Weakness to Rally: Gold Follows Rate Hike Pattern

Rate increase and political uncertainty in US are primary drivers in March

Expectations surrounding the Federal Reserve's 15 March rate announcement were the principal drivers of the gold market in March. US economic statistics have been positive recently, leading the market to expect the Fed to become more aggressive and make four rate increases in 2017 (one more than the Fed had announced in December). As a result, gold was weak ahead of the Fed's rate decision, falling around $50 over two weeks below the US$1,200 per ounce level. However when the Fed implemented its rate hike as expected, it maintained its projection of only two more rate increases for 2017. Economic guidance also remained unchanged and Chair Janet Yellen said the Fed is willing to tolerate temporary inflation in order to overshoot its two percent target. Gold rallied to end the month with a small gain closing March at US$1,244.85 per ounce.

Political activity in the US in March also supported the price of gold. As we had expected, the market euphoria surrounding the November US presidential election continues to dissipate. The Trump administration has suffered two strikes:

1. the courts blocking the implementation of new travel restrictions, and

2. the cancellation of the vote on health care reform.

In our opinion, these early defeats make it increasingly unlikely that the administration will be able to deliver on the expected pro-growth reforms that drove the market to highs following the election. One more strike could create a confidence crisis.  Tax reform is the next issue on Trump’s agenda and is now vital for Trump’s presidency to gain some positive momentum.

The price trend for gold stocks mimicked gold bullion in March. The NYSE Arca Gold Miners Index (GDX Index) fell ahead of the March Fed rate announcement and gained afterwards, ending the month with a small gain.

Gold's before and after rate hike pattern

The March 0.25% Fed rate increase was the third in this tightening cycle that began in December 2015. In all three instances, increasing pessimism in the gold market caused gold to fall to long-term or technical lows. This pessimism was caused by anticipation of rising real rates, a strong US dollar and faith in the Fed's outlook for a strengthening economy. However, the economy has not been as robust as hoped and recently, rising inflation has caused real rates to fall. The Fed rate increase in December 2015 was a major turning point, marking the end of the historic 2011 - 2015 bear market for gold. A shift in sentiment also lead to gold rallies following the December 2016 and March 2017 rate hikes. Markets were irrationally causing the US dollar to become overbought and gold to be oversold before each rate increase. Three times makes a pattern and if we have learned anything in our history of investing, it's that trading patterns end once they are recognised. We will look for market sentiment, Fed behaviour or some other driver to help change the pattern when the Fed hikes rates again. The market expects the next rate hike at the June Federal Open Market Committee (FOMC) meeting.

The current (more rational) market bubble could pop on growing debt

The current economic expansion and bull market in stocks are among the longest on record. Such cycles do not last forever and we have commented in the past on the risks an economic downturn would bring to the financial system. While valuations for stocks are lofty, the level of mania that we had felt ahead of the tech bust (2001) has not materialised.

Since the subprime crisis of 2008-2009 the financial system has been in such a precarious state that even a mild recession could be financially devastating.  This environment has benefitted gold and gold stocks and there are a number of potential catalysts in the short term that could benefit the precious metal:

• Globally sovereign debt is higher than it has ever been during peacetime and it continues to grow.

• In the US the Congressional Budget Office's (CBO) annual report shows the debt/GDP ratio has doubled since 2008 to 77% today and is forecast to reach 150% in 2047. The CBO also forecasts debt service rising from 7% today to 21% in 2047. The budget deficit was not mentioned in President Trump's 28 February speech to Congress. We believe no politician wants to seriously tackle the debt bubble for fear of getting voted out of office for raising taxes or cutting entitlements.

• It appears politically impossible in the US to implement necessary reforms required to avoid insolvency or a systemic failure of the public healthcare insurance system. Social Security is also another entitlement that appears to be heading toward insolvency. Gridlock reigns, which makes a debt crisis or another calamity a prerequisite to motivate those in Washington to act constructively. The Fed's three rate increases in this cycle amount to 0.75% and US rates remain below historic norms but rates in other advanced economies are even lower. Quantitative easing did not work as well as planned. The Fed is holding trillions of dollars in US Treasuries and mortgage-backed securities on its balance sheet and may have to resort to more radical policies to stimulate the economy in the next recession bringing added financial risks.

While we hope that President Trump is able to bring tax, regulatory and other reforms that energise the US economy, political headwinds suggest it is prudent for investors to begin to hedge against the financial pain that a recession might bring.

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