Will the yellow metal’s nonchalance prove president in the months ahead?
With the gold price continuing to rise, the yellow metal approached $1,900 on Jan. 9. Moreover, with the USD Index and the U.S. 10-Year real yield heading in the opposite direction, the medium-term bullion bulls continue to ride the wave higher.
But, with the crowd confusing momentum for fundamentals, the economic backdrop supports a sharp reversion in the months ahead. For example, a subscriber highlighted the recently broken relationship between 10-year inflation-linked bonds and the gold price.
In a nutshell: the gold price should move inversely to real interest rates, as the latter’s strength is bullish for the USD Index and the U.S. federal funds rate (FFR).
In addition, the PMs are non-yielding assets, so when real interest rates are positive, the theoretical nominal return from owning bonds is higher than owning gold. As a result, the combination of a stronger dollar and higher-yielding alternatives depresses the outlook for the yellow metal.
Please see below:
To explain, the gold line above tracks the price tallied by the World Gold Council, while the red line above tracks the inverted (down means up) U.S. 10-Year real yield. We wrote on Apr. 11, 2022:
The historical fundamental playbook shows:
- When a crisis erupts, the Fed cuts interest rates and commences QE
- Real yields turn deeply negative
- Gold rallies sharply
- The Fed normalizes monetary policy, real yields surge and gold plunges
If you analyze the left side of the chart, you can see that the U.S. 10-Year real yield soared and gold plunged during the global financial crisis (GFC). However, when the Fed launched QE and the U.S. 10-Year real yield sunk to an all-time low, gold hit a new all-time high along the way.
Furthermore, the current situation is a spitting image. When Fed Chairman Jerome Powell performed a dovish pivot in late 2018, the U.S. 10-Year real yield suffered. Then, when the Fed fired its liquidity bazooka in March 2020, it pushed the metric to another all-time low. And surprise, surprise, gold hit another all-time high.
However, we're now in stage four of the historical fundamental playbook. With the Fed normalizing policy, the U.S. 10-Year real yield has surged in recent weeks. Moreover, the Fed needs to push the metric above 0% to curb inflation.
To that point, while the fundamentals unfolded as expected, and the gold price sunk below $1,650 in September, October and November, the yellow metal was still far from the lows implied by the U.S. 10-Year real yield. Likewise, with pivot optimism pushing the gold price higher in recent months, the crowd is drooling over the potential return of pre-pandemic monetary policy.
As a result, investors are buying gold and ignoring the U.S. 10-Year real yield because they believe the Fed will fold. Remember, buying the dip has been profitable since the GFC because monetary authorities ran to the rescue during every crisis and saved the bull market. Therefore, it’s hard to break that psychology, as investors rely on what worked for them in the past.
Consequently, with the crowd pricing in rate cuts in late 2023, the medium-term gold bulls will say: “why should we worry about a higher U.S. 10-Year real yield when the Fed will cut the FFR and real interest rates will turn negative in the months ahead?”
Thus, their mindset is to front-run the prospective fundamental environment, and dismiss the real yields they believe will be much lower over the medium term.
Conversely, we believe the thesis is shortsighted:
- Inflation is still highly problematic, and the consensus underestimates the difficulty of returning the metric to 2%.
- The FFR has eclipsed the peak year-over-year (YoY) core CPI in every inflation fight since 1961; and since the YoY core CPI peaked (for now) at 6.66% in September 2022, the historically-implied peak FFR is at least 6.67% , and the crowd is ignoring the historical lessons of where the FFR needs to go to eliminate inflation.
- Nine of the last 10 bouts of rising inflation ended with recessions, and recessions are bearish for gold. During the dot-com collapse, the GFC, and the COVID-19 crisis, gold declined substantially when panic ensued. As such, U.S. Treasury bonds and the U.S. dollar are the primary safe havens during liquidations, not gold.
- While everyone assumes that the FOMC is wrong about higher-for-longer interest rates, we believe the fundamentals support its outlook.
So, while the crowd pushes the gold price in one direction, the fundamentals are far from supportive. In addition, another question considers whether real interest rates can rise if the Fed raises the FFR to 5.25% and then pauses. Historically, after a pause, the answer is no. But, plenty of upside can be realized until then. To explain why, we wrote on Oct. 7:
The U.S. 10-Year real yield often peaks alongside the FFR (or near it). With the Fed poised to raise the FFR by at least another 1.25% (to reach 4.5%), the U.S. 10-Year real yield should have more room to run, which is bullish for the USD Index.
Please see below:
To explain, the red line above tracks the U.S. 10-Year real yield, while the green line above tracks the FFR. As you can see, a higher FFR supports higher real interest rates. Also, when the FFR hit ~4.5% in February 2006, the U.S. 10-Year real yield reached a monthly high of 2.14%, and it occurred with a YoY CPI at roughly half the current rate.
Thus, with the U.S. 10-Year real yield hitting a 2022 high of 1.74% and ending the Jan. 9 session at 1.31%, a rise above 2% is well within the expected range of outcomes. Furthermore, if the FFR surpasses the YoY core CPI like it has in every inflation fight since 1961, the U.S. 10-Year real yield could hit 2.5% or more. Either way, the current market pricings contrast the historical and economic realities required to normalize inflation.
Overall, the crowd continues to dismiss the hawkish warnings from the FOMC. When QE was fashionable, the motto was ‘don’t fight the Fed;’ and now that QT is fashionable, the motto is ‘fight the Fed.’ Therefore, while the bulls want to have their cake and eat it too, the latter creates a bearish environment for risk assets, and they should learn this lesson the hard way in the months ahead.
Please let us know what you think. Why are investors so keen to fight the Fed? Is history irrelevant in this inflation fight? How do you see Powell reacting to their dismissive behavior?
Alex Demolitor
Precious Metals Strategist