‘Heads You Win, Tails You Don’t Lose’
Boring. I never thought I would say that about gold prices, but the gold price action for the last nine months has been boring.
And that’s actually a good thing. Why?
After beginning with the boring part, I’ll explain. Let me unpack this…
Gold prices hit an all-time high of $2,069 per ounce on August 6, 2020.
The yield-to-maturity on the 10-year Treasury note hit an interim low of 0.508% on August 4, 2020. The near simultaneity of those two benchmarks is no coincidence.
The interest rate on the 10-year note has been practically the sole determinant of the dollar price of gold since that August convergence of low rates and high gold prices.
But that isn’t always the case…
More Than Meets the Eye
Many factors can affect gold prices, including fundamental supply and demand, geopolitical and other external shocks, liquidity preferences in market drawdowns, and the distinction between real rates and nominal rates.
I watch all of those factors closely and include them in my analyses.
Still, those other factors haven’t mattered much to the gold price lately.
Supply and demand are in a rough balance. Global mining output is flat, and Russia, a major gold buyer, is curtailing its large-scale buying. We’ve also had geopolitical shocks in Ukraine and, most recently, Gaza.
We’ve had other external shocks, such as the U.S. presidential election debacle and a riot in the Capitol.
None of these events seemed to matter to gold.
In short, these external, non-rate factors haven’t mattered to gold. The gold price is looking exclusively at the yield on the 10-year note.
At the same time, there haven’t been any major market drawdowns in stocks.
The yield on the 10-year note is not an isolated data point. In fact, it’s information-rich. That yield represents expectations on economic growth, inflation, disinflation, exchange rates, capital flows, and returns on alternative asset classes such as stocks, private equity, venture capital and commodities.
The yield on the 10-year note is also a good proxy for capital spending and business investment plans because they involve a five-to-twenty-year forecast.
If you’re building a skyscraper, for example, you don’t finance it in the overnight repo market. You get a two-year construction loan and replace it with a 30-year mortgage. The average period of home ownership for a particular property in the U.S. is approximately seven years.
In short, the 10-year note rate is a summation of a range of rates for investment activity in the real economy. This means we have to break down the drivers of the 10-year note rate to see what it’s really telling us…
Lower Highs, Lower Lows
The 10-year note rate — which is currently about 1.61% — is almost exclusively a reflection of inflation expectations.
There’s no doubt that inflation expectations have been rising, especially after a spike in the CPI core and non-core data, which was reported on May 12.
From the low yield of 0.508% on August 4, 2020, the 10-year note yield peaked at 1.745% on March 31, 2021, and hit a recent peak of 1.704% on May 13 (intraday) on the CPI news before backing down a bit to the current level.
The dollar price of gold has moved down in lockstep as the yield on the 10-year note has risen.
Still, there’s less than meets the eye in the recent increase in rates. As recently as November 4, 2018, the yield on the 10-year note was 3.238%. On November 4, 2019, the yield was 1.942%.
The fact is today’s “high yields” are actually quite low and are much lower than the two interim peaks of the past three years. That means the historic 40-year bull market in bonds, which began in 1980 with yields around 14%, is alive and well.
What we’re seeing is a classic technical pattern of lower highs and lower lows. Based on that pattern, I expect that rates are near their highs for this cycle and will soon retreat to new lows around 0.50% or lower.
I know that puts me out of the consensus. All you hear about now is inflation and rising interest rates. But I’ve seen this movie before.
The One Wild Card
The only shock that would break this cycle and cause rates to reach 3.0% or higher is real inflation. But real, sustained inflation is unlikely to materialize soon. The same forces that have held inflation in check for the past decade and more are still in effect. We’ll have inflation eventually, but not yet.
You can’t look at recent price increases as proof of sustained inflation. Temporary price spikes in lumber, for example, are the product of pandemic-induced shortages, not a general rise in overall prices.
The surge in CPI reported on May 12 was driven predominately by base effects (lockdowns produced such low numbers that the year-over-year numbers were bound to be stronger). April 2020 marked one of the steepest output declines in U.S. history. Prices plunged.
Many of those prices are recovering especially in the areas of travel, airfares, hotels, restaurants and other service sectors that were almost completely shut-down in the first half of 2020. Year-over-year price gains off the low 2020 base are normal. They are also transitory because the 2020 output collapse was transitory.
As we move into the third quarter of 2021, the new base will reflect the strong growth in Q3 2020, when many lockdowns eased. That’s a higher baseline. That means a much steeper hill to climb for inflation metrics.
That’s why I believe inflation will come down sharply, and the ten-year note yield will come down with it.
That’s also why gold’s boring price performance has been a good thing. Essentially, gold is off the top but is nowhere near new lows; (gold was only $1,184 per ounce as recently as August 12, 2018).
The gold bull market is entirely intact…
The Running of the Gold Bull
Gold has traded in a narrow range between $1,700 and $1,900 with very few exceptions since last summer. That’s about a 10% overall range and just 5% above and below the central tendency of $1,800.
In a world of volatile stocks, commodity prices and exchange rates, the price of gold has been well-behaved.
And that’s the good news.
Given rising interest rates, a case could be made that the price of gold should be much lower. But gold has held its own against stocks and fixed income alternatives (not to mention Bitcoin and other high-flying speculations that compete with gold for investor dollars).
If inflation does not appear and rates retreat, gold will rally. If inflation does appear, rates may rise but gold will also rally on inflation fears.
We have been stuck in a rut where inflation expectations are driving rates higher but no sustained inflation has appeared. That’s a tough environment for gold. Still, gold has held its own.
Technically, this is what we call an asymmetric trade.
Downside is limited because of residual inflation fears, but upside is huge because gold prices have been moving inversely to interest rates and a plunge in rates is likely to occur.
You can call it, “Heads I win, tails I don’t lose.” When it comes to investing, that’s as good as it gets.
for The Daily Reckoning