From our perch, the hyper-bullish conditions for gold occur when the US Federal Reserve is “inflationary” not when there is actual above-average inflation. That is a subtle but important difference. For example, during the post 2008 episode, the first Fed rate hike in that cycle occurred in December 2015. At the time, the short-term interest rate markets expected 4 additional rate hikes. However, due to a global growth scare, the Janet Yellen-led FOMC was forced to make a dovish pivot in the first quarter of 2016. Effectively, there was a capitulation in Fed and market beliefs on the path of future short rates with the Fed remaining extremely accommodative policy settings.
Macro conditions at the time were not inflationary. Indeed, the prevailing bias was that low trend growth, inflation and interest rates was a “permanent state.” However, the Fed’s dovish pivot meant that policy settings were inflationary at least until the fourth quarter, the election of the Donald and the shift to aggressive fiscal policy. The Fed then resumed the rate hike cycle in December 2016. At the time we initiated a position in GDX, the VanEck Gold Miners ETF on the day of the Fed Rate hike in December 2015 (chart 1).
From our perch at the time, the Fed was unlikely to deliver additional policy tightening for the key reason that macro conditions had already deteriorated. It was the first time the Fed had hiked rates with the ISM manufacturing in contraction (below 50). Moreover, world gold miners were trading 40% below book value and with a genuine improvement in trend free cash flow (for the first time the majors were managing their business for cash). GDX rallied over 105% and the GDXJ rallied 125% in the first half of 2016. More importantly, the sector outperformed global equities by 102% over that period. Put another way, GDX was an excellent diversifier for cross-asset investors.
Another way to make the same point is observing the Federal Reserve balance sheet against the spot price of gold (chart 2). Aggressive Fed balance sheet expansion (and contraction) has only been a major policy feature since 2008. Moreover, it is important to note that Fed balance sheet expansion is only inflationary when it leads to credit creation and not when it remains as reserves on the central bank balance sheet. Policy only really generated consumer price inflation when it was combined with aggressive fiscal easing in the current cycle. However, there is some evidence that earlier phases of quantitative easing contributed to asset price inflation. Gold and gold miners tended to perform well in phases of Fed inflation (or balance sheet expansion).
From a tactical perspective, the Fed has raised the policy rate by 525 basis points in the current cycle and has also resumed quantitative tightening of the balance sheet (after a brief pause during the regional banking crisis earlier this year). The real yield – the competing asset for gold – has also increased materially over the past eighteen months and is a plausible reason for the recent weakness in gold mining equities. Indeed, the spot price of physical gold has performed well given the increase and level of real yields. Interest rate expectations have also been a key contributing factor for US dollar strength. The dollar is also inversely related to the price of gold.
The great bull market in spot gold occurred from the end of the Gold Standard in 1971 to late 1980. Over that period spot gold rose from $35 to $666 (chart 3). The rise in spot coincided with the sustained increase in US consumer price inflation from 1965 to the early 1980s (pre-Volcker). The continuous rise in consumer price inflation drove the real interest rate deeply negative over the period in two phases through the 1970s. That period also coincided with the 1973 Yom Kippur conflict (almost 50 years ago to the day). While there are differences in the current episode from a geopolitical perspective and the starting point in spot, interest rates and the dollar, nonetheless, the price of financial risk (CDS spreads) can also be a factor driving gold.
Tactically, as we noted above, the next major bullish phase for spot gold (and global miners) is likely to be when the Federal Reserve pivots “inflationary.” That is, when the Fed is forced to cut rates and/or expand the balance sheet to support the real economy. Our sense is that the best leading indicators of the labour market suggest that is closer than the prevailing bias of market participants thinks. Although while policy remains restrictive, real rates elevated and the dollar firm, spot gold and miners will likely remain under pressure. However, when the Fed pivot occurs miners are trading at a 54% discount to world equities. That would be hyper-bullish for the VanEck GDX ETF.
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