Gold: The Everything Hedge

My All Clear Ahead! outlook from early November was wrong. Even though Jerome Powell and the rest of the players at the Fed had been increasingly accepting inflation’s staying power, I saw how he telegraphed the tapering of bond purchases for months before actually doing it and assumed it would be the same for rate hikes.

Within weeks it became clear that hikes will happen sooner. Ironically, even though rate possibilities push gold around every day, I don’t actually think rate hikes really matter that much. I’ll reveal my conclusion now (spoiler alert!): markets will only tolerate rate hikes if the economy is strong, in which case gold and metals can rise right alongside a few hikes; if the economy falters even a bit the Fed will be forced to lower rates again, which would cement negative real rates and the need for security thus supporting gold.

But that’s a considered outlook. I don’t mean to call myself smart but I think right now markets are too busy trying to trade what Powell might do – how much might he accelerate tapering? How soon might they raise rates? – to step back and put the question of rates in context.

That context is admittedly confusing. The confusion is most obvious in bond yields. If inflation is here to stay in a real way, you would think bond yields would be rising across the board. (Inflation makes a dollar today worth less in a year or two or ten, so bond prices decline when inflation is strong. When bond prices fall, yields rise – investors demand more yield to compensate for the value loss.)

Not so much. From mid-November to early December the 10-year yield fell off a cliff, dropping as low as 1.356% on December 3. It has since bounced back to 1.5%.

Why did it drop? Has to be because bond traders saw less inflation ahead following Powell’s comments about inflation sticking around. They might think raising rates will hurt US growth or they might think the market will not tolerate hikes and the resulting correction will force the Fed to backtrack. Or both.

We’re getting another inflation print on Friday, for November. Bloomberg surveyed economists and the median forecast is that CPI will be up 6.7% year over year. Yep, even higher than the oh-my! 6.1% number from October. Jeffrey Gundlach, famous chief investment officer of the large DoubleLine fund, is expecting 7%.

Another strong inflation print will simultaneously do two things.

1. Encourage hawkishness from the Fed. The Fed meets again next week and will very likely announce an acceleration of the taper program. I think they will leave rate hikes off the table until tapering is done…but doubling the pace of the taper would put hikes back in contention by April rather than July.
2. Make real rates even more negative.

Traders sell gold on the expectation of rate hikes, even though that’s a backwards move because gold reliably gains with rates early in a hiking cycle. Nonetheless, knee-jerk selling on the idea that higher rates are bad for gold is very reliable.

Of course, real rates are already negative and strong inflation pushes them farther down. And even more negative real rates argue for gold.

So which way will gold go if we get a strong inflation number on Friday? I don’t know. The cynic in me says gold will go down, because traders are so obsessed with keeping ahead of the Fed. But I can also see gold gaining with such news (remember a month ago when it gained $40 per oz. on the October inflation number?), because 6.7% inflation is very significant.

6.7% inflation steals a lot of one’s buying power. It erodes carefully built wealth in a very real way. As such, it demands response.

That demand is exactly why the Fed is accelerating tapering. They will have to raise rates but they can’t until the taper is done, because overlapping the two kinds of tightening is a sure-fire way to create market chaos. They tried that in 2018 and the market Taper Tantrum-ed until the Fed backtracked and lowered rates again.

So. A strong inflation print on Friday ensures a faster taper and brings rate hikes forward. That means two or three hikes in 2022, according to surveys of economists and the CME FedWatch Tool.

This FedWatch tool estimates future rates using Fed Funds futures contract prices and that approach gives 70.5% odds that three is the max number of hikes next year.

What would three rate hikes do to gold? I discussed this in two webinars already this week. Here’s the slide I used. You can get the full replay for one of those webinars here.

Bottom line: for gold, I don’t think it matters if we get a few rate hikes. Either the economy will remain strong through the hikes, in the kind of inflation-driven growth that is ideal for all commodities including gold, or the economy doesn’t handle the hikes and the Fed has to backtrack, which would cement negative real rates as the new normal and prompt people to consider safe-haven investing.

I think gold rising alongside rates and inflation in a growing economy is the more likely outcome. China’s recent pivot to supporting its economy supports that outlook. And even the gold-up-alongside-rates setup comes with an important caveat: the economy can’t handle rates of any magnitude. It’s widely accepted now, even by members of the Fed, that the new ceiling for the federal funds rate is 2%, well below the old 4% top. The flattening of the yield curve of late conveys the same message: a few hikes and then done.

Given the Fed targets 2% average inflation (which suggests a notable period higher than that, to counter the less-than-2% inflation we’ve had for years), the math is simple: rates are staying negative.

How much attention will people pay to gold in such a setup? That to me is the real question. Investors are undoubtedly more interested in stocks.

That is a pretty crazy chart, hey? Investors have put more money into equities in the last 12 months than in the previous 19 years combined. It was the Hedgeless Horseman who pointed out this chart for me in this post. He followed it with this chart, which is also crazy.

This is margin debt being used in trading. Ooh-e.

I am not saying the market is going to roll over. I have no such foresight abilities. But we are in a weird world. Bond yields should be much higher than they are given inflation. Sprott is always pro gold and so I take their data-drive analyses with a grain of salt, but here’s an interesting quote from a recent Sprott Monthly Report:

Above 8%…but instead trading at 1.5%. That’s weird. So are immense debt levels and M2 money supplies and endlessly surging equity valuations and so much margin in equities and and and.

I think all of this generates two results.

One: gold feels boring to traders making multiples in the stock market. Fair enough. Whether it’s cryptos or tech or shipping or real estate or nutrition or fashion or whatever else – the market has been doling out returns and investors are entranced.

Two: investors who have been through speculative whooshes before will increasingly move to hedge their exposure. Gold is an obvious option. This will not generate a sudden uplift but I think it could well build support over time. And should markets tumble, gold will do what it usually does: initially get sold alongside but rebound first and hardest to rise to new levels.

The webinars I hosted this morning focused on the relationship between gold and inflation. One of the CEOs commented that, as cryptos have led equities to these heights and modern monetary theory has taken hold, he and the investors he knows increasingly see gold as a wealth protector, a fundamental holding there to hedge everything else.

The comment caught my attention. It makes a lot of sense but it feels counter to the game we play with junior gold explorers. With juniors, it’s about picking winners, about discoveries generating multiples overnight, about risk and excitement.

Or is it? To be sure, pre-discovery explorers are heavy with risk and excitement. But even with that burden – they will rise with the tide. It comes back to that saying I referenced a few weeks back: if you believe in gold, just be in.

I think gold will work very well for the next few years. The weirdness, the fact that it works whatever happens with rates, the negative real rate reality, the risk in equities – gold hedges it all. Heck, even central banks that haven’t bought gold for years are buying again now, including Ireland and Singapore.

That role as an everything hedge should create a rising tide.