Gold bulls became very excited when gold prices tested overhead resistance at the 2000–2100 level. In the past, such tests had been met with selling pressure, but technical analysts would interpret a definitive breakout at these levels as opening the door to significant upside.
Moreover, the bottom panel of the accompanying chart shows that the gold to S&P 500 ratio has been making a multi-year bottom, which argues for the start of a cycle that favours hard assets like gold and commodities over paper assets like stocks and bonds. Before you get too excited, such bottoms can take some time to develop and a hard asset bull market may not appear for several years.
In addition, the long-term bull case for commodities and hard assets is underscored by a regime of chronic underinvestment in capital expenditures in commodity extraction industries.
I am no gold bug and I have no strong opinion on the direction for gold prices. I am more interested in the cross-asset implications of this gold rally.
What’s driving gold prices?
What’s driving gold prices? Historically, gold has been inversely correlated to the USD Index. However, the relationship began to diverge in late 2014 and diverged further in 2021. If history is any guide, gold prices should be a lot weaker than it is today.
In addition, gold is positively correlated to the price of inflation-indexed bonds (TIPS) and inversely correlated to TIPS yields. A similar bearish divergence appeared in late 2022. To be sure, similar negative divergences showed up in 2006 when gold prices began to rally and the divergence didn’t close until 2013–2016.
The bond and TIPS market received a boost when Fed Governor Christopher Waller gave a dovish update to his assessment of the economy. In a previous speech on October 18, 2023 (see Something’s Got to Give), Waller highlighted a divergence in the economy and a question for Fed officials. Economic growth seems to be accelerating while inflation is slowing. Either inflation reaccelerates, which would force the Fed to adopt a tighter monetary policy, or the economic slows, which allows a more dovish path [emphasis added].
The data in the past few months has been overwhelmingly positive for both of the FOMC’s goals of maximum employment and stable prices. Economic activity and the labor market have been strong, with what looks like growth well above trend and unemployment near a 50-year low. Meanwhile, there has been continued, gradual progress in lowering inflation, and moderation in wage growth. This is great news, and while I tend to be an optimist, things are looking a little too good to be true, so it makes me think that something’s gotta give. Either growth moderates, fostering conditions that support continued progress toward our 2 percent inflation objective, or growth doesn’t, possibly undermining that progress. But which is going to give—the real side of the economy or the nominal side?
Waller’s latest update (see
Something Appears to Be Giving) observed that “something appears to be giving, and it’s the pace of the economy”. Waller has been seen as a hawk and this speech was a signal that there is little appetite for further rate hikes. In a subsequent Q&A, Waller addressed the issue of rate cuts: “If you see this [lower] inflation continuing for several more months, I don’t know how long that might be—three months? four months? five months? You could then start lowering the policy rate because inflation’s lower.”
In other words, if monthly core PCE continues to print at 0.2% for 3–5 months, the Fed would start to cut rates as it’s becoming evident that inflation is moving toward its 2% target.
Fed Chair Jerome Powell also underlined Waller’s signal that the Fed is done raising rates in a
speech made last Friday.
The strong actions we have taken have moved our policy rate well into restrictive territory, meaning that tight monetary policy is putting downward pressure on economic activity and inflation…Having come so far so quickly, the FOMC is moving forward carefully, as the risks of under- and over-tightening are becoming more balanced.
Though he tried to push back against the market expectations of rate cuts:
It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.
The market sided with Waller and dismissed Powell’s warning by discounting rate cuts that begin in March.
The conditions set out by Governor Waller are similar to remarks by Goldman Sachs strategist Jan Hatzius in a
Bloomberg podcast:
We have a proof of concept that we can bring down inflation and rebalance the labour market without having to crush the economy and put the economy into recession and I think we’ve seen that clearly in 2023.
Fed watcher Tim Duy was more blunt in his assessment of the direction of monetary policy:
If the Fed has already restored price stability, nominal rates need to come down, both quickly and deeply. If the run rate of inflation is just over 2% now, it’s reasonable to believe that inflation a year ahead should be 2%. But not if real rates stay above 3%. If real rates stay above 3%, the Fed will undershoot its inflation target.
Falling rates would put downward pressure on real yields and boost gold prices. Such an environment would also be bullish for the price of risk assets such as stocks. In the past, gold and stocks have moved in opposite directions as gold has acted as a risk-off asset, a dovish Fed would be bullish for both stocks and gold. All else being equal, lower U.S. rates would put downward pressure on the USD, which has been inversely correlated to gold and stock prices.
Chinese gold demand
While falling real rates as a driver for gold prices are bullish for equities, a more neutral factor for risk asset prices might be Chinese physical demand. The New York Times recently published an
article, “Gold Bars and Tokyo Apartments: How Money Is Flowing Out of China”, which highlighted Chinese physical demand for gold.
In some cases, Chinese are improvising to get around China’s strict government controls on transferring money overseas. They have bought gold bars small enough to be scattered unobtrusively through carry-on luggage, as well as large stacks of foreign currency.
To assess the seriousness of Asian physical demand, I studied the spread between the London AM and PM gold fixes as an apples-to-apples measure of Asian demand. The AM fix occurs roughly at the end of the Asian trading day, and the PM fix is more reflective of the gold market at the end of European trading day. All else being equal, the spread should be a random walk. However, a persistently negative spread would indicate strong Asian demand, which includes both China and India, as India has traditionally been strong buyers of physical gold.
An analysis of the London AM-PM gold spread in the last two years shows some seasonal demand in Q2 and at year-end, but no persistent buying from Asia as postulated by the New York Times article. As a consequence, we can reject the hypothesis that significant Asian demand is boosting gold prices.
Rotate Into early cycle stocks
From a technical perspective, the U.S. equity market appears to be undergoing a rotation into early-cycle leadership of financials and other interest-sensitive stocks. In theory, leadership would rotate into mid-cyclical industries such as retailing and advertising as it becomes evident that the economy is expanding. Eventually, inflation-sensitive commodity producers would lead as inflation becomes a problem.
The accompanying chart shows an upside breakout by financial stocks and a constructive saucer-shaped relative bottom by the sector. In addition, the relative breadth indicators (bottom two panels) are equally supportive of further gains by these stocks.
Even though I highlighted the long-term potential of hard asset plays in the next market cycle, it’s too early to make a significant commitment to cyclicals and commodity producers. The gold/CRB and gold/oil ratios favour gold. In addition, the cyclically sensitive copper/gold ratio hasn’t turned up yet, indicating the absence of cyclical reflation as an investment theme.
In summary, I have been more interested in the drivers of gold strength than trying to forecast gold itself. My analysis indicates that gold is rising on expectations of falling real rates, which also depresses the USD. These factors should be bullish for the price of risky assets. Specifically, I would focus on financials and other early market cycle groups.
Inside financials, insurance co’s,, capital markets, specialty finance, and investment services are going thru strong up moves.