Where is gold going?

MARKET INSIGHTS

Great expectations

To properly get to grips with where gold is going, it’s vital to understand how inflationary forecasts affect the market

Guy Le Page

GUY LE PAGE

In July the G-7 imposed a ban on the importation of gold from Russia. Despite the British Government saying that the move “will have a global reach”, it is unlikely to have any effect on gold prices in the medium term. Instead, the Russian government will have the following options:

◾Use gold as collateral for borrowing ◾ Change the chemistry of the gold by re-smelting and mixing with various trace elements and impurities ◾ Report gold as mined gold through a foreign jurisdiction, e.g., find a mine in a foreign country and report increased gold production. There are certainly a few foreign gold producers in need of positive production news…? ◾ Sell the gold to non-western aligned countries such as China.

So, with that in mind, what has been happening in the gold market?

Despite a weakening AUD (keeping gold in AUD terms relatively flat), ASX-listed gold shares have been on the nose (refer

Figure 1: ASX Gold Equities vs Gold Price. Source: Macquarie (22 July 2022). to figure 1) as high inflation has impacted production costs.

In these times, it is useful to revert to the facts and remember what actually drives the gold price.

There is a little more nuance to the actual relationship between the macroenvironment and gold prices than gold bugs like to let on. Understanding it can be the difference between timing the market and wearing it on the ass. Along the terrace in Perth, it certainly seems that more have fallen into the latter...

Gold is most statistically correlated (inversely) to real US 10-Year Treasury Yields (figure 2). Real yields are 10-Year Yields minus inflation expectations for that 10Year period. The distinction between inflation and inflation expectations is important. Whilst inflation has persistently exceeded market expectations, the market has reacted by reducing long-term inflation bets. This is due to the Fed’s reaction to elevated current inflation, which the market has correctly anticipated will trigger a recession impairing aggregate demand.

Interestingly, when we look at the chart above, there seems to be a recent disconnect between the relationship. This either implies that gold is overvalued or that gold punters have a different belief to those who are setting inflation expectations. Those same expectation-setters were spectacularly wrong this year – but I digress.

The US has a significant debt problem, and one would be forgiven to mistake this chart (figure 3) with that of a meme stock.

Looking to the far-right side of the chart, you’d also be forgiven to think that the US has reduced its debt position since the end of the initial COVID stimulus. WRONG. It has decreased in real terms because inflation is the friend of the debtor, not the creditor. After all, there is two ways to default on a loan: 1) either fail to repay the principal; or 2) repay the principle in full in the depreciated currency it is denominated in.

With the budget currently running at a deficit of ~6% GDP and the 10-Year Treasury yield currently at 2.7%, the cost of servicing debt will exceed US GDP growth. In other words, the US is a zombie country.

Which is why the Fed may be forced to allow inflation to run a little higher for a little longer. The backdrop of energy inflation due to ESG stupidity, and deglobalisation due to geopolitical tensions, may provide a convenient excuse.