by Jim Rickards
Posted 6th January 2017
Gold ended 2016 about 8.5% higher than it started the year and is off to a good start in 2017.
But you wouldn’t know it from the wails and moaning of gold investors and analysts.
The reason for the gold gloom is obvious. Gold may have been 8.5% higher in 2016, but it ended the year 16% lower than the July 6 high of $1,366 per ounce. As the saying goes, “What have you done for me lately?”
This price pattern speaks volumes of the virtues of a steady long-term approach to buying gold.
Certainly if you read the gold headlines in July, raced out and bought gold ETFs from your broker only to lose 16% since then, you’re not feeling great about gold right now.
But that’s exactly the point. Gold investors should accumulate steadily and hold for the long term. Don’t chase the headlines; focus on the long game.
But there’s also nothing wrong with buying dips if you’re accumulating.
I’m not a day trader, and I don’t have a crystal ball when it comes to short-term highs and lows. There’s no secret formula, but when the TV talking heads are trashing gold, that’s a good time to accumulate.
There has been no change in my intermediate-term forecast for gold prices, which is that gold will rise to $10,000 per ounce in stages (slowly at first and then quickly, to paraphrase Hemingway), probably in the next three–four years.
The reason there’s no change in the forecast is because there’s no change in the mathematics. Those numbers are what they are.
A $10,000 per ounce price is simply the implied nondeflationary gold price based on current global M1 money supply and official gold hoards.
(M1 money supply includes physical money like paper and coins as well as checking accounts.)
The $10,000 scenario has three possible vectors: (i) a global liquidity crisis in 2018, if not sooner, (ii) a return to a gold-based monetary system to restore confidence or, alternately, (iii) the use of the IMF’s special drawing rights (SDRs) to reliquify the system, which will be highly inflationary.
Vector i is likely. Vectors ii and iii have separate probabilities depending on vector i, but both end up in the same place — much higher gold prices.
My short-term forecast for gold prices rests almost entirely on my short-term forecast for the dollar.
The dollar price of gold is simply the inverse of dollar strength. A strong dollar implies a lower dollar price for gold. A weak dollar implies a higher dollar price for gold.
In effect, the dollar/gold relationship is just another cross-rate like the dollar/euro or the dollar/pound.
Once you view gold as money, not a commodity, the relationship is easy to grasp.
The short-term price of gold depends on the dollar. But the short-term price of dollars depends on the Federal Reserve.
After all, the Fed controls interest rates, which are implicitly the “price” of owning or borrowing dollars.
How will Fed policy affect gold prices in 2017? Will the Fed cause the very recession it’s trying to prevent? And how does Trump fit into it all?
Fed forecasting is surprisingly easy despite the sturm und drang of the talking heads. It’s a matter of considering what we know, and what we don’t know, and observing the indications and warnings that presage the unknown.
What we know is that the Fed is biased toward rate increases as long as the economy is growing.
This is because the Fed needs to raise rates to 3.25% before the next recession in order to cut them back to 0% when the recession hits; approximately the amount of cutting needed to pull the economy out of recession.
The Fed is unlikely to reach this goal without either causing a recession, or facing one anyway, but they will try.
Simply because the Fed wants to cut rates does not mean they will. The entire course of 2015 and 2016 was a case study of not being able to raise rates more despite wanting to.
What stands in the way of rate hikes? There are four hurdles, which can arrive singly or in combinations.
These are deflation, job losses, technical recession, and tighter financial conditions from sources other than rate hikes.
The last hurdle includes a number of conditions such as global contagion or a stock market correction.
There are many examples to illustrate this. The Fed was on track to raise rates in September 2015, but did not do so because of the Chinese devaluation and US stock market correction in August.
The Fed was on track to raise rates in March 2016, but did not do so because of the stock market correction from January 2 to February 10, 2016.
The Fed also did not raise rates in September or November 2016 because of the US election, but that’s a one-off constraint on policy. The Fed is highly political, protestations to the contrary notwithstanding.
So, forecasting the Fed is straightforward. If you do not see any of these hurdles, the Fed will raise rates every March, June, September, and December from now until the end of 2019.
If you do see these hurdles in strong form, the Fed will not raise rates. Insiders call this a “pause,” and that’s a good way to understand it.
As of now, none of the pause indicators are flashing red so the Fed will raise rates in March.
That rate hike is not fully discounted in the market yet. The Fed’s job from now until March will be to communicate the likelihood of a rate hike through speeches, leaks, and various statements.
This will be a headwind for gold and it should not be surprising if gold trades lower in the next few months.
What about Trump? The Fed has not changed its policy bias as of now because they simply do not have enough information about Trump’s actual policies. (Ignore the “dots” from the Federal Open Market Committee (FOMC) meeting in December. They are nothing more than the median of 17 blind guesses forced upon the FOMC participants).
But using causal inference (also known as Bayes Theorem), my estimate is that Fed chair Janet Yellen expects Trump policy to be stimulative because of the combination of tax cuts, reduced regulation, and higher spending on defence and critical infrastructure.
This tips the Fed’s bias even more strongly toward tightening and creates a strong case for a rate hike in March.
I’ve written a lot about helicopter money and about how it’s one of the “tools” the Fed has in its toolkit.
But at least for now, it doesn’t appear that the Fed will use helicopter money to accommodate Trump’s stimulus.
That’s primarily because of their misplaced reliance on the Phillips Curve that posits lower unemployment means higher inflation.
There’s also the fact that monetary policy works with a lag. The Fed does not want to get behind the curve on inflation. Yellen will lean-in against Trump stimulus with rate hikes.
Besides, Yellen personally dislikes Trump and is not out to do him any favours.
But beyond that, there’s good reason to believe that the Trump stimulus will not arrive as many expect.
Congress is already pushing back against tax cuts that are not revenue neutral.
This means tax cuts have to be offset with either spending cuts or other tax increases thereby diluting the stimulative impact.
There’s no evidence for a Laffer Curve effect that will make up for tax cuts with higher growth despite claims. The most stimulative tax cut would be a reduction in social security taxes (this helps poorer people with a higher marginal propensity to consume), but that is not on the table.
Reductions in regulation can be stimulative, but they take months to implement and even longer to affect investment decisions.
Spending increases will also be held in check because the US has $20 trillion in debt and a debt-to-GDP ratio of 104%. Congress will balk at busting budget caps.
Even if Congress goes along with more spending, the economy is at the stage of diminished or negative marginal returns after eight years of growth.
Neo-Keynesian solutions work best, if at all, in the early stages of recovery not the late stages. Further deficit spending will push the US toward the same debt-deficit death spiral already achieved in Greece.
In addition to the lack of stimulus from Trump’s tax, regulatory and fiscal policies, there may be additional headwinds to growth coming from Trump’s trade and foreign policies, especially as they relate to China.
The Fed has given the prospect of a trade war little weight so far.
There are even more troubling global tremors coming from the dollar shortage and a looming crisis in dollar-denominated emerging markets corporate debt.
European banking problems are another wild card.
This disjunction between the Fed’s (and the market’s) view of the Trump reflation trade and the reality of little or no stimulus in the pipeline will cause a head-on collision between perception and reality.
This collision will take place in the spring.
At that point a technical recession or a violent stock market correction may occur.
The Fed will be late to react, but either outcome will throw the Fed off its rate hike path once again. The Fed will be forced to ease by forward guidance; rate cuts are still some way off.
Still, markets will get the easing message and gold will resume its long march higher.
I view the next several months as an excellent entry point for gold buyers before this next episode of Fed flip-flopping becomes apparent.
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