You might just as well flip a coin ..... a gold one, naturally.

Thursday 5th October 2017

You might just as well flip a coin ..... a gold one, naturally.

ref :-  " Higher rates and low inflation test gold's mettle" , Analysis / Commodities , Markets and Investing, The Financial Times

It wasn't the pretty picture of gold ingots and jewellery on the back of the FT that caught our eye this morning  --  rather, it was the two little charts tacked alongside. Not that they reveal anything the world doesn't already know :  1) because it's quoted in dollars, a strong dollar (that makes the mettle more expensive for investors not based in the US currency) is BAD for the market price; and 2) So too are higher rates, which makes gold less attractive to investors because it does not offer them any yield.

But it's interesting to see in graph form just how close the correlations are between both the dollar and rates, and gold. More accurately of course, we should say "the INVERSE" correlations : the dollar and rates UP, the yellow metal DOWN , and vice versa.  Take a look if you can at the relationship between gold and the Dollar Index from the start of the year, and between gold and real US rates going back to before the financial crisis  --  you'll see what we mean.

We've traded a fair bit bit of gold in our time and in a thoroughly unprofessional way we retain a certain fondness for the gold market ..... which is not at all the same thing as saying that we're natural gold bulls. As we alluded to earlier this week in a slightly different context it can be a dangerous game for something known as a safe haven, and can move at least as quickly on the way down as it does on the way up. As ever, the influence of nervous traders holding highly-leveraged futures positions is not hard to spot.

For the most part, 2017 has been a pretty happy year for holders of gold. Around the turn of the year, investors began to get over the Trumpflation fever that had greeted the election of the new President. They realized that he was going to have great difficulty in making good his promises on growth. Cue : a fall in previously rising yields and rate expectations, which in turn initiated a sharp reversal in the fortunes of the dollar that had been on the up for so long  --  both developments good for the gold price. In addition, the safe haven features of gold have drawn support from one real or potential geopolitical risk after another, of which the N. Korean thing is just the latest.

By Sept 8th, gold had hit a high of $1,358 per oz, a rise of 15% this calendar year. But since that time, it has fallen back to $1,270 (at one point yesterday), just as the dollar has rallied alongside expectations of rate rises. The reason ? Obviously, it's mostly to do with the administration finally getting to lay out it's tax proposals (in a general sort of a way), and a reigniting of the hopes for growth that lower tax rates engender. As regulars will know, there are some serious reasons to be cautious about what modifications will have to be made to the proposals in order to get a bill passed into law, but that hasn't stopped a renewed bout of enthusiasm for the Trumpflation trades that had waned throughout the administration's stumbles of 2017.

In fact, the recent fall in the price of gold brings to mind its 10% drop during the period between Mr Trump's election and the end of 2016  --  the original bout of Trumpflation excitement.

If it should all peter out one could expect gold to regain some benefit from a dollar back on the defensive and a reining back of expectations for higher rates  --  just as one could expect it to suffer if faith in Mr Trump's growth-inducing measures (and importantly,his ability to get them through Congress) is restored.  Those are the kind of factors one would normally expect to take into account when considering the prospects for gold. But there is one scenario that looks as though it could become a reality which is anything but normal.

Historically, gold has been used as a hedge against inflation. Even if its effectiveness in that role does not always stand up to the closest scrutiny, one could say that in many ways it's THE classic insurance against rising prices. It's often been the flip-side and compensating factor to rising rates, which of course are frequently being raised specifically to counter upward inflation pressures. But now gold is facing a potentially toxic combination of a Federal Reserve keen to continue the rate-rising cycle despite inflation remaining stubbornly and mysteriously low.

*** NOTE : If anybody asks you why inflation refuses to accelerate when all wisdom (until now, at least) says it should, you can honestly answer that nobody really knows  --  not really and truthfully. But if you offer three things :

1. Globalization

2. Technology

3. Demographics

...... you've probably got it covered.

Anyway, the Fed is giving a very good impression of a body determined to hike rates in December and what's more, the dot-plot reveals that the median view among members is that they expect to raise three more times in 2018. That would suggest  they still have considerable faith that the old laws about tight labour markets begetting inflation will reassert themselves  --  eventually  --  but they do have others reasons to consider hikes, fear of asset bubbles for example. Whatever the case, rates up but no inflation is a BAD combination for gold.

The FT is suggesting therefore that we are at a critical juncture not just for gold, but also for the dollar and interest rate-based instruments such as US Treasuries. Will the Fed really have the appetite to keep raising rates even if inflation refuses to make a meaningful appearance ? And beyond that, will the administration be able to get its fiscal stimulus packages (tax, infrastructure spending etc) through a Congress where the Republicans may hold majorities, but can't count on the support of all in their party ?

Recent action in the gold price and falling numbers of speculative bulls on New York's Comex exchange point to falling confidence in gold-friendly conditions to come, but frankly neither is a totally reliable indicator. Expecting a rate hike in December and three more next year is assuming an awful lot. Sure, it's bearish for gold if it happens but if the market prices in rate "normalisation" on that scale and it doesn't pan out, which is very possible, the future for gold may be a bit rosier. And as for the dollar, some may think of it as undervalued because of its weak performance this year but it's still stronger than it was between 2006 and 2014, and is not immune to further downside moves. That too could happen if other parts of the world follow suit with monetary tightening that definitely hasn't been priced in yet.

All things are possible, and "beware of market sages talking their own book". Some long-held market assumptions may be in doubt, about inflation for instance, but that's a market maxim that will always hold true.