Evaluating The Bullish Case For Gold

Gold has certainly been a strong-performing asset class so far this year, up 11.49%, and most of the credit is going to the Fed. Gold, the non-yielding bullion, tends to become more attractive when yields on Treasury securities decline. The dovish Fed has raised expectations of looser monetary policy conditions ahead, causing yields to drop, which has been one of the main catalysts for the surge in the price of the precious metal this year. Though a dovish Fed may not be sufficient to continue supporting gold prices higher, thus this article assesses other developments and factors that should also boost the precious metal higher going forward.

While many gold bulls are counting on monetary policy loosening to drive gold prices higher, it is important to acknowledge that lower fed funds rates is not always bullish for the commodity. To evaluate the performance of gold during periods of a dovish Fed, the correlation between gold prices and the Effective Fed Funds Rate (EFFR) has been calculated for such periods since 1969. Note that the time periods in the table below reflect periods of sustained declines in the EFFR surrounding rate-cutting cycles.

Note: the last two rows both represent the periods since the financial crisis, with one ending in December 2008 when rates bottomed, and the other ending at the beginning of 2015 marking the end of Fed balance sheet expansion through QE.

As the table above exhibits, while there were certainly periods of monetary policy easing during which gold rallied strongly, such as during the 1970s, it is important to acknowledge that this is not always the case. The negative correlation between EFFR and gold has not always been strong, and in fact, has sometimes even been strongly positive. For instance, during the 1989-92 dovish Fed period, the correlation between EFFR and gold was actually 0.70, as gold declined together with the fed funds rate.

If lower rates/ dovish Fed would always lead to gold bull markets, then Gold should have been outperforming amid the Zero Interest Rate Policy (ZIRP) for the most part of this decade. However, this was clearly not the case, as reflected in the chart below.

There are several reasons behind gold not performing strongly during this decade, even amid ultra-loose monetary policy conditions, and are factors we must incorporate into our evaluation of the bullish case for gold going forward.

Firstly, it is important to take into consideration the appeal of other major asset classes relative to gold during the respective time period. Over the past decade, risky financial assets such as equities offered very attractive returns, as capitalists benefitted from a growing economy and loose monetary policy conditions simultaneously. Strong earnings growth and expanding margins due have resulted in the longest bull market in stocks. Gold tends to be a more attractive alternative investment choice when riskier assets such as equities are performing poorly, but this was not the case during the 2010s.

The onset of Quantitative Easing from the Fed in 2009 was also expected to cause high inflation, which had initially made gold an attractive investment choice, given that the asset class is a good inflation-hedge. However, given that such high inflation rates never materialized, the appeal for gold diminished following the bubble burst in 2011.

Furthermore, the Dollar-denominated precious metal also tends to witness bullish moves when the USD weakens (as it becomes more competitive internationally). However, while ZIRP from the Fed should have been supportive for gold as this should keep the dollar weak, keep in mind that simultaneously other major central banks have been engaged in even looser monetary policies by adopting Negative Interest Rate Policy (NIRP), namely the ECB and BOJ. As a result, the Dollar remained relatively stronger regardless of loose monetary policy conditions in the US, which was also partly responsible for inhibiting gold from witnessing sustained bullish moves.

Looking forward

While gold failed to deliver lucrative returns over the past decade even amid loose monetary policy conditions, there are several other catalysts that should push gold prices higher over the coming years.

Economic and Political Uncertainty

Gold is an asset class that is more attractive during times of political tensions and economic uncertainty, particularly when there is a loss of confidence in the government/ Fed to deal with economic issues. Ultra-loose monetary policies (ZIRP and QE) at best have resulted in sluggish growth rates over the past decade. Hence re-introducing these measures amid the onset of the next recession may not prove sufficient to ease economic concerns and restore confidence. In fact, the 10yr Treasury yield (currently 2.05% at time of writing), which is considered a barometer for the future economic outlook, has not moved meaningfully higher even as the Fed has turned to a loosening stance. This reflects that the Fed will have to do a lot more to improve the economic outlook. Though if they are seen running out of effective tools, it would damage investors’ and public’s trust in the Fed, raising the appeal of gold amid rising economic uncertainty.

While the lack of confidence in the Fed is one concern, a lack of trust in the government in general is an even bigger issue. But what could cause such deterioration in trust in the government? Fiscal irresponsibility is becoming a major concern. The Trump administration’s tax cuts have coincided with surging outlays on items such as defense. As a result, the government is expected to run a trillion dollar deficit in fiscal year 2019. While trillion dollar deficits are not unprecedented, they are unusual so late in the economic cycle, as record low unemployment and rising wages should be boosting tax revenue and minimizing the need for outlays. In fact, spending caps that had been put in place through the Budget Control Act (BCA) of 2011 (amid the fiscal tensions that year) are also expected to be exceeded by $300 billion (in 2019) to allow for more spending. These fiscal developments and circumstances are undoubtedly sowing the seeds for a return of fiscal crisis going forward. If the government is already breaking spending caps and running trillion dollar deficits during the late stage of the economic cycle, it is worrisome to ponder over how ugly fiscal conditions will become when a recession hits.

