For all of our faithful lip service, gold has had a bad six months and a worse February to top it off.
What’s going on?
Gold price (yellow) and silver price (grey) since late 2019
Gold and silver surged higher until summer last year. Since then, gold has stumbled significantly, while siler has simply consolidated.
Above the $2,000/oz mark, gold was reasonably overbought in the short term, after an incredible bull run.
The pullback into 2021 was all rather reasonably – and seemed like nothing more than the breath-catching pause a bull market of this magnitude deserved.
Inflation expectations had continued to rise, reaching seven-year highs not two weeks ago.
Real rates, which show interest rates adjusted for inflation, has continued to rise in line with silver, as you might expect.
But gold lagged behind all of a sudden.
Last week saw some especially severe moves which have caused many gold investors to panic.
One thing which is very interesting to me is that it has faltered in perfect unison with the most speculative tech stocks – like Tesla which peaked in the week of 8 January.
It’s interesting because in some ways, gold ought to be anti-correlated to such speculative stocks.
But they have one thing in common – they benefit from low interest rates/bond yields.
The action last week was all driven by a sudden realisation by all market participants that inflation is coming. And this took its toll on the bond market, which I’ll get to in a moment.
With the price of things like copper, timber, corn, sugar, and oil shooting up in the last 9-12 months, I was surprised that it took markets so long to clock.
But as we’ve discussed here quite often, bond markets are the most sensitive to changes in inflation expectations.
Higher inflation automatically lowers the value of their return, making people sell some of their bonds.
As those bonds are sold, the price of the bond goes down and consequently, the yield on the bond goes up.
Across bond market, this has happened steadily for six months, and then rather suddenly last week.
This is the primary transmission mechanism of inflation into asset prices, with bond prices so high after 40 years of falling inflation.
Now though, it’s worth investigating what this means for our other favourite asset – gold and other precious metals.
Instinctively, inflation rising should be good from gold. It’s the ultimate inflation hedge after all.
So why has its long-awaited arrival heralded such a poor few months for our shiny friend?
Because of that very same transmission mechanism – the bond market.
Bond yields rising as people sell them in fear of inflation makes gold seem less attractive.
If you can get 1.5% on a US ten-year government bond instead of 0.5% (last August), then it becomes less appealing to own an asset with no yield.
It’s also worth mentioning here that as stocks continued to roar higher, fears of a stock market crash or an economic collapse have dissipated – an oft-cited reason for holding gold (it’s a “safe haven”).
The combination of inflation and interest rates leads to something we have discussed here before – the “real yield”.
“Real” rates are the interest rates you can get on bonds, adjusted for inflation.
What gold investors really want is inflation to rise faster than yields.
What happened last week was yields spiking much faster than inflation (which takes forever to show up). This means that real yields, the true driver of gold prices, rose.
When real yields rise, the inflation-adjusted return investors can get from bonds is higher, which makes precious metals less attractive on a relative basis.
So gold took a hit.
What to do? Sell?!
Well, here’s the thing.
Firstly, the moves in bonds last week were very powerful, and as such are likely to see some sort of pullback or bounce at some point – perhaps it’s already happening.
We are likely to get a period in which to catch our collective breath.
Another group of market-watchers catching their breath are the employees of the Federal Reserve, and other global central banks.
Because they are coming up to a pretty big decision.
You see, if government bond rates rise too far or too fast, it starts wreaking havoc.
In fact, just look at what a move to 1.5% on the US ten-year did to financial markets – last week was carnage!
So the Federal Reserve needs to decide whether or not to impose “yield curve control” – ie, buying so many bonds of specific maturities (three-month, five-year, 30-year, or whatever) that it forces prices up and yields down.
Why would they do this?
Because the US cannot tolerate higher yields.
Higher interest rates mean a higher interest burden.
For example, a 0.5% increase in interest rates is equivalent to the annual budget for the US Navy. Another 0.3% is the equivalent for the US Marines.
Remember that last year, the total US public debt jumped up to $27 trillion.
In 2008, it was “just” $9.5 trillion.
So it is far more sensitive to higher interest rates, expressed by government bond yields.
The higher the tower of debt rises, the more fragile it becomes.
If rates rise, the public debt becomes crushing, business and individuals can’t repay the interest on their debt. Defaults rise and spread. And debts have grown massively in recent months and years.
If the Fed wants to avoid this eventuality… it must buy more bonds to push prices up and yields down, and accept the risk that inflation runs hot.
If the Fed does do this (and succeeds!) then it will be a bonanza for precious metals.
With bond yields tethered to very low levels, and huge asset purchases driving inflation higher, it will be the number one asset to own.
However, if bond yields rise very quickly before this takes place, or if the Fed decides to accept higher yields…
… then gold is likely to suffer, as bond yields rise faster than inflation.
This is a surprisingly clear fork in the road ahead (a sentence which will surely come back to bite me).
And it makes the path clear for those who are worried about gold in the short term…
Banks are the number one asset which will benefit from higher yields.
Just look at the share price of NatWest (red/blue) or Deutsche Bank (red/black) since 2008, when central banks set interest rates at or near zero:
Both are still over 90% down from their pre-2008 highs. They have never recovered. However…
Both have doubled or more in recent months.
And both endured last week’s turbulence rather calmly and were up 20% or 30% in February.
If you’re worried about your gold position – I don’t think it’s time to panic.
But as always, if you are worried then it’s always reasonable to trim positions a little – though the timing doesn’t feel great – I imagine better opportunities to do so will come around soon.
Alternatively, you could consider hedging by buying some banks. With inflation set to continue pushing yields higher, they offer a good foil to our gold position, and at these prices have plenty of merit in their own right.
I had perhaps not fully appreciated this, and some real introspection during last week and over the weekend has gone into this. I am sorry I hadn’t written more about banks before.
I had got a little lazy with gold and stopped questioning it. I imagine I wasn’t the only one!
Adding banks could be like adding peace of mind. It’s true diversification. And it’s also probably going to balance a yield-less asset with a very high-yield asset if you pick right.
But for that, you’ll have to do your own careful, considered research as always.
All the best,
Editor, UK Uncensored