Gold Price Strength Shouldn’t Be a Major Surprise

The recent decision by the Federal Reserve to raise interest rates in the face of a rapidly weakening global economy has given a new lease of life to gold.

A year ago, oil and other commodities signaled that potential turmoil was coming to the global economy. Now the signal is starting to come from gold.

We’ve commented consistently that we expected gold to firm in the wake of the US rate rise – not fall – contrary to what so many other market-watchers had predicted. In formulating our views we’d looked at the underlying health of the US economy, along with actual evidence from previous rate-rising cycles over the past 50 years.

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At the end of the day it’s about negative real interest rates, where the rate of inflation is still well above the underlying rate of interest.

As we’ve previously written, “The Dow Jones at record levels does not necessarily reflect a robust economy – it’s in many respects a reflection of an equity market that’s been pumped full of Fed-administered hot air.”

The Federal Reserve made a big mistake when it raised interest rates in December. It wasn’t the mixed economic data that caused the change in policy, it was a desire to ‘normalise’ monetary policy. The data makes it seem like the US economy is on a roll, when it clearly is not.

Firstly, the US labour force participation rate is averaging 4% less than it did a decade ago, prior to the Great Recession. This means 10 million unemployed people are categorized as having given up looking for work and not in the labor force. They are therefore unemployed – and if properly accounted for – the unemployment rate would be reported as being a little over 10%.

Secondly, the unemployment rate is determined by a survey of 60,000 people each month. It’s like a giant poll. If a person says they have started a business they are counted as employed. If they lost their job and can’t find one, but start up an E-bay business selling stuff from home, they are counted as fully employed – no matter how little their business makes.

Many people who can’t find work try to pick up what they can by starting some sort of small service business. This little known fact makes a mockery out of the headline numbers.

Other data also paints a less than glowing picture of the US economy, as recently released US 2015 fourth quarter GDP was just 0.7%. To demonstrate how worried the markets are, the Japanese 10-year government bond fell to negative interest rates last week.

The rate has never been negative before and this movement is not confined to Japan. Rates on debt instruments perceived as safe are falling everywhere. It is possible the yield on the German 10-year bond may also fall below zero.

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10-year Japanese Bonds, Source Bloomberg

Markets’ Loss of Fed Confidence

Markets are expressing a loss of confidence in the global economy and a loss of confidence in the Federal Reserve, as Chairman Yellen commented this week that the Fed may pause on expected additional rate rises this year based on outcomes in the economy.

What’s intriguing is that The Fed has consistently ‘talked tough’ with respect to interest rates, seemingly recognising the dangers of keeping rates too low for too long. It has also pointed to economic growth in the US as clear evidence that its ‘easy money’ policies have been working.

Yet it seems to now be admitting what we’ve been saying for some time – that all isn’t well. Something the Fed hasn’t previously been prepared to directly acknowledge for fear of spooking markets.

One lesson here is that the Fed’s great monetary experiment since the recession ended in 2009 looks increasingly like a failure. Recall the Fed’s theory that quantitative easing (bond buying) and near-zero interest rates would lift financial assets, which in turn would lift the real economy.

While stocks have soared, as have speculative assets like junk bonds and commercial real estate, the real economy hasn’t. The Wall Street Journal recently commented that “This remains the worst economic recovery by far since World War II, and we’ll be watching to see if financial assets now fall to match the slow real economy.”

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The table above is courtesy of The Wall Street Journal and compares GDP growth projections by the Fed’s governors and regional bank presidents to actual results. What it highlights is how optimistic the Fed has been with its growth forecasts, with actual growth rates falling well short. Fed policy was also supposed to raise inflation to its target of 2% a year, but it has failed even that test.

The same monetary also lesson applies to the rest of the world. Bond buying and near-zero rates have been implemented worldwide, but the global economy has to this point failed to respond with faster growth. The European Central Bank’s bond has so far prevented a recession, but European growth remains sluggish.

Meanwhile, the emerging-market economies that benefited from capital inflows during the height of QE are now seeing those flows and economic growth recede. China is trying to clean up its stimulus excesses without going into recession.

However the far bigger concern lies in the fact that financial markets have become so dependent on QE and artificially-suppressed interest rates that it will be very difficult for the Fed to reverse these policies without major repercussions.

Markets of course have typically been comfortable with the ‘easy money’ scenario continuing, as it will help maintain the value of already-inflated share and property investments. For now the game of musical chairs continues, but the day of reckoning seems to be getting closer.

Good News for Gold

All of this of course is good news for gold, for which I am an unashamed bull – as it remains the ultimate ‘insurance policy’ for investors and which has stabilized and strengthened in the wake of the Fed announcement.

As I read in a recent article, “As bond yields have been dropping gold, has been rising. But bonds can only go so low. Once the rates are negative the bond buyer is the one paying interest. At some point it would be better to ask for cash and pay for a safe deposit box.”

Gold however has no real top – and with each bout of bad news, gold can keep its rally going. And the Fed is signaling they won’t step in for some time. Gold tripled in value during the Great Recession, has since fallen back by more than 40%, but just this year has rallied by 10% off its lows.

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The latest statistics further reinforce this demand strength. Buying by central banks as well as Chinese investors seeking protection from a weakening currency have helped lift gold demand for Q4 2015 – and the trend looks set to continue.

The World Gold Council reported last week that China remained the world’s biggest consumer of gold, ahead of India – with economic headwinds influencing purchasing.

Chinese demand for gold coins surged by 25% during the fourth quarter compared to the same period a year earlier, as consumers sought to protect their wealth after Beijing devalued the yuan currency. But stock market turmoil and a slowing economy negatively impacted consumer, with Chinese demand for gold jewellery falling by 3% compared to the previous year. Indian jewellery demand reached its third-highest level on record in 2015 at 654.3 tonnes.

It’s clear that central banks have continued buying gold in order to diversify their reserves away from the US dollar, with purchases firming to 588.4 tonnes last year, second only to a record high of 625.5 tonnes during 2013. In particular, central bank buying accelerated sharply during the second half of last year and jumped by 25% during the fourth quarter.

Investment demand for gold is also improving and flows into exchange-traded funds (ETFs) turned positive this year. Barrons reported last week that gold ETFs are going global, and one strategist contends that wider ownership will fortify the precious metal from selling by fickle American investors.

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“You can quibble about magnitude, but a flood of dollars into gold-tracking exchange-traded funds seems to be stoking a rise in price of gold itself. John Teves, a strategist at UBS, notes on that global ETF holdings have increased by 3.86 million ounces so far this year, and that fully two-thirds of this haul is from U.S.-listed funds such as the SPDR Gold Shares (GLD). This ETF has already taken in $2 billion in 2016, essentially recouping last year’s $2.2 billion full-year outflow, according to”

At the same time the global supply of gold fell by 4% last year to 4,258 tonnes, partly because of slower mine production. Mining companies have scaled back since 2013 in a bid to slash costs, with mine production shrinking during the fourth quarter of 2015 – the first quarterly contraction since 2008.

Accordingly, I maintain our optimistic price forecast on gold of between $1,100 and $1,300 during 2016.