Gold Market Déjà Vu

There’s an overwhelming sense of déjà vu as far as the gold market is concerned. Two years ago at almost this exact time at the end of 2015, we witnessed the first US Fed rate hike since 2008’s GFC – a 25-basis point increase. This followed years of promises, threats and jawboning by the US Federal Reserve with respect to interest rates.

Back then, gold finished 2015 in limp fashion, with market experts fully expecting the Fed to follow through on its stated commitment at the time of 3–4 rate planned rate increases during 2016.

Gold however did the exact opposite – it surged out of the blocks during early 2016, as it became obvious that the Fed’s rate talk was exactly that – all talk and no action – and it sustained its positive performance right up until the election of Donald Trump as President in November 2016.

So here we are again, with the Fed to finally get tough on rates. Of course, we’ve heard all this for 24 months now – and instead of gold meekly surrendering, it’s outperformed both the broader US share market as well as the US currency so far during 2017. This is clearly illustrated in the graphic below.

As we’ve suggested before, the Dow at record levels does not necessarily reflect underlying economic good health. Helicopter money has inflated equity prices to an enormous extent, whilst what I believe to be the more accurate indicators of economic wellbeing - such as labour force participation rates, productivity levels and real wage growth – still point to economic malaise.

From a corporate perspective, EPS for companies have been bolstered by management utilising cheap money share buybacks using, whilst underlying productivity continues to stagnate.

In my view, systemic risks still exist. Let’s look at what bond markets are telling us. The US 10-year bond yield has fallen as a result of strengthening bond prices to 2.36% at the time of writing, having traded up to 2.47% within recent days. When one analyses the spread between the US 2-year treasury and the 10-year - which currently is at 74 basis points - we see it’s at its lowest level since November 2007.

This is an important metric to watch, as it gives one a view of the bond market’s expectations on future US economic performance. It suggests that growth and inflation will be subdued in the coming years. With US stock indices regularly taking out new record highs, it gives me a feeling that there might be dark days ahead. A veteran market-watcher and broking friend of mine points out that he learned a long time ago that the bond market is never wrong - and is always ahead of stock markets.

Ultimately, the US market at record levels provides a risk that could ultimately benefit gold. But in the near-term, I believe there are other factors at play that will help boost gold prices.

Expect Further US Dollar Weakness

I believe we should expect US dollar weakness to continue. A US dollar that increases in value would present challenges for the US economy. Markets have factored in a Trump growth explosion, with a heavy emphasis on job creation, a renaissance in manufacturing and export growth.

A strong US dollar however would be a killer for US manufacturing and exports in particular. Trump himself has said that the strong US currency is “killing American exports.” Emerging markets in particular will shy away from purchasing from the US when their own currencies are weak relative to the dollar. In my view there is likely to be a focus on ensuring that the dollar trends lower.

President Trump's pick to lead the US Federal Reserve after Janet Yellen steps down in early 2018, Jerome Powell, has pledged to support the Fed's dual goals of stable prices and maximum employment. Along these lines, I don’t see an aggressive program of rate increases anytime soon.

Markets have also failed to take into account the impact that rising interest rates would have on the US economy, in terms of servicing the enormous level of debt that has built up.

The graph below shows the amount of federal debt outstanding over the past 40 years. As is clearly evident, federal debt exploded upwards with the financial crisis of 2008 and began its meteoric ascent to more than $19 trillion outstanding.

Given its sheer size, if the interest rate on that debt were to rise by even 1%, the annual federal deficit rises by $190 billion. A 2% increase in interest rate levels would up the federal deficit by $380 billion and if rates were 5% higher, the annual federal deficit rises by $950 billion.

In the case of the United States, interest rates have been controlled for some years now through the actions of the Federal Reserve. At the very same time that the federal deficit has soared, the Federal Reserve has been quite literally creating trillions of dollars out of nothing and using this brand new money to purchase United States debt – not directly from the US government, but via the markets. And if rates rise, the US economy will have to deal with a major problem.

It’s Not about Higher Rates, but Real Interest Rates

How often have we heard commentators uttering statements about higher interest rates being bad for gold? The fact is that if something’s repeated often enough, it tends to become accepted as truth. But what exactly is the underlying reality? History shows us that when the ‘real’ interest rate is negative, gold performs well.

The fact of the matter is that it’s not about rising rates per se – it’s really about the underlying ‘real’ interest rate (i.e. the interest rate after taking into account the rate of inflation). The real interest rate in the US has been in negative territory since 2008 (i.e. well below the inflation rate) and even if we see further interest rate increases, the likelihood is that the ‘real’ underlying interest rate in the US will still remain in negative territory.

There are numerous recent examples of a rising rate/rising gold environment. In fact over the past five decades the rising rate/rising gold scenario is common, with the last four raising cycles accompanied by stronger gold. The most recent was when the Fed increased interest rates between 2003 and 2007 - with rates rising from 1% to over 5.5%, while gold rallied by 150% to $800/oz.

Another significant period was from the 1970s, when the Federal Funds Rate rose from below 4% in 1971 to over 18% in 1980 - while gold rose by 2,400% from $35/oz to $850/oz.

Gold prices have been much more likely to rise if interest rates go up than if they stay the same, according to data from the Federal Reserve Bank of St. Louis. Between 1986 and 2016, the chance of gold rising in the months the Fed raised rates was 55%. The chance of gold being higher 12 months after a Fed hike was 61%. On average, gold prices moved 0.7% in months where the Fed hikes, versus 0.4% in months where policy stays the same. The average price change 12 months later was 7.2%.

This data essentially shows that a rising interest rate environment led to gold prices increasing, a fact that will be lost on many investors who assumed otherwise. A rising interest rate environment in the three decades following the 1950s was the largest precious metals bull market in modern history. Below is a comparison of the Federal Funds rate and gold prices between 1968 and 1990.

Gold’s Supply Side Challenges

Let’s not also forget that there are significant supply side challenges impacting the gold industry. Major gold miners face a dilemma - robust demand for their product, but question marks over how they will meet demand. Annual gold production is currently running at record levels, but will it be able to sustain itself - given slashed exploration budgets, falling levels of new discoveries and declining reserves.

It's little wonder that market watchers like BMO Capital Markets anticipate that mine supply will peak during 2019, then keep falling through to at least 2025. Randgold Resources' CEO Mark Bristow, an industry veteran, is of a similar view. In the past, new technologies were able to keep old deposits going longer and make previously uneconomic ones viable.

However the industry is not finding as many new deposits as they need to in order to maintain current production levels. Although we can expect incremental technological improvements in processing, mining, and exploration, there is nothing revolutionary on the horizon. Reserves from aging deposits are not being replaced by new discoveries, a situation exacerbated by rising exploration and development costs, as well as development hurdles like sovereign risk and project financing.

Conclusion

Real interest rates are likely to remain negative in the years to come, even with multiple rate rises. Gold has finished the past two calendar years in the relative doldrums, but burst out of the blocks at the beginning of both 2016 and 2017 – and I believe we’ll see a similar performance during 2018.

I also believe we’ll see further curbs on the rise of the US dollar during 2018 in order to maximise the performance of US exports and minimize the impact of servicing the country’s extraordinary debt burden that has escalated enormously since the GFC. 

Accordingly, we maintain confidence in our base-case gold price target range for the yellow metal during 2018 of between $1200 and $1400/oz.