Current Gold Price Cycle Started at the End of 2015…
Since we have presented our gold price framework the first time in late 2015, we have argued that we have entered a new cycle in the gold market. At the time we believed that longer-dated oil prices (5-year forward Brent) had likely set a bottom in late 2015 (at US$47/bbl, now US$60/bbl) and that real-interest rate expectations (10-year TIPS yields) were close to their cycle peak at 0.8% (now 0.3%) (see Exhibit 2). Our view was that – while there was some room to the downside – risk for gold prices were clearly skewed to the upside. While we weren’t extremely bullish near term for longer dated energy prices[1], the reason for our bullish view on gold was that we saw much more downside risk than upside risk for real-interest rate expectations.
By the end of 2015, the FOMC members were predicting terminal Fed funds rates at 3.5% (see Exhibit 3). The Fed also has a PCE (Personal Consumption Expenditure) inflation target of 2%, which, in our view translates into CPI (Consumer Price Inflation) of around 2.5-3% that is embedded in TIPS yields. Thus, we expected TIPS yields not rise much above 1% even if the Fed was able to raise rates as many times as it signaled at the time.
Importantly, with terminal rates at just 3.5%, any economic slowdown or even a recession would require the Fed to sharply slash rates, maybe to even negative territory, which in turn would bring down real-interest rate expectations. Hence, we argued that the next larger move in gold prices would likely be up due to declining real-interest rate expectations.
However, we also acknowledged that there was significant uncertainty about the path of real-interest rate expectations for the next few years. The Fed’s famous dot plot simply shows what the FOMC members expect for future nominal rates, not their stated target. A sharp pick-up in economic activity could allow the Fed to raise rates further. In our view, a “normal” 10-year treasury yield of 5-6% would have had quite a strong negative impact on gold prices. Assuming that the Fed would stick to its inflation target of 2%, real-interest expectations would most likely be around 2-2.5%[2]. All else equal, our model would predict gold prices to drop below US$1,000/ozt in such an environment.
In the aftermath of 2016 US presidential elections, that was exactly what the market started to price in. The market hoped that deregulation would unleash economic growth that would offset the negative impact of the Fed unwinding its balance sheet. And for a while, it looked like the economic environment in the U.S. did indeed gain steam and surprised both the market and the Fed. In turn, the FOMC members started to raise their expectations for terminal rates from just 2.75% back to 3%.
While this pushed 10-year inflation expectations from 1.2% in early 2016 to 2.2% in 2018, nominal rates rose even more quickly as the Fed was finally able to raise rates multiple times a year, pushing the 10-year Treasury yield to 3.2% in late 2018. The result was that real-interest rate expectations rebounded one more time to 1.2% (see Exhibit 4)
Gold has predictably struggled a little bit in this environment, but the dreaded gold bear market scenario never materialized. The price of gold was close to US$1,300/ozt before election day and it was down less than US$100/ozt by the time we saw peak rates late last year, despite also being in a bearish energy environment.
Part of the reason for this resilience is that, while the Fed tightened monetary conditions by raising rates and unwinding its balance sheets, central banks globally continued to ease, and total central bank assets are right now at an all-time high. This also explains why gold prices in some other currencies are also at all-time highs. On net, the up cycle that started in 2015 remains intact, and it just got confirmed by the Fed.
