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Enjoy The Quiet. It Won't Last.

It’s been a while since I wrote about the price of gold. Time to revisit the yellow metal – though to be honest, we haven’t missed much.

Gold has had a pretty boring couple of months. After running to almost $1300 per oz. in January and then falling back to $1150, the yellow metal has sauntered sideways, staying mostly between $1170 and $1215 per oz.

When it manages to attract attention, gold’s narrative remains stuck on the same points. When will the Fed raise rates? Are the US markets topping? What will happen with Greece and the EU? Is the US economy really growing? What’s the outlook for the greenback?

On a day-by-day basis, much can be said on each of these points. Stepping back, though, the drama dies away and it looks more like these macro questions simply make up our new normal.

The markets have gotten used to the endless debate over rates, to the unsustainable mess that is Greece, to a constant argument over US market valuations versus economic indicators. Even the most ardent gold bugs seem to have quieted their prophesizing that money printing is leading the world towards fiat currency collapse, despite continued quantitative easing in Europe and Japan.

As the market has relaxed into this new normal of uncertainty, gold too has calmed.

In some ways that’s great. Summer is always a quieter time in the mining world and we all need the break, whether the markets are hot or horrid. For gold to be reasonably staid means mining operators and investors can walk away for a few days without stressing that the sector will shoot up or plummet down while they are gone.

However, don’t let gold’s calm façade lull you into complacency.

For one, deluding yourself that current conditions are a new, long-term normal makes you part of the status quo-biased market masses: the huge number of investors and analysts who expect that current conditions will persist tomorrow, next month, next year.

It’s easy to see the comfort in expecting more of the same. We can know why the markets did what they did yesterday, but we cannot know what they will do tomorrow – and you only have to get burned a few times before you stop wanting to guess.

But stock markets are nothing if not cyclical, which means change is always pending.

Today is no exception.

In the hierarchy of investment popularity gold is currently on the bottom, buried underneath US equities that have been gaining for six years. That’s an age in the investing world and so it has cemented the status quo bias that gold is dead and US stocks will rise forever.

Supposedly supporting that notion is the belief that a Fed rate hike would be bad for gold. But just as the US markets will not rise forever, neither is a rate hike bad for gold.

Historically, gold’s biggest bull runs coincided with high and rising rates and its long bear stint in the 1980s and 1990s paralleled declining interest rates.

In addition, there are solid structural reasons to believe a rate increase would help gold (after an initial, emotional dip).

First off, gold garners support from the Fed’s rock-and-hard-place position. The Fed wants to see inflation reach at least 2%, indicating significant and real economic growth, before raising rates. When that happens, increases will be teensy because each inch up in rates adds a mile to the government’s debt costs.

So once inflation bests 2% rates will be inched upward – but small rate increases mean real yields will remain negative!

This is important. When inflation is greater than interest, the deteriorating power of the dollar eats up all the interest earned on a deposit and then some. That’s known as a negative real yield. Real yields are what really matter and when they go negative the conventional financial instruments that rely on interest rates – bank deposits, bonds, T-bills, and the like – become financial sinkholes.

So interest rate-driven instruments are a bad choice if rates rise. And that matters because rate increases also push down on the markets.

Higher rates hit corporate profits, increase debt-servicing costs, and reduce consumer cash on hand, all of which drag on valuations. Stocks start to underperform.

That prompts bond investors, who had been forced into stocks because low rates made their regular yields disappear, to desert equities. Since this is a large group, their selling pushes markets even lower.

Where do these safe haven seekers go? Not into bonds. The assumption that interest-paying bonds are the obvious choice in a rising-rates environment doesn’t hold water, in general and today in particular.

There’s the negative real rates problem. Then there the fact that a bond is a debt contract that pays a fixed yield fixed (the coupon). To remain viable, though, its yield has to match current rates. That means when rates are rising, bond prices have to decline until their fixed payments match current rates.

In other words, when rates rise bondholders watch their principals erode away, unless they can stomach actually holding bonds until maturity (damn tough when rising rates mean new bonds with higher yields are constantly available).

So when rates rise, stocks decline and bonds are unforgiving. It all means that, despite not paying interest, gold really does make sense in a higher or rising-rates environment.

That logic become action during gold’s last bull run, when interest rates were much higher than they are today. Between 2001 and 2011, 1-year and 10-year Treasury yields averaged 2.2% and 4.1%, multiples of today’s rates. Yet gold shot up 7-fold. Clearly gold can gain even when interest rates are higher.

Today we have a market aching to see rates raised, to assure everyone that the US economy is indeed doing well and to create the tiniest bit of wiggle room should things head south again. But rates will only go up if inflation is established and, odds are, will rise more slowly than inflation. Thus real rates will remain negative.

At the same time, rate raises generally push down on stock markets and thus push investors away from equities and towards ‘safer’ investments. However, the Go To safe haven spots are financial sinkholes in a negative real rate environment, inflation eating up their yields. The potential for further rate increases only worsens bonds’ appeal, since that ensures prices will go down.

And all that will happen in a world where bonds, supposedly the world’s most reliable instruments, are acting as volatile as a junior miner. OK, maybe not quite that volatile, but close.

Bonds are generally in uncharted territory, with prices falling and yields rising with record speed. In fact, Q2 is shaping up to be the worst quarter for sovereign bonds in decades: the Bank of America Merrill Lynch Global Government Index is down 2.9% since the end of March, which if it holds will mark the biggest quarterly loss since 1987.

The reason: bonds had moved into the surreal world of negative yield because traders assumed that, with the European Central Bank buying 60 billion euros worth of bonds every month, EU bonds would be scarce. Low availability meant high prices, which for bonds means low yields.

Except that six years of fiscal effort are finally paying off and the EU is coming back to life. That lift overwhelmed the scarcity effect on bonds. Now that deflation play is unwinding. Bond prices are dropping and yields rising. The rapidity of the change is shocking for the bond world.

And shocking is exactly what the average bond investor does not want. Bonds are supposed to be safe instruments. Today that safety is clouded by worries of a crash, or more generally concern that the world’s unprecedented experiment with quantitative easing and debt will hold interest rates in check for a long time, rendering bonds unappealing.

Gold carries none of these concerns. It has the longest track record of cyclicality of any asset. It is cheap to buy today. There are legion reasons its price should climb, whether rates rise or not. Heck, you can even add seasonality to the list right now, as gold is usually weakest in June.

Timing is uncertain, but the essence of the gold bull argument remains strong. In the meantime, establish positions in the best exploration and mining stocks out there. And then sit back and try to enjoy the sector’s summer stillness – because it will not last.

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-E (August 2019)

Thanks Gwen. Always enjoy your views. Tough market to read short term. Long term metals / energy look very strong.

-NH (October 2022)