australian Growth model portfolio. I am not sure how many readers are aware that Market Analysis updates are included as part of any model portfolio subscription.