Since our article Friday morning gold and silver continued their rally and crypto’s joined with a vengeance as well. The current theme is most definitely a flight to safety and specifically a flight to alternative monetary investments. Late last week saw multiple news events building a very strong case for negative real interest rates on their way and the threat of war, and specifically a middle east (read ‘oil’) war.
Gold cracked US$1,400 and Bitcoin through US$11,000. In local terms at the time of writing we are looking at AUD2027 gold and AUD15,750 bitcoin. Each is up 3.7% and 15% respectively in just the last week.
Quite simply, the argument against each is there is no yield (which we debunked in our 15 year investment comparison here
). When rates drop below inflation (negative REAL interest rates) that becomes a non argument. When rates are dropping due to the level of fear of recession and war before us, people then weigh up the risk of deposits in a bank (for nil return v bail in
) versus a hard, uncorrelated asset without counterparty risk. Few credit Bitcoin for such a correlation but that is changing quickly. The chart below highlights what we’ve witnessed this year.
The researchers at Goldmoney some time ago developed a gold pricing model that has proven to be a remarkable predictor of the gold price. That model principally takes in 3 factors determining the price of gold. In their words:
“In a nutshell, we found that the majority of changes in gold prices can be explained by just three drivers: Central bank policy (more specifically real-interest rate expectations and QE), changes in longer-dated energy prices, and central bank net gold purchases (the least important driver). These three drivers can explain over 80% of the year-over-year changes in the gold price (see Exhibit 1).”
Whilst they have maintained a view since the end of 2015 (exactly when gold bottomed) that gold will head higher they have been cautious since Trump was elected when tax cuts and irrational exuberance saw the market improve and the Fed start to tighten (raising real interest rates). The end of 2015 also saw the bottom in the oil price.
However the market, and importantly the Fed, is seeing that the Trump effect has worn off. Last week we saw US Manufacturing PMI plunge to a 10 year low and existing homes sales tumble for a 15th straight month, marking the worst run since the GFC housing crisis. i.e. the news wasn’t getting any better after the Fed basically confirmed it was going to keep cutting rates. We saw similar data out of Europe and China. Both the Fed and ECB clearly left the door open for QE to return as well.
They highlight, as we have many times, that when you start an easing cycle from such a low base, you have little way to go other than negative.
“And it’s just the logical conclusion. If the Fed cannot raise rates over 2.5% before the next recession, slashing rates by 5.5% means the new target rate would have to be -3%. That is a level of NIRP no other central bank has come even close to. The Swiss national bank has been keeping its target rate at -0.75% for the past years, but it argues it is doing this to keep the Swiss Franc from appreciating too much as the surrounding economies of Europe struggle, rather than trying to stimulate the Swiss economy. Hence, it seems inevitable that QE will be redeployed when the next recession arrives, and rates will cut to at least zero.”
Their closing summary and updated gold price prediction table are as follows:
“Hence in our view, it’s a question of when – rather than if – the U.S. enters the next recession. In a few weeks, this will become officially the longest period of economic expansion in U.S. history, exceeding the 120 straight months of economic expansion from 1991 until 2001. Given the strong headwinds for economic growth, we have little hope that this expansion has a lot more lifetime. And it seems that the Fed is now agreeing. While the Fed has left its target rate unchanged in the June meeting, both the language in the Feds’ statement as well as the rate expectations of the individual FOMC members has changed significantly. At their March meeting, the median expectation of the FOMC members for end of 2019 and end of 2020 rates was 2.375% and 2.625%. Three months later the end of 2020 expectations have dropped to just 2.125% and while the end of 2019 median expectations remained the same, 8 members now expect lower rates from previously none. The market is taking this as an indication that it is imminent that Fed will reverse course and start cutting rates.
In our view this means that we are now solidly in the next cycle. The risk of sharply higher rates – meaning 5-6% - are firmly off the table. The next big move in real-interest rate expectations thus will be down. The table below shows the model output for different scenarios (see Exhibit 10). It is important to highlight that QE has a positive effect on gold that goes beyond QE’s impact on real-interest rate expectations. Hence more QE will not just push gold higher through lower real-interest rate expectations but is a positive driver on its own. QE’s impact on gold is much harder to estimate in a multiple regression analysis though. Every round of QE had a different impact, and so did the tapering and the subsequent unwind. Hence in the table we show where the model predicts gold prices to go under different scenarios of real-interest rate expectations and longer-dated energy prices. More QE implies that there is more upside to these targets.”