The Stars Are Aligning for Gold

The dollar price of gold is up about 2.7% in the past month, 8.4% in the past three months and 14% in the past year. That’s not only a strong performance, but good evidence that the long 16-month dry spell from Oct. 1, 2020–Feb. 1, 2022, when gold traded in a range between $1,700 per ounce and $1,900 per ounce with very few exceptions, is also over.

Gold has moved to higher ground in the $1,900–2,000 per ounce range since late February, including two interim peaks of $2,078 (intraday) on March 8 and $2,015 (intraday) on March 10. Just as important as the highs were the lows. Gold held the line at $1,900 per ounce and has not closed below that level since Feb. 25.

Today, gold was down quite a bit, but is still trading at $1,950, solidly above $1,900.

Apart from the positive price action, gold investors can take comfort from the reasons for the higher price and higher trading range. The first and most obvious reason is the war in Ukraine.

The war has badly disrupted global supply chains in ways that will not be fixed for years.

This creates higher prices for basic commodities, energy, strategic metals, agricultural goods and all manufactured goods that require those commodities as inputs. The higher prices feed cost-push inflation from the supply side in ways that central banks are powerless to stop in the short run.

The war has also created global uncertainty about important geopolitical outcomes. Will Ukraine prevail against the Russians with NATO and other allied help? Will Russia take over a large part of Ukraine through sheer force and superior numbers?

It’s impossible to predict whether either outcome will result. Indeed, there are many intermediate outcomes between these two extremes. The outcome that has received the least consideration is that the war may drag on inconclusively for years with no decisive result.

Every one of these scenarios is possible. None can be predicted with certainty. The resulting uncertainty drives investors to gold as a safe-haven asset.

The second reason to own gold is the unprecedented economic war between the U.S. and Russia that’s raging side by side with the shooting war in Ukraine. Economic results always receive some consideration in times of war, but there has never been a war where the economic costs of sanctions are greater and more long lasting than the destruction caused by the actual fighting.

One of these costs is a loss of confidence in the U.S. dollar.

It was fully expected that the U.S. would impose sanctions on certain Russian industries, exports and its oligarchs. It was not expected that the U.S. would seize and freeze the reserve assets held by the Central Bank of Russia.

Now that that has happened, every central bank in the world is reevaluating its dollar-denominated reserves and asking itself if the U.S. will freeze those holdings in some future dispute.

Ministers of finance are not waiting to find out. They’re acting preemptively to reduce dollar holdings. The problem with such reductions is that it’s not easy to find alternatives to the dollar because of the lack of large, liquid securities markets governed by the rule of law. That’s a problem that will require long-term solutions.

In the meantime, gold is available to central banks and has proven to be an excellent store of value over centuries, even millennia. Central banks have been net buyers of gold since 2010. Now the tempo has increased in order to shield reserves from dollar seizures.

The third reason for higher gold prices obvious to anyone who has filled up her car with gas or gone grocery shopping is inflation. The U.S. Bureau of Labor Statistics reported in April that the consumer price index for March 2022 rose 8.5% compared with March 2021. That’s the highest rate of inflation recorded since 1981.

Inflation by itself does not necessarily drive gold prices higher. What it takes is a condition where inflation is running ahead of interest rates. If inflation is 10%, but interest rates are 12%, gold might not necessarily rally because gold has no yield.

Gold competes with notes and bonds for investor dollars. An environment with 12% rates and 10% inflation has a real yield of 2% (12 – 10 = 2), which can seem attractive relative to gold.

The opposite is true when inflation is running hotter than interest rates. That’s the environment we’re in right now. Interest rates are 2.9% on the 10-year U.S. Treasury note compared with inflation of 8.5%. This makes the real rate of interest negative 5.6% (2.9 – 8.5 = -5.6).

In that world, gold with zero yield is highly attractive compared with notes with a negative real return.

The question for investors is whether these three conditions — war, lost confidence and inflation — will continue. Unfortunately, the answer is yes.

Even if the shooting stops in Ukraine, the geopolitical uncertainty and supply chain disruptions will take years to repair at best. Confidence in the dollar will not return easily. That confidence has been maintained since 1944, even in the face of the end of the gold standard in 1971.

But confidence is intangible and once lost, it is not easily regained. The flight from the dollar will continue even if it’s mostly behind the scenes in the short run.

And inflation will not abate soon. The Fed is about a year behind the curve and shows no signs of being able to catch up quickly. Even if the Fed raises interest rates a full percentage point between now and June as I expect, real rates will remain deeply negative.

The only cure for inflation is recession. Paradoxically, even a recession may boost gold prices because of the high uncertainty and further loss of confidence in the dollar that come with a downturn. Gold rose 2,700% from 1971–1982 despite three recessions (1974, 1980, 1981).

What this means is that the gold rally has far to run. The initial gains are rewarding to patient investors, but they are just a beginning compared against the rally yet to come. The war will get worse, lost confidence will not return and inflation has far to run.

That’s a bad recipe for American citizens. But it’s a perfect recipe for higher gold prices.


Jim Rickards
for The Daily Reckoning

The Daily Reckoning