There are good chances of a recession in 2020, putting tax receipts further under pressure and raising government expenditure needs. Simultaneously, the need for increased Medicare/Medicaid and Social Security spending is also increasing. The re-emergence of political fiscal disputes and near-default scenarios, the likes of which we witnessed in 2011, will once again damage trust in the government’s ability to be fiscally responsible and support the economy. While it would be widely expected for the government to continue raising the debt ceiling to avoid default, one must question the extent to which the US government can continue increasing the national debt while maintaining investor/ public confidence. In 2011, Congress had introduced the aforementioned Budget Control Act, which had put in place spending caps to impose fiscal responsibility and restore confidence in the government. However, given that the government has stopped adhering to those spending caps already (even in the absence of a recession), it undermines the ability of any future such Acts to ease investor/ public fear. Amid the August 2011 fiscal tensions, rating agency Standard & Poor’s had even downgraded the US government’s credit rating to AA+ (down from AAA), which at the time had propelled gold to its $1895 peak. The next inevitable episode of fiscal tensions will be harder to effectively deal with due to the lack of public/investor confidence in the government’s ability to adhere to any spending caps decided upon. Hence, the resulting rise in economic uncertainty, political tensions, and government distrust will bode well for gold going forward.

The 10yr Treasury also tends to witness bullish moves during such periods of fiscal tensions/uncertainty, as it is also considered a safe-haven. However, the ‘safe-haven’ nature of Treasuries is dependent upon confidence that the US government will be able to repay its debt to its creditors in the future. If the tensions and uncertainty have been spurred by lack of trust in the government’s fiscal responsibility in the first place, it would be more rational to allocate capital to gold over Treasuries as a ‘safe-haven’ bet. Whether we witness a temporary spike or sustained bullish trend in gold prices amid the next fiscal crisis will depend on how well and how long it takes for the government to handle its plight. Worsening political gridlock, downgrades in US government credit ratings and deteriorating trust in the US government could indeed result in more sustained rallies in gold prices going forward.

Deteriorating appeal of risky asset classes

While fiscal tensions and economic uncertainty are certainly potential catalysts for a gold bull market, we must also take into consideration other asset class performance prospects. Loose monetary policy conditions are not only favorable for gold, but also for risky asset classes such as equities. In fact, while investors have lately been focused and dependent on a dovish Fed to make bullish bets on gold, the prospects and relative performances of risky asset classes actually plays a more important role in gauging the potential performance of gold. Earlier in this article we found that the correlation between EFFR and gold is not always strongly negative during easing cycles, and can even be positive. The same is true for tightening cycles, as during 1973-74 the Fed had been raising rates, regardless gold had continued to climb higher (150%), as during that same period stocks performed horrendously, with the S&P 500 falling by 40%. Gold becomes more appealing as an alternative investment choice when risky asset classes are performing poorly, mostly due to rising economic uncertainty.

Over the last decade, stocks have soared and volatility has generally been low, which made gold an unappealing investment choice even amid loose monetary policy conditions. However, the appeal of equities could fade going into the next decade, due to several reasons. Public corporations have witnessed expanding profit margins over the past few decades thanks to automation efficiencies, globalization allowing for lower labor costs, and most recently corporate tax cuts worth $1.5 trillion. Corporations have also been engaged in large-scale debt-financed share buybacks (boosting Earnings Per Share through lowering share count), thereby taking advantage of ultra-low borrowing costs to propel their stock prices higher.

However, amid a widening wealth gap, the rise of populism/socialism and anti-capitalist sentiment could reverse these profit margin expansions. In fact, if Democrats take over the White House and gain more control over the House and Senate following the next election, they are likely to push for policies that redistribute wealth from the capitalists to the working-class. This would be in the form of higher minimum wages, more Health Care/ Social Security benefits for employees, and increased corporate regulations and tax rates. All these measures would put pressure on profit margins. Moreover, corporations have spent $4.8 trillion on buybacks since the stock market bottom in 2009, which has been an important driver of the bull market this decade. Though while corporations have been engaging in share-buybacks to boost their stocks higher, declining earnings and cash flows amid a slowing economy/ recession may limit their ability to continue their buyback programs. In fact, this year already, capital returns to shareholders have exceeded free cash flow for the first time since the crisis, with a buybacks to free cash flow ratio of 1.04, as corporations are increasingly using debt to engage in these buybacks. This raises companies’ leverage levels and weakens their balance sheets, making such stocks unattractive investment choices going forward. Moreover, Presidential candidates like Bernie Sanders are even planning to introduce constraints on companies’ ability to engage in share-buybacks. Hence if such Democratic plans gain traction going into the next decade, it could further hurt the appeal of equities. Therefore, equities performance overall is likely to be disappointing going into the 2020s due to intensifying anti-capitalist movements. As a result, looser monetary policy conditions are more likely to turn favorable for gold over risky asset classes like equities during this time period.

Risks to the bullish outlook

Relatively stronger Dollar

Due to the fact that gold is a Dollar-denominated precious metal, to a certain extent the strength of the Dollar relative to other currencies also influences gold prices. Even though the Fed had maintained loose monetary policy conditions over this last decade, the USD remained strong relative to other currencies as other major central banks engaged in even looser monetary policy conditions by adopting NIRP. Hence, the relatively stronger Dollar was partially responsible for inhibiting rallies in gold even amid a dovish Fed.

As a result, there is a good chance the Dollar could still remain stronger relative to other global currencies as other major central banks continue to adopt easier monetary policies compared to the Fed, which could undermine the rally in gold prices going forward. However, amid a diminishing effect of ZIRP/ QE in the US, the government/ central bank will need to find alternative measures of easing, and weakening the USD relative to other currencies (to make exports more internationally competitive) is certainly an option. In fact, the political will to actively try and weaken the USD has certainly gained traction during the current administration, as President Trump has repeatedly complained about China and Europe taking measures to weaken their currencies, disadvantaging American exporters and the economy overall. While White House aids have recently ruled out taking active steps to weaken the US Dollar in order to maintain its safe-haven status, President Trump has signalled that he is still open to it. Whether a potential Democratic leader next decade would also be in favor of weakening the Dollar remains to be seen, but the US is clearly seeking to mitigate the disadvantages that come with a stronger Dollar relative to other currencies. Hence while other central banks could turn out to be more dovish than the Fed over the coming years, active measures taken by the government to weaken the Dollar would help support gold prices higher.

The rise of crypto-currencies

During previous periods of economic uncertainty and political tensions, gold had been one of the few asset classes to turn to when confidence in the central bank and trust in the government declined. However, now there is a new asset class available that also offers an alterative to the fiat currency controlled by the central bank/ government; crypto-currencies. We must not ignore the potential for investors to also flee to crypto-currencies during times of fiscal distress and uncertainty (discussed earlier). While there is still skepticism present over the role of crypto-currencies, capital allocation towards this asset class could also undermine any future rallies in gold.

However, given that crypto-currencies are still relatively new, they still carry certain risks relative to gold. Firstly, gold is much more liquid than Bitcoin, given that there are a limited number of exchanges allowing Bitcoin/crypto-currencies to be converted to government-issued currencies, and there are also daily limits in place for how much can be converted to fiat currency. Until the utilization of crypto-currencies like Bitcoin becomes more widespread (relative to fiat currencies) in terms of daily use, its liquidity constraints could undermine its ability to offer a ‘safe-haven’ alternative.

Bitcoin’s safe-haven status is also undermined by the lack of regulation in the industry, making it susceptible to fraud, such as the Mt. Gox disaster. Comparatively, gold is less prone to fraud, making it a more reliable option for ‘store of value’ purposes. Furthermore, even though increased regulation could improve the safety of the new asset class over the long-term, the uncertainty of the type of regulation these crypto-currencies could face and how it could affect its viability for commercial and value transfer use could also undermine its appeal as a store-hold of value.

Furthermore, Bitcoin price is also still very volatile, currently trading significantly lower from its peak of around $20,000. Alternatively, gold offers relatively more price stability; making it a more appealing safe-haven hedging instrument. Bitcoin is more likely to pose a threat as an alternative to gold when its price stabilizes. While the threat of Bitcoin should certainly not be ignored, it is also unlikely to pose a significant challenge to gold’s safe-haven characteristics during the coming period of economic/political uncertainty.

Bottom Line

While investors are turning increasingly bullish on gold amid an increasingly dovish Fed, research reveals that loosening monetary policy conditions are not always necessarily favorable for gold, as the correlation between gold and EFFR is not always strongly negative, and sometimes is in fact positive. If loose monetary policy conditions were always bullish for gold, then the precious metal should have delivered lucrative returns over the past decade of historically easy monetary conditions. Hence investors should not solely rely on a dovish Fed to drive gold prices higher.

Nevertheless, while this past decade was not favorable for gold, there are various catalysts in the making presently that should support gold prices higher going into the next decade. Lack of confidence in the central bank to deal effectively with future economic weakness/ recessions, and lack of trust in the government to be fiscally responsible (and potential credit rating downgrades) are likely to augment the appeal of gold. Furthermore, while stocks have had a phenomenal decade, the rise of populism/socialism and anti-capitalist sentiment going into the new decade could present several headwinds for public corporations, which could pressure profit margins and equity prices. As a result, looser monetary policy conditions are more likely to favor bullish trends in gold over equities in the 2020s.

Therefore, it is highly advisable for investors to increase their portfolio exposure to gold, to better weather the economic uncertainty, political tensions and rising volatility ahead.