During the summer months, precious metals consolidated sharp gains of June and early July in a constructive sideways pattern. Between June 30 and September 13, spot gold was basically unchanged, declining 0.3% (from $1,322.20 to $1,319.01), while spot silver gained 0.8% (from $18.72 to $18.87). The US dollar was similarly flat, with the DXY Index declining 0.5% (from 96.14 to 95.63). Given relative calm in precious-metal and US dollar markets, it is interesting to note that 10-year Treasury yields jumped 18% over the same span (from 1.47% to 1.73%).
It is still too early to know exactly which fundamentals are driving this mini “tantrum” in global rates. Are rising yields signaling incipient inflation? Do they portend stronger global growth? Do higher yields foreshadow an important inflection point in global central-bank policies? Or does the existence of $13 trillion in negative-yielding sovereign bonds simply signal the bond market is in need of a healthy correction? Perhaps most ominously, what if recent yield-upticks are signaling the beginning of the end for the epic 35-year bull run for bonds?
Answers to these questions will shape prospects for the precious-metal complex in coming quarters. As always, gold prices will be impacted by a wide array of monetary, economic, political and fundamental variables. However, we would like to highlight a helpful framework for how investors might assimilate the full range of investing inputs in shaping their gold allocations. In essence, some factors affecting gold prices are short-term in nature, and others are extremely long-term. Examples of short-term factors might be handicapping of individual FOMC meetings or U.S. employment reports. Examples of long-term factors might include such seminal variables as aggregate valuation of global financial assets and even the evolving composition of the global monetary system. As short-term noise affects gold prices on a daily or weekly basis, we believe it is important to remain focused on the longer-term variables underpinning the gold investment thesis. Along these lines, we would suggest that the current juncture represents a textbook example of an instance in which short-term considerations in gold markets may have temporarily distracted consensus from far more important long-term fundamentals.
Specifically, asset markets seem to be reacting in early September to two potential shifts in global central bank policies. First, the ECB and the BOJ have sent mixed signals in recent weeks as to whether the end of the road may have been reached in fruitful easing of monetary policy. Second, FOMC embers have, for the umpteenth time during the past six years, begun to jawbone higher the probabilities for rate hikes at imminent FOMC meetings. The combination of these factors, at least for the time being, has caused a hiatus in the bond market’s relentless march toward negative (nominal and real) rates.
While it is certainly possible that the Fed chooses to raise rates at either the September or December FOMC meeting, we believe markets are significantly overestimating the lasting significance of such a move. After all, the Fed’s December 2015 rate hike was its first since June 2006 (nine-and-a-half years). Immediate upticks in virtually every measure of financial stress caused Fed Vice-Chairmen Stanley Fischer and William Dudley to backtrack in early-February from the Fed’s telegraphed plans for four 2016 rate hikes. Probabilities for a December 2016 hike still hover at only 50%. Our reading of the five Fed Governors (permanent FOMC voters) is overwhelmingly dovish, most recently underlined by Lael Brainard’s market-moving speech on 9/12/16. St. Louis Fed President James Bullard (2016 FOMC voter) has even dropped out of submitting forecasts to the Fed’s dot plot (citing insufficient visibility) and currently maintains that only one additional rate increase will be appropriate between now and December 2017!
During the next few years, we view the probabilities of an extended Fed tightening cycle as extremely remote. In the meantime, whenever short-term handicapping of imminent FOMC moves provides downward pressure on the gold price (as may have been the case since gold’s 7/6/16 intraday high of $1,375.45), we would view such trading as providing a fortuitous buying opportunity for both gold and gold shares. Between June 2004 and June 2006, the Greenspan Fed raised rates at 17 consecutive FOMC meetings (more than quintupling fed funds from 1% to 5.25%) and spot gold rose 73% over the interim. We don’t think the Fed’s current pace of a quarter point increase every year or so presents much challenge to firm gold prices.
Outside Fed handicapping, there are other fundamentals which can provide short-term buying opportunities while gold’s long-term investment thesis remains intact. U.S. economic data releases are a prime example. Since our gold investment thesis is based on the irretrievable mismatch between claims on future output (debt) and productive output in the U.S. (GDP), we would argue we are far past the point at which individual economic statistics hold much bearing on gold’s investment relevance. With $64.2 trillion in total-credit-market-debt sitting atop an $18.2 trillion economy, no amount of GDP growth, by itself, can ever rebalance the U.S. financial system. Even if GDP were to post eight straight quarters of 10% growth, this would only increase GDP to $22.0 trillion, a level of output no more capable of servicing $64.2 trillion in total debt than $18.2 trillion. Of course, should ratios of the past 15 years hold even remotely true, an aggregate increase of $4 trillion in GDP would require at least an additional $20 trillion in fresh credit, vaulting total credit towards $85 trillion.
While there may be an occasional bright spot in individual U.S. economic releases, we would argue that the pattern of U.S. economic performance has become sufficiently weak for such an extended period that gold investors should look past short-term noise in assessing investment cues. Why has the U.S. economy been unable to generate a single year of 3% real-GDP-growth since 2005? Why did the U.S. economy, after seven years of unprecedented monetary stimulus, post in Q2 2016 nominal GDP growth of only 2.4%, which, outside the financial crisis and a 2.1% print in Q4 2001, was the lowest nominal growth since 1961? Why are productivity and labor participation rates mired at 40-year lows? Despite gaping yield premiums to other sovereign bonds, why are foreign investors selling Treasuries at an unprecedented rate?
In our October communication, we will be presenting a comprehensive update on the critical factors, some many years and even decades in the making, which we believe are finally coming together to support significantly higher gold prices in coming periods. For the time being, we would like to review our three litmus tests for gold’s ongoing portfolio relevance. As short-term traders react to evolving prospects for an FOMC rate hike, an individual policy decision from the BOJ, or an outlying non-farm payroll report, we would suggest gold investors remain focused on assessing whether any important components of the overriding gold investment thesis have truly changed.
The most powerful litmus test for gold’s ongoing relevance is an assessment of whether the U.S. financial system could endure normalization of interest rate structures. Should the Fed raise fed funds to 3%-to-4%, or should 10-year Treasury yields trade back to 6%-to-8%, without significant negative impact to the U.S. financial system, we would concede constructive progress might have been achieved in rebalancing US financial markets. We view prospects for either of these developments as quite remote. In such an environment, gold remains a mandatory portfolio asset.
Second, gold will remain a productive portfolio-diversifying asset until the process of debt rationalization is allowed to proceed in the United States. Since 2000, the Fed has now interceded to forestall this rebalancing process on at least three prominent occasions. To us, eventual normalization of the relationship between claims on future output and productive output itself will return ratios such as debt-to-GDP and HHNW-to-GDP to historically sustainable levels, say below 200% and 350% respectively. Because these ratios at prevailing GDP levels would imply (respectively) $20 trillion and $30 trillion in either debt defaults or depreciation of financial asset prices, we are quite certain the Fed will do everything in its power to postpone this rebalancing. Given implications for declining intrinsic value of U.S. financial assets, as well as ongoing Fed efforts to debase outstanding obligations, gold remains a mandatory portfolio asset.
Third, should the US economy ever be able to resume GDP growth between 3%-to-4%, with a net national savings rate in the 8%-to-10% range (now roughly 1%), there would no longer be a need for the $2.0 trillion-or-so in annual U.S. nonfinancial credit growth now necessary to service debt and drive consumption. In such an environment, U.S. securities markets would be replete with opportunities for true capital formation, and gold would hold limited investment utility.
Next month, we look forward to sharing our expanded thoughts on gold’s strengthening long-term investment fundamentals.
Courtesy: Trey Reik
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