Gold Commentary - December 2016

Following the Fed’s well telegraphed 25 basis point interest rate increase the market was surprised by the Fed’s more hawkish stance. Specifically, the Fed signaled three rate hikes in 2017, up from two previously. Surprisingly, these revisions occurred without a material change to economic projections and core inflation forecasts. It is important to note that financial conditions were already tightening pre-FOMC (incredible USD strength, inflation expectations surging, rising yields), dampening growth prospects and reducing the need for the Fed to tighten more aggressively. 

Trump’s anticipated policies consist of considerable fiscal stimulus. Despite a lack of detail surrounding any stimulus plan, the market has already discounted a bullish outcome. A majority of Trump’s proposed policies appