• What is the relationship between the gold price and interest rates? Can the gold price rise in the face of rising nominal interest rates? And is it possible for the next bull market in gold to begin as the Fed normalizes monetary policy in 2016?

• The conventional view is that gold prices fall as real interest rates rise. Therefore, most market commentators believe that the gold price will remain under pressure as the Fed raises interest rates in 2016.

• In contrast, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed could mark the start of the next bull market in gold.

• First, markets are discounting mechanisms. Markets have long-expected the first interest rise by the Fed and, after much delay, it would seem that the moment is finally upon us. Various speculators have taken a negative position on gold in anticipation of the event and these positions may be unwound in the months ahead as gold speculators “sell the rumor and buy the fact”.

• Second, the view of the Money Enigma is that the primary driver of the gold price (in USD terms) is confidence in the long-term future of the United States, not the level of real interest rates. More specifically, the gold price tends to peak when people are most pessimistic, and the gold price tends to bottom when people are most optimistic about the long-term economic future of society. Today, most market participants are extremely optimistic about the future of the United States, but this confidence will be challenged as the Fed begins to unwind nine years of highly accommodative monetary policy.

• The third and related reason is that the process of policy normalization by the Fed may trigger a sudden rise in the rate of inflation. The view of The Money Enigma is that the value of fiat money is driven by confidence. Fed policy over the past twenty years has enabled a bubble of overconfidence to develop regarding the long-term prospects of the United States. If the Fed begins the process of policy normalization and is forced to stall or defer this process due to unfavorable market and/or economic conditions, then confidence in the United States may be damaged and the markets could be caught off guard by a sudden surge in inflation.

December 8, 2015

Is There a Light at the End of the Bear Tunnel?

Gold has been in a bear market for nearly five years. Since gold peaked in August 2011, the gold price in USD terms has nearly halved.

Interestingly, this collapse in gold and gold equities has occurred during a period in which both fiscal and monetary policy can only be described as highly accommodative.

On the fiscal side, most developed countries, including the United States, continue to record budget deficits and government debt levels as a percentage of GDP continue to climb. On the monetary side, the Federal Reserve has, at least for now, stopped additional rounds of quantitative easing, but globally both Japan and Europe continue to expand the monetary base. Moreover, none of the major central banks have begun to unwind their bloated balance sheets.

Perhaps more surprisingly, gold has just suffered one of its worst bear markets in history before a single major central bank has their benchmark interest rate even once. In most developed countries, short-term interest rates have been stuck at zero for much of the past five years. Yet gold, which supposedly is a beneficiary of a negative real interest rate environment, has been pummelled.

Clearly, all of this creates a concern for gold investors. If the gold price can’t rally in an environment of monetary excess, then how will the gold price manage to climb in an environment where the major central banks are raising interest rates?

While the concern is a legitimate one, the view of The Money Enigma is that the beginning of monetary policy normalization by the Fed is likely to mark the end of the current bear market in gold and the start of a period of great economic uncertainty that will ultimately drive gold prices much higher.

The theme “the Fed is going to raise interest rates” has been hanging over the gold price now for at least a couple of years. At the beginning of 2014, many experts were certain that the Fed would raise interest rates by the end of 2014. It didn’t happen. But that didn’t stop investors from unwinding their positions in gold.

As the calendar flipped over into 2015, many experts were once again absolutely positively certain that the Fed would raise interest rates no later than June 2015 or, at the very latest, September 2015. Again, it didn’t happen. But once again, that didn’t stop an accumulation of negative sentiment against gold.

Indeed, one of the key problems for the gold price over the past couple of years is that everybody knew that the Fed would have to do something eventually. The Fed can’t just leave interest rates at zero indefinitely. Moreover, consensus is that easy money is good for gold and, therefore, rising interest rates must be bad for gold.

In this groupthink environment, it is a brave junior trader that decides to go long an asset that is an “obvious loser” on the Fed-tightening theme.

So, why might this change when the Fed does begin to raise interest rates?

Until the Fed actually raises interest rates, the question is largely one of “when” will the Fed raise interest rates? But as the Fed begins the process of tightening, the question will become more about the “pace” of tightening. For example, will the Fed raise interest rates by 25bp at each meeting or only every second meeting?

This may seem like a subtle change, but it’s an important one for investor sentiment. Arguably, it is much easier for the Fed to disappoint the markets on the pace of tightening once the process starts. For example, imagine that the Fed does tighten interest rates three times but then the US economy hits a “soft patch”. Suddenly, the Fed is on the back foot and stalls the tightening process. This stalling of the normalization process could easily create a much more positive trading environment for gold.

However, the real upside for gold comes at a slightly later point. At some stage, the Fed will need to decide what is “normal”, i.e. what is the end point of monetary policy normalization.

While many people don’t appreciate it, current monetary policy settings are exceptionally loose by historical standards. Since the 2008 crisis, the Fed has quintupled the size of the monetary base. The Fed has overtly manipulated markets to ensure that both short-term and long-term interest rates are well below historical norms.

If the Fed is genuine about “normalizing” monetary policy, i.e. if it raises interest rates back to historical norms and cuts the size of the monetary base down to roughly one-quarter of what it is today, then it will be a tough environment for gold.

The problem with this scenario is that is likely to involve a cost to financial markets and the real economy that is too great for Fed officials to bear. Indeed, the view of The Money Enigma is that the Fed will find that the economic and political costs associated with a genuine “normalization” of monetary policy are too high and the Fed will stop well short of this goal.

At the point the markets realize that the Fed will not deliver on its obligation to deliver monetary policy discipline, the price of gold is likely to surge higher. More specifically, the value of the US Dollar and other associated major fiat currencies will be undermined and investors will search for good alternatives to fiat, most notably, gold and silver.

