Major central banks have ramped up their hawkish tone in recent weeks as headline inflation numbers continue to reign uncomfortably high. Expectations of more aggressive interest rate increases by the US Federal Reserve (Fed) as well as its European counterpart have kept gold prices in suspended animation since the first quarter of this year. As can be seen from the enclosed graphic, government-issued money of all denominations trends lower against gold over the long run, a phenomenon we expect to accelerate in due course.

Fiat currency depreciation vs gold

Fiat currency depreciation vs gold

Source: Bloomberg, as at 23.08.2022

At the end of March, gold peaked at $2050 an ounce, a key technical level that has been reached four times in the past four decades on an inflation-adjusted basis. When this level finally breaks, we feel that the viability of the petrodollar system that began in 1971 will be genuinely in doubt. The position of risk-free status, in the minds of investors if not central banks, has been held by the US Dollar since Nixon closed the gold window in 1971 but a breakout (or breakdown for the dollar versus gold) will throw that underlying assumption that runs through all markets into question.

As markets expected the Fed to take a measured approach to rate hikes in Q1 this year following Russia’s invasion of Ukraine, alongside rising energy inputs, real rates fell and the $Gold price rallied challenging that key $2050 level. Immediately, as in 1980, 2011 and 2020, the Fed responded with a raft of hawkish guidance, driving $Gold back down from this critical level. The question is, when the Fed does have to pivot, how quickly will gold prices leap up and challenge this key technical level?

While inflation continues to be a bugbear for policy makers and the general public, recent policy measures may lead to further deterioration in economic growth, indeed that is the intention. The central banks are truly in a bind now. Oil prices have declined from their peak and commodity prices too have eased, but inventories are at perilously low levels, risking another leap higher. Risk assets and non-dollar currencies (including gold and silver) are facing the brunt of the Fed’s policy, which they hope in turn will adversely affect demand in the economy. Higher mortgage rates are already slowing the housing market, which contributes about 15%-20% to the US GDP. In effect, the Fed are endeavouring to raise rates into a slowdown, triggering a hard landing of the economy. This of course could prompt a Fed pivot next year if the likely hard landing outcome is what follows. Such a scenario would increase the allure of gold as long-end real rates would drop precipitously from current elevated levels.

History shows the best time to buy gold is when central banks are on the cusp of turning dovish after a period of hawkish jawboning. The waves lower for government-issued money in the enclosed graphic are driven by that shift to accommodation and dovish policy and the bounces of course are the generally briefer moments of hawkishness. The key learning outcome here is that the primary driver of gold prices in all currencies is the language used by central bankers and their policy stance which signals either accommodation or tightening to the bond market. Between 2002 and 2011, we were in a supportive and generally dovish central banking environment, which was not just confined to the Fed. In late 2011, however, we entered a period of about five years of broad-based but relatively low octane hawkish guidance.

The price of gold differs in different currencies, depending on how advanced their central banks are in their monetary cycle, but it can be seen clearly that they do also move directionally as a pack against gold. To reiterate, at the moment the price of gold in dollars is lower relative to those priced in other major currencies simply because the Fed has been substantially more hawkish than other central banks. This is the way to think about gold priced in each national sovereign currency.

A dovish Fed pivot would shift the direction of US dollar real rates from rising to falling and gold would likely once again rise towards the peak of $2050 touched in March. The same level was touched in 1980, 2011 and 2020 on an inflation-adjusted basis. Given that the time taken to hit the peak each time has shrunk over the years and the fact we are relatively close to that level with peak hawkishness priced in, gold may surprise the market and be poised for fresh highs in the coming months. This we think could reinforce the market’s preference for a hard and apolitical instrument such as gold over government-issued money and could have broad implications for all asset prices, not just affecting the outcome of gold and silver mining equities.

The value of active minds: independent thinking


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