Why gold’s rally has legs

Why gold’s rally has legs

Gold’s recent spike has been fuelled in part by geopolitical concerns surrounding the Syria missile attack by the US and rising tensions in North Korea.

Neither of these situations will be resolved soon, and both have the ability to escalate into war for the United States.

Geopolitics will continue to keep a floor under gold prices.

That said, what’s most impressive about gold’s multi-month rally is that the macro environment has not been particularly good. The Federal Reserve raised rates on March 15, and has been preparing markets for another rate hike on June 14.

The path toward higher rates is set in stone. The only debate is whether there will be two or three more rate hikes this year, but no one expects a pause of any length.

Fed tightening has supported a strong dollar, which is typically a headwind for the dollar price of gold. If you think of gold and the dollar as two forms of money, which I do, then it’s unusual for both to be getting stronger at the same time.

But that’s exactly what’s been happening.

After all, gold has no yield and competes with interest-bearing investments that do.

And therein lies a mystery. Increases in the fed funds rate, controlled by the Federal Reserve, are supposed to be negative for the dollar price of gold. After all, gold has no yield and competes with interest-bearing investments that do.

When interest rates go up, that yield comparison looks worse for gold and is supposed to result in lower gold prices.

Instead, gold has been rising along with interest rates. What gives?

In fact, the conventional wisdom about higher rates being bad for gold is incorrect. The correlation between the dollar price of gold and the fed funds rate is quite low. Those expecting gold prices to fall on higher rates are missing one very important element.

Those analysts are focused on nominal interest rates.

That’s the wrong benchmark. The key is to focus on real interest rates, which are computed by subtracting inflation from the nominal rate.

Inflation has been rising lately. When that inflation is subtracted from nominal interest rates, it turns out that real rates are going down, not up.

It’s those lower real interest rates that are providing a boost to gold prices.

With gold rising in a difficult environment, imagine how much more it will surge if the Fed moves to an easing policy.

And that’s exactly what I expect.

One more Fed rate hike in June might be the last nail in the coffin for the US economic expansion that began in June 2009.

The US economy is already weak. The Atlanta Fed estimates that first quarter GDP will be only 0.6% (the official figure will be announced by the Commerce Department on April 28).

This expansion is already one of the longest on record, over 91 months long. The average expansion since 1980, a period of long expansions, is 80 months. Clearly the economy is living on borrowed time as well as borrowed money.

The important thing to realise is that the Fed’s raising rates for the wrong reasons. It’s not raising rates because the economy is stronger. It’s raising rate in the face of weakness and it’s going to make that weakness worse.

In the short run we can expect higher rates and a slightly stronger dollar. But when the economy hits stall speed, which I expect around July, we might also see a big stock market correction. That’s highly likely because the stock market’s priced to perfection based on expectations about Trump’s policies, many of which are hitting the wall.

We’re not going to get the tax reform the markets want, or at least not anytime soon. Nor can we expect the type of infrastructure spending the market’s priced in for the foreseeable future.

Trump’s making more headway on regulatory reform, but that takes a long time to have an effect.

I haven’t even mentioned the health care fiasco. It’s not clear how that’s going to be resolved, if at all.

And beyond the distractions Trump has to contend with over Syria, China and North Korea, the issue of the Russian hacking is still out there.

We could see hearings to get to the bottom of it all, which chews into the calendar.

So it doesn’t look like we’ll be seeing a lot of progress on the economic front anytime soon. And there are signs that growth is already stalling.

When the Fed eases after June to resuscitate the economy, gold should soar on the news.

Then we have to consider the global factors that are driving the gold price.

Rising geopolitical tensions are an obvious factor, as mentioned. And nations like Russia and China have been buying lots of gold.

But that’s not all. The dollar’s been strong, based on the global dollar shortage combined with the Fed’s tightening. In China, citizens and companies are desperate for dollars to get their money out of the country before the China credit bubble explodes.

Other emerging markets countries are also scrounging for dollars to pay off their dollar-denominated corporate debt before the dollar gets even stronger and US rates go up.

Normally dollar strength means a lower dollar price for gold. But, gold is responding to its own dynamic based on supply and demand. The same Chinese who are desperate for dollars are also desperate for gold.

They need a store of wealth other than stocks, real estate, and bank deposits to weather the financial storm they know is coming.

Those who are stuck in China and can’t get their money out can at least buy physical gold and move to the sidelines before the credit storm strikes. Mining output is flat lining just as refinery demand is spiking so that puts upward pressure on the gold price as well.

But there’s another powerful factor boosting gold prices. That’s the shortage of physical supply relative to demand in the wholesale market.

Later this week, I’m having dinner with one of the most plugged-in gold industry insiders there is. This gentleman has his finger on the pulse of supply and demand in the physical gold market. And he’s been a source of excellent insights in the past.

I’ll be writing about our dinner soon, and I expect to have some valuable new information to share.

For now, gold continues to rise based on a combination of higher inflation, geopolitical concerns and tightness in supply.

We see no change in this landscape in the near term.

The message here is that, while gold is up, it’s not too late to jump on the bandwagon. This rally has legs.

Gold miners should do even better than physical gold because of the internal leverage in mining stocks. They can rise much faster than the physical gold price, often dramatically so.

It’s a good time to look at adding gold mining shares to your portfolio. Click here to see how much you can make if you invest in the right gold miners.