The barbarous relic (gold) made a new all time high this morning in Asian trade on Monday. From our perch, the shift in consensus beliefs on short term interest rate expectations and a correction in the US dollar is a plausible explanation for gold price strength. Recall that spot gold largely reflects three underlying fundamental drivers; 1) the real yield or the value of the competing asset; 2) the inverse of the US dollar; and 3) the price of financial risk (CDS credit spreads).
The shift in the prevailing bias on short term rates since late October is still modest. The December 2024 Implied SOFR Yield is down by 100 basis points from peak (chart 1). While the shift in beliefs is no longer trivial, it is still underestimating the probable move if there is a recession in 2024. More likely, the Fed will be forced to cut the funds rate by 250-300 basis points. Of course, the consensus belief on rate cuts is mild because most investors believe in a “soft landing” according to the Bank of America Fund Manager Survey.
What’s interesting or unusual about the strength in the spot price of gold over the past year is that it has coincided with a meaningful increase in the real yield (chart 2). Disinflation (or a slow down in the pace of inflation) while nominal yields remain elevated, has increased the real short and long dated Treasury yield. The real yield or 10-year nominal Treasury yield less the 10-year breakeven is inverted on the time series below (light blue line) and is typically inversely correlated to the spot gold price. Recall that gold is effectively a negative yielding haven currency with a cost of carry or storage, so it tends to move inversely to real yields. The strength in the spot price of gold have been impressive given the level of real yields. Spot price strength might reflect sustained demand (purchases) from central banks and/or expectations about future policy settings (monetary and fiscal).
From our perch, the strongest phases of performance for gold are when the Fed implements “inflationary” policies rather than actual consumer price inflation as the driver. That is a subtle but important difference. For example, in the 2015-2018 policy tightening cycle, the initial Fed rate hike was in December 2015. That coincided with the trough in spot gold and gold mining equities. The Fed was forced to pivot in the first quarter of 2016 due to the global growth scare. Instead of hiking rates four times in 2016, the Fed only hiked once (again in December). Through the first half of 2016, VanEck’s GDX gold miners ETF rallied 122% and the junior miners ETF rallied 160%. However, spot gold and miners then declined again once the policy tightening cycle resumed in late 2016 until the Fed was forced to pivot again at the start of 2019. Simply put, the bullish regime for gold and gold mining equities tends to coincide phases of Fed accommodation and declining Treasury yields (the competing asset).
The underperformance of gold miners through the recent episode has de-rated the sector to 30% discount to global equities of a price to cash flow basis (the discount was 55% in December 2015 – chart 3). A key observation we made in 2015 was the shift in focus to managing the businesses for cash. That contrasted with the prior behaviour during the bull market of over investing in capital expenditure. The good news for miners in Australia and Canada or outside the United States, is that the spot price of gold in local currency is even more attractive (costs in local currency and revenues in dollars). If the spot price of gold remains elevated, the cash flow for producers is extremely strong. We have been “standing aside” from spot gold and the sector on basis that the competing asset (real Treasury yields) have remained elevated. However, if the Federal Reserve is forced to become “inflationary” again (cut rates and renew asset purchases/QE) gold miners could be an inexpensive diversifier for global equities.