In summary, the first rate rise by the Fed has been hanging over gold for the past three years. As the Fed does begin to raise rates, investors will begin to focus not on the start of the normalization process, but on the end of the process. Starting the process of policy normalization is easy for the Fed. Finishing it will prove much harder.

What Drives Bull and Bear Markets in Gold?

While a shift in investor sentiment may help the gold price in the short-term, the real question for long-term investors in the precious metals space is when will the bear market in gold end and the next bull market begin?

In order to answer this question, we need to establish a theory that can successfully explain what drives the major cycles in the gold price.

Many gold market commentators focus on the relationship between real interest rates and gold. The theory is that as the real rate of return on yielding assets rises, an asset with no yield, i.e. gold, becomes less attractive and, therefore, people will sell gold.

The empirical support for this theory is mixed. While it is true that there have been periods where negative real interest rates have been accompanied by rising gold prices, most notably the 1970s, this same price action is not be observed across all time periods.

From a theoretical perspective, it far from clear that real interest rates are the key driver of gold prices. Intuitively, there is a much better case to be made that the gold bull market in the 1970s had more to do with the declining fortunes of fiat currencies than it did with negative real interest rates per se.

So, if real interest rates are not the primary driver of bull and bear markets in gold, then what does drive the price of gold? This is a subject that was addressed at length in a recent Money Enigma post titled “What Determines the Price of Gold?”

In essence, the view of The Money Enigma is that the gold price is driven by confidence in the long-term economic future of society. As people become more optimistic about the long-term economic future of society, the gold price falls. As people become more pessimistic about the long-term outlook, the gold price rises. In this sense, the gold price can be considered to be a barometer of pessimism regarding the long-term future of the United States.

Why is the price of gold inversely related to confidence in the long-term economic future of society? Well, in simple terms, gold is an anti-fiat asset. When the value of fiat money is stable, gold tends to lose its attractiveness as an alternative form of money. However, when the major fiat currencies come under pressure, gold offers an attractive alternative. In this sense, gold is not a commodity, but rather an anti-fiat currency.

In turn, the value of any fiat currency is primarily determined by expectations regarding the long-term economic future of the society that issues that currency. In simple terms, fiat money is only as good as the society that issues it. In more technical terms, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. If people become more concerned about the long-term economic prospects of society, then the value of the fiat currency issued by that society declines. In this scenario, an anti-fiat asset such as gold becomes a more attractive alternative.

If we extend this theory to bull and bear market cycles in gold, then we can say that bear markets in gold tend to begin when people are overly pessimistic about the long-term future of society. Conversely, bull markets in gold begin when too many people in the crowd are wearing rose-colored glasses.

Arguably, the markets were quite pessimistic on the long-term economic outlook for the United States in August 2011 when S&P downgraded the credit rating of the US. Perhaps not surprisingly, this low point in confidence marked a peak for gold.

However, the key question for gold investors today is whether markets are too optimistic regarding the long-term future of the United States.

Over the few years, it is likely that any attempts by the Fed to normalize monetary policy will disrupt both financial markets and the real economy. More specifically, low short-term interest rates and quantitative easing have pushed down the required cost of capital for business. As the Fed attempts to unwind these policies, the required cost of capital will rise and this will put enormous pressure on asset prices and reduce the incentive to invest. [See “Has the Fed Created the Conditions for a Market Crash?”]

There is a very real possibility that the Fed’s actions over the next couple of years will pour a bucket of cold water over the markets and that this will lead to a loss of confidence in the long-term economic future of the United States. Such a loss in confidence would lead to a significant rise in the price of gold, even in an environment of rising interest rates.

In summary, the Fed’s actions are likely to hurt confidence and this should lead to a rise in the price of gold. However, even if this theory of gold and economic confidence is wrong, there is still one phenomenon that could surprise markets in 2016 and drive the price of gold to much higher levels: inflation.

The Outlook for Inflation

The consensus view today is that rising real interest rates are negative for gold and, therefore, the gold price will remain under pressure as the Fed raises interest rates.

Even if we accept the theory behind this view, i.e. the relationship between real interest rates and the gold price, the problem with this outlook in practice it assumes that inflation will not accelerate over the course of the next few years. While the Fed is likely to raise nominal interest rates over the next 18 months, there is a real risk that the Fed will find itself behind the curve as the rate of inflation accelerates.

Most market commentators think that the risk of acceleration in the rate of inflation is low because inflation can only be produced by an “overheating” economy and that the Fed will “put on the brakes” well before this occurs. Frankly, this represents a very one-sided and dangerously simplistic view of the price determination process.

What these commentators fail to remember is that the price level depends upon two key factors: the value of goods and the value of money. More specifically, the price level can rise for one of two reasons; either (a) the value of goods rises, i.e. the economy overheats, or (b) the value of money falls.

Most market commentators pay little or no attention to this second factor or what drives it, despite the fact that it is the value of money, not the value of goods, that is the primary driver of inflation over long periods of time. [See “Why Do Prices Rise Over Time?”]

The view of The Money Enigma is that the next few years could represent a turning point for the major fiat currencies.

Long-term confidence in the future of the major Western economies has provided tremendous support to their respective currencies, despite the borderline reckless behavior of both fiscal and monetary policy makers. But as these policy makers attempt to normalize policy, it is likely that the structural cracks in the economic story will begin to appear. As these cracks appear, market faith in the major fiat currencies will be tested, the value of the fiat currencies will decline, and prices, as expressed in fiat money terms, will rise.

A sudden surge in the rate of inflation in 2016 would provide the key catalyst that is required to end the bear market in precious metals and commodities more generally. Unfortunately, it would also lead to a serious decline in equity and bond markets, damage the market’s confidence in the Fed and add further pressure to those struggling to make ends meet.