As a student of macroeconomics, I find the monetary roles of gold fascinating. Gold has been used as money for thousands of years. In today’s world, credit assets without counterparty risk, including gold, provide valuable cover for investors. This is why the late JP Morgan in 1912 said, “Gold is money. Everything else is credit.”
Money is supposed to be boring. It’s supposed to be as boring as possible. Money is not supposed to be risky. It’s not supposed to promise a big reward. It’s supposed to be the same day after day, for millennia. Hence, gold.
As one can imagine, silver plays a role in every investment portfolio as the ultimate liquidity. As such, gold should not be expected to consistently outperform other higher risk assets. But there are times when rock beats scissors, paper beats rock, and boring beats risk.
As I predicted in my previous article on gold, the Fed’s rate hike cycle triggered the next phase of the gold bull market. The signs are now a “go”. Houston, gold-backed funds like the SPDR Gold Trust ETF (NYSEARCA:GLD) are ready to go, done.
Following BASEL III, gold was added to the list of Tier 1, Tangible Zero Risk Assets, by the Bank for International Settlements. This puts gold in the same class as cash and treasury bills.
Gold is a superior form of money as it sports a high stock to flow ratio of around 67. This means that the supply of gold has increased at a rate of around 1.5% over the past 100 years. . While technology has made gold production better and more efficient, gold reserves are dwindling and the grades of deposits are declining, overall.
This compares to the M1 and M2 money supply growth rate of 13% and 11% in February. According to the US Debt Clock, the ratio of the annual increase in M2 to the annual increase in global ounces of gold is 21,160 to 1. Today, the gold/M2 ratio is much lower to the 50-year average. A reversion to the mean, with no further M2 growth, implies a gold price of $2,600 per ounce. The table is below.
The following is a chart of the price of gold (black) and the 10-year-2-year Treasury yield curve (orange). The yield curve has fallen significantly over the past 6 months. The curve is rapidly heading into negative territory. Note that when the yield curve breaks below 0.50, it coincided with a rise in gold. This has happened twice in the past two decades, starting in 2005 and again in 2018. While the curve was below 0.50, gold rose at a CAGR of 24.7% and 18 .6%, respectively.
The yield curve fell below 0.50 for the third time. Gold has risen 5.8% since then, at an annualized rate of 49%. This suggests that the next phase of the gold bull market has begun.
Inflation has hit long-term highs of 7.9% and is likely higher than that. Real yields have fallen, including the 10-year Treasury note which now offers a negative real yield of 5.5%. It is very attractive for gold.
Investors may be wary that these negative rates necessitate a rise in nominal yields and that this rise will be negative for gold. The problem is that the US government cannot afford significantly higher rates. If the average US public debt rate increased to 7.6% by 2051, interest payments would consume more than 25% of US GDP. Every 1% increase in interest rates now increases debt service by about $300 billion, or about 1.4% of US GDP. Due to these conditions, rates cannot rise significantly without causing serious economic problems.
Oil is an important input cost for gold mining production. Oil prices have risen in 2022 and are supporting higher gold prices as costs rise. I continue to be positively bullish on oil over the long term unless we experience a recession. The article “Oil crisis unfolds in slow motion” published by Goehring & Rozencwajg does a great job explaining the current oil market. Here is an excerpt from the article:
Today, oil represents less than 3.3% of US GDP and is expected to rise to $140 a barrel before approaching the critical 5% threshold. Why are we only focusing on the United States? Demand is most elastic in wealthy, energy-intensive countries and least elastic in developing countries that need energy to fuel their ongoing development. In 2008, prices soared to $145 a barrel, albeit temporarily. In this cycle, we believe that oil prices will at some point reach and potentially significantly exceed the previous high of $145 a barrel before we start to see signs of demand destruction.
These are several of the reasons why I expect oil and gold to perform better.
In my last article on gold, I highlighted the massive cup and handle pattern on the gold chart, below:
The handle played faster than expected. I expected the handle to bottom near the Fed’s first rate hike, which happened on March 16th. Instead, gold immediately started going up. I suspect events in Ukraine prompted the early start. The cup and handle pattern is nearly complete and signals gold prices in the $2,500-$3,500 range by 2024.
This coincides with a long-term bottom in the spread between COMEX Gold Swap Dealer Spread positions and COMEX Gold Managed Money Spread positions. A rally in gold usually follows when this spread falls below zero. This was the case between 2006 and 2008. At the end of 2021, the gap was the lowest for a decade.
Gold bulls may breathe a sigh of relief as gold was able to hold above the 40-month moving average. For a moment, it looked like gold might repeat 2011. While the chart isn’t out of the woods yet, I want to point out a key fact: the rate hikes have already begun. In 2011-2013, the Fed announced tightening and rate hikes. Today, the market has taken this into account.
Gold is now above the 40 and 12 month moving averages, a key condition during the bull market of the 2000s. The 12 month RSI has recovered above the 50 level, also a condition of the last bull market.
The RSI is now above its 14 moving average. This condition has flagged every major race in the last 20 years. Given technical and fundamental conditions, I compare the current gold market to that of 2005. The fed funds rate was rising, oil was booming, and real yields were negative.
Gold tends to be correlated to bond performance, primarily in response to changes in yields and economic uncertainty. One could easily suggest that the recent strength in gold is the result of the uncertainty that resulted from the war in Ukraine, and I’m sure that had an impact. But curiously, a tendency had taken shape before the war. Gold (black) and bonds (blue and green) started to diverge in January. I think this is the market adjusting to persistent inflation and fully pricing in Fed rate hikes. We should expect bonds to perform in the face of such uncertainty. This may be the start of something big.
Finally, the DXY benefited from the anticipated quantitative tightening, rate hikes and economic uncertainty. Again, I see similarities between the current DXY and 2005. The RSI was similarly stretched during a corrective move in a secular bear market. If the DXY rolls from here it will provide jet fuel for gold.
The SPDR Gold Trust ETF is a premium-free, highly liquid vehicle for gold exposure. Investors can use GLD to gain exposure to gold with the benefits of owning a brokerage account, including features for options and stop-loss orders.
It’s not always a good time for gold. Right now, conditions are favorable and investors can seek protection against inflation, rising rates and uncertainty in this risk-free Level 1 asset. Gold is sitting on the launch pad and has just received orders: launch.