Envision if you will a man with a bright red face … at first glance you might think he is in excellent health, glowing even … and on the other hand, it might suggest he has a fever … two completely opposite interpretations from the same facts … so to decide, you fall back on context. The same might be said of financial markets. Inflation can signal a robust economy or it could also signal trouble. The same might be said of bond yields.
On the face of it (pun intended), gold’s decline seems to be because it has held a long-term inverse binary relationship with declining bond yields (with a correlation co-efficiency of over 93%) and the recent rally in the 10 year rate has prompted 120 tonnes of ETF selling by Western institutions YTD (or 3.6% of total holdings) … but maybe markets are mis-reading events.
Bonds are falling and yields are rising because the market foresees inflation. The data is yet to catch up with the narrative and gold is being punished. In short, maybe they are on the wrong end of the deal.
If you didn’t get the memo about the beginning of a new gold bull run in Q3 2018 then this is your last call.
But of course it’s not all about bonds. The dollar has been on a rampage with the USDX at the highest for nearly a year. Late last year you would have struggled to find a dollar bull and so universal was the dislike that the short dollar trade was arguably the most crowded. As a contrarian it worried me then… and it has come to pass.
The market has inflicted the largest amount of damage on the greatest number of participants and the short covering rally in the dollar has piled pain on top of misery for gold bugs. Again … for fundamental reasons, the wrong outcome.
So where does that leave us … ? Well firstly at current levels gold looks to be an absolute steal. If you didn’t get the memo about the beginning of a new gold bull run in Q3 2018 then this is your last call.
All things considered, the current market price looks like a good entry point.
To be honest though, the path ahead is not entirely clear either. Things depends upon how Central Bankers navigate the very fine line between two great dangers … between the proverbial Scylla and Charybdis if you like. On one side lies austerity and a mired economy struggling to shake off the effects of the policy response to covid, and on the other lies inflation and over-heating.
Clearly the gods of the financial universe will seek the goldilocks option (not too hot, and not too cold) but there’s absolutely minimal margin for error. The negative convexity of raising rates means that even a 1% lift risks tipping the market back into recession and will massively increase the cost of servicing the burdensome debt.
Meanwhile the market is short of quality portfolio diversifiers – what with bonds still generating negative yields. Where to look …
As an exercise this morning I selected a random list of commodities to see how they have risen over the past 12 months … since just before covid. Most are up double digits … sugar up 14%, oil up 30%, iron up 90%, rubber up 67%, steel up 30%, minor metals and rare earths up 112%, GSCI up 28%, coal up 45%, lumber up 105%, oilseed rape up 39%, wheat up 22% and the grains index up 34%.
The only fallers were milk, live cattle and salmon. Copper is referenced as “Dr Copper” because its seen as a good benchmark in determining the health of industry … well that’s up 41%. Of course cost-push inflation is only part of the story … as economies unlock you should see demand-pull, plus the accelerator as the velocity of money increases. All things considered, we would expect the real rate of inflation in H2 to be somewhere between 6% and 12%. Enough to prompt significantly higher gold prices.
We last saw inflation rates north of 5% between 1976 and 1982 and over that period gold saw a CAGR (compound annual growth rate) of just under 20% per annum … pretty close to our last 2 years. Hence an alternative headline to this thought-piece was “GOLD – Back to the 1970’s”. Perhaps 40 years of disinflationary forces are coming to an end, and with it, the traditional 60/40 portfolio mix will need re-examining.
For a good read on the outlook for inflation, you would do well to read the expert views of RUFFER here.
Back in December last year in the LBMA gold forecast we predicted gold would average $2025 – we still hold that view. 2021 we think will be a game of two halves.
In short, at below $1700 we would call gold a significant “buy” (caveat emptor) … and if I am right, you can buy me a beer this Christmas … and if I am wrong, well then I shall have a red face … now what could that mean ?
(This article first appeared in MetalsDaily.com)