First quarter performance of precious metals and precious-metal equities caught many investors by surprise. After a four-year correction from September 2011 highs, spot gold posted its strongest quarterly performance in 30 years, rising 16.1% (from a year-end 2015 level of $1,061.42 to a 3/31/16 close of $1,232.71). Themes we have communicated during recent quarters appear to have crystalized with a growing number of investors. We have suggested the bearish thesis for gold rests on four expectations in the process of being disproven: i) protracted U.S. dollar strength, ii) significant Fed tightening, iii) escape velocity U.S. economic performance, and iv.) incremental gains in U.S. equities. So far in 2016, the U.S. dollar has encountered significant headwinds, the Fed has abruptly reversed telegraphing of 2016 rate increases, Q1 GDP growth estimates have collapsed towards zero, and the S&P 500 Index remains near levels first reached in December 2014.
Bullish gold sentiment has rested on expectations that unprecedented central bank liquidity would eventually back central banks “into a corner.” The gold thesis suggests excessive debt levels require consistent credit creation to maintain elevated financial asset prices. While global central banks have grown their balance sheets by over $10 trillion since the Global Financial Crisis, indeed providing significant support to financial asset prices, the move to zero (and now negative) interest rate regimes has also had cumulative negative impact on various aspects of the global economy, which are now coming into focus. Reflecting classic Austrian economic doctrine, artificially depressed interest rates have distorted economic decision-making, demand for capital and especially the motivation for savings. In a worst case scenario, ZIRP and NIRP have fostered trillions-of-dollars-worth of malinvestment—capital allocations destined to prove uneconomic. At the very least, ZIRP and NIRP have distorted the temporal preference for money, such that economic growth has been “borrowing from the future” for quite some time. As gold bulls have long predicted, the Fed and other central banks may now find themselves in the awkward positon in which global economies are addicted to incremental liquidity in order to function, but cumulative impact of poor capital allocation in prior years rends the simulative impact of further stimulus insufficient to remain economic status quo.
We have long suggested that the Fed’s final tapering of QE3 in October 2014 lit the fuse on a global deflationary spiral, the intensity of which we believe received significant boost from the FOMC’s decision to raise rates in December 2015. However, the resultant and immediate uptick in financial stress, by almost any domestic or global measure, has quickly led the Fed to retract previously telegraphed expectations for multiple rate increases during 2016. We attribute gold’s recent strength to growing investor recognition, still at the margin, that the Fed and other global central banks have reached the conundrum in which further liquidity measures are necessary, to keep both financial asset prices and economic growth from declining, but the economically corrosive effects of these policies are becoming hard to ignore (penalty on savers, financial repression, compression of economic returns).
We submit two observations about recent developments in the monetary and central bank arena, which may pose significant positive implications for future gold prices. First, market reactions to global central bank policy-decisions in recent months suggest central banks may be losing their effectiveness in channeling monetary stimulus directly into financial assets. The 1/29/16 Bank of Japan adoption of negative interest rates (-0.10% deposit rate for financial institutions at the BOJ) was clearly designed to facilitate yen weakness and domestic inflation. Somewhat counter-intuitively, the yen has strengthened some 10% (versus the U.S. dollar) since BOJ Governor Kuroda’s decision to espouse negative rates. Similarly, the ECB’s adoption of a panoply of easing policy tools on 3/10/16 weakened the euro for all of about thirty minutes, before a stunning 3.7% intra-day reversal to the upside, which has left the euro stronger still against the U.S. dollar ever since. We would suggest that at least with respect to the BOJ and ECB, faith in the effectiveness of monetary policy may be hitting an inflexion point. While the Fed continues to enjoy the confidence of consensus, we would observe that an increase in conflicting communication in recent weeks suggests even the Fed’s credibility may be increasingly “under the microscope” in coming periods.
Finally, while our investment thesis for gold has never centered on CPI-type inflation (to us, monetary inflation is far more relevant to the gold thesis), we recognize that no investment cue for gold has a stronger pedigree than inflation in the prices of goods and services, especially in the United States. By our way of thinking, a gold investment-decision should have little to do with the price of hedonically-adjusted- hot-dogs-in-Houston, but we recognize we may be in the minority in this regard. Importantly, we would suggest that if central banks are losing their ability to channel monetary inflation (already extant in the financial system through many years of QE) directly into financial assets, we are quite certain existing monetary inflation will soon be seeking a new resting place, quite possibly toward the CPI-type inflation favored by consensus for gold investment.
Figure 1: US Core Inflation Trending Higher
Source: FRBATL, FRBCLE, BLS, FRBDAL, BEA, Haver Analytics, DB Global Markets Research
Along these lines, Deutsche Bank presents in Figure 11, above, several measures of inflation which are trending distinctly in the upwards direction. Most notably, we would highlight that on the very morning of the Fed’s highly dovish March FOMC statement (3/10/16), the BLS reported a 2.3% year-over-year gain in U.S. CPI (ex food and energy), the highest reading in some eight years. That such an incremental increase has accrued following an extended period of commodity-price collapse is fairly provocative. Could a perfect storm for higher gold prices be in the process of unfolding? Time will tell!
1 Source: Deutsche Bank Research Report, Torsten Slok March 2016.
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