We Are Close To A Low In The Gold Price (Commodity:XAUUSD:CUR)
In my last gold article in July, I said that gold could drop as low as $1,400 if it broke the $1,700 level. The precious metal did go lower, but it is finding support just as pressures appear in the market and could be near a low.
What many investors get wrong about gold
Many investors have problems in the market because they are tied to correlations and rules that do not always hold up. In a period when inflation has been rampant, investors have expected gold to move in lockstep with the rise of consumer prices.
In my book, “The Stock Market is Easy,” I noted that investors can get hung up on this obsession with rules-based investing. The reality is that although gold and commodities can be an inflation hedge, the aggressive rate hike policies from the Federal Reserve have been the driver for lower gold prices. Yes, there is inflation, but because the U.S. dollar is the world currency, the rate hikes are feeding a dollar frenzy and that hurts gold because it trades for dollars on the world’s largest exchanges. The second part of the story is that the Federal Reserve increased the market appetite for the world’s other big safe-haven – U.S. treasuries. In the new age of super-fast trading, big institutional investors can move big sums across the world at lightning speed, so there is no need to put their money into gold with the associated headaches of storage and delivery when there are alternatives.
How investors should look at gold
What we have in markets at the moment is some hot inflation being driven by supply imbalances that are the legacy of the pandemic and the Ukraine conflict. The lockdowns in China are another reason for the friction in supply chains and they are being worsened by other issues such as Hurricane Ian where ports and airports have been closed.
These issues may ease over the next year, but the likelihood is that we are more at risk from a deflationary bust than hyperinflation. As Goldman Sachs highlighted in a report this week, the fear of hyperinflation will bring about a deflationary mood. Speaking of the U.K. policy actions, the central bank said:
“The victor was Hyperinflation over Depression. They will keep raising rates for now. But all plans to sell assets out which itself reduces money supply while suppressing Gilt prices, were scuttled in favor of its exact opposite. Buying more bonds with freshly printed money. The UK chose the risk of hyperinflation over the risk of depressionary collapse.”
“When you tell people you are fighting inflation by raising rates, but give people money to buy stuff, you are hitting the gas and brake at the same time. If you keep doing that you get bald tires, worn brake pads, and worse. Something has to give or the whole machine is useless. The driver has to back off one or the other.”
“The inflation will continue, people will get fired, unemployment will soar, standards of living will drop, and we will all have money but be unable to afford anything. Goodbye Middle-class if this continues while the west retools its industries.”
In the end, gold will outperform other assets as a hedge against the government. We have seen some problems in peripheral economies such as Sri Lanka, but this week, the market was shocked by the stimulus package and spending commitments from the U.K. government.
As one British analyst said this week of the Bank of England’s market intervention:
“If there was no intervention today, gilt yields could have gone up to 7-8 percent from 4.5 percent this morning and in that situation around 90 percent of UK pension funds would have run out of collateral… They would have been wiped out.”
It is a shocking statement and one that shows the first crack in a developed economy. The Bank of England is now at odds with the government and the huge unfunded spending was just a hail Mary pass from the new Prime Minister and her team.
Gold rose to $2,000 after the 2020 COVID pandemic market crash because the markets saw that same level of unprecedented government spending. At the time, we still had the ultra-low interest rate environment but that has completely changed. Gold rallied over fears that the lockdowns and spending would collapse the economy and the ability of governments to balance the books. That period could return in the next six months as a myriad of risks collides.
Gold has settled down due to the soaring dollar, but we could soon start to see the precious metal start moving higher WITH the U.S. dollar. Investors lost their appetite for bullion when yields were soaring on government bonds. But this week was the first crack in one of the world’s major bond markets and the stage has been set for another fear rally in gold.
ETF outflows have dominated for the last three months
Global gold-backed ETFs recorded net outflows of $4.5 billion in July due to the dollar strength, according to the World Gold Council. North American and European funds accounted for a large share of the outflows, while gold holdings increased in China.
