Gold seeks clarity amid inflation haze

Gold markets trying to make sense of it all
The US Federal Reserve (Fed) is on track to begin tapering its bond-buying program and Fed Fund Futures indicate the market is looking at December 2022 for the next Fed interest rate hike. The gold market was confused in October, unable to decide whether a tighter Fed policy presents a risk to the economy, and whether inflation is transitory or long-term. On October 13, the headline Consumer Price Index (CPI) increased more than expected with a 5.4% annual gain in prices paid by US consumers. Gold jumped US$32 per ounce on the day. However, two days later gold gave up those gains when retail sales unexpectedly increased.

Inflation uncertainty does not seem to be helping
On the morning of October 22, gold was up as much as US$30 per ounce when the five-year breakeven inflation (as reported by the Federal Reserve Bank of St. Louis) rose sharply, moving north of 3% for the first time in over 20 years. However, by afternoon gold gave up most of those gains after Fed Chairman Jerome Powell stated in a panel discussion that he expected “inflation will move back down closer to our 2% goal” and that “if we were to see a serious risk of inflation moving persistently to higher levels, we would certainly use our tools to preserve price stability”.

Gold has responded to inflationary pressures. However, this has been offset by a belief in the market that tighter Fed policies will manage inflation and that the economy is robust enough to withstand higher rates. The confusion in how to interpret gold’s response during this Fed transition period will require patience. Unlike the market, we believe there is substantial risk that the liquidity-fueled economy and stock market might fail to perform once the Fed moves to drain the liquidity. Also, as explained in our September commentary, we believe structural changes in the economy should lead to a multi-year inflationary cycle.

Silver linings
The silver market performed well early in the year, when it became a favourite investment in popular online trading venues. Since then, silver has lost some of its shine, underperforming gold by approximately 14% in the third quarter. However, silver rebounded in October with around a 6% outperformance versus gold. Metals Focus, an independent precious metals research consultancy, stated several reasons for the stronger silver market as follows: First, tightness in supply was caused by delays in sea freight, which transported much of the silver bullion; second, bullion imports into India surged in September as the Indian market had reopened following a devastating COVID-19 outbreak; and finally, European demand had increased due to a recovery in industrial demand in Germany—a 21% rebound in Italian jewelry fabrication and strong retail purchases of bars and coins.

Support still in place for higher gold prices
While we have spent ample time discussing the weak gold market of the past year, a longer view provides a more positive perspective. From 2013 to 2019, the gold price was stuck in a range between US$1,150–1,360 per ounce. Gold busted out of this range in mid-2019 when the Fed began cutting rates. While gold is off its highs of over US$2,000 per ounce, current levels of around US$1,800 is a lofty price and one in which the miners are able to thrive. The gold price has held its ground despite the Fed’s tightening expectations, higher yields, US dollar strength, competition from other asset classes and persistent net selling from gold bullion exchange traded funds. This suggests that gold is underpinned by a core of investors who see the need for investments that can help protect their wealth from unwanted risks.

The US Treasury department reported the fiscal 2021 deficit was US$2.77 trillion, compared with the previous year’s US$3.1 trillion. The Congressional Budget Office expects the deficit will total US$1.15 trillion in 2022. The chart below shows that the last three administrations have shown no resistance to wanton deficit spending. While living within one’s means is a basic law of economic survival, it seems an overreliance on debt is the favourite tool of fiscal and monetary policy. With rates near zero, money is nearly free and debt service is minimalised. However, once either the Fed or the markets decide it is time for rates to rise, a debt trap might close on the US economy.

Plunging the depths of US deficits

Source: Ned Davis, CBO, Federal Reserve of St. Louis (FRED), VanEck. Data as of September 30, 2021.