Although July was the third consecutive month of outflows from gold ETFs and the largest monthly outflow since March 2021, holdings were up. At the end of July, total holdings stood at 3,708t (US$209bn), up 5% over the year.
Another article from the WGC said that central bank net purchases of gold also slowed to 20t in August, which was 50% lower month-on-month. The number still marked a fifth consecutive month of net purchases from the central banks.
Gold purchases can be seen slowing over the last months due to interest rates moving higher, but we can take a contrarian approach to those figures due to the current market environment.
The Ukraine conflict is another elephant in the room
In January of this year, I warned investors to get out of European stocks. The German index is now down -22% and the S&P has performed better, which was another thesis I offered. The market can see all of the present risks, but they choose to ignore them and apply their own behavioral lens.
We are in that phase again where we have seen the first chink in the armor of a big world economy in the U.K. and it will not be the last of the problems. Europe has just recorded a record 10% inflation today and there is pressure on the ECB to raise interest rates. The bank stayed behind the curve because of the toxic debt that they purchased in bulk during the ultra-low interest rate period and prayed that inflation was transitory – it was not.
The Eurozone is in no better shape than the U.K. economy and adds another 19 countries to the pile. We are staring at the potential for a full-blown debt crisis in Europe and the coming winter brings further risks from energy prices as we saw again this week.
Big gas leaks in the Nord Stream pipeline were reported with the West and Russia both blaming each other for the “sabotage”. But behind the political intrigue, there is still a risk of real problems for the German economy and others if gas slows to a halt this winter. In the Russia and Ukraine conflict, there is no sign of an imminent end, and Russia has gone ahead with its votes in occupied regions, which have handed Russian rule to 15% of Ukraine. That has led to further sanctions from Western nations but may eventually lead to further conflict. After all of the funds and support committed to Ukraine, it is unlikely that the West will allow itself to appear defeated.
The next proposal from the U.S. government and its European allies is a price cap on oil and that can bring “further instability” to energy supply chains.
Households may not stay quiet for long
We can add two more issues to the list of toxic problems for the financial markets: Economic stagnation and a housing market correction.
In the 2008-09 financial crisis, households were flush with savings and income. Consumer spending continued after the turmoil and the system was repaired. But that landscape is changing in developed nations. Inflation has reduced real wages and is hurting consumer demand as global growth grinds to a halt and flashes recession risks. The U.K. and Germany are said to be there and this week saw a second negative quarter for the U.S. economy, which is a technical definition of recession.
Adding to the squeeze will be a housing market correction, and in the U.S., we saw mortgage rates rise to 15-year highs. The tremors in the U.K. market are now expected to increase costs by 70% for homeowners. “Higher borrowing costs for lenders mean the average monthly cost of a two-year fixed-rate mortgage will rise by 70% by March from January this year,” Bloomberg said.
In previous financial market crises, governments had free reign to use debt for bailouts. Central banks could slash interest rates to spur demand and stabilize bank balance sheets with new debt. And more importantly, the public had a wealth effect from stable wages and rising house prices.
All of those pillars are now being removed and the market will soon catch up to the idea that gold’s dip on interest rate hikes was only a correction. Consumers are being squeezed on all fronts and as the U.K. showed this week – any attempts to soothe them with debt will not be tolerated. If we were also to see a collapse in pension funds, then it could lead to civil unrest. The U.K. police force has already been drawing up plans for such an event before this week’s market turmoil.
Gold was at risk from further losses after the breach of a critical support level but has held up well. This could be a low in the precious metal and we do not have to look hard for a catalyst to higher levels. Investors should forget about inflation hedges and the U.S. economy. A debt crisis is unfolding in Europe and as we get closer to winter, there is a risk of escalation between Russia and Ukraine that could drag western nations further into the mess. The U.K. economy has been the canary in the coal mine this week. Where governments had free reign to print money in the past, we have seen margin calls on pension funds due to a government stimulus package and that signals that we are at the end of the road for debt. Consumers are starting to feel the heat on all fronts with soaring energy bills and mortgage rates on a home that is set to decline in price. This is a toxic mix and gold should be a benefactor over the next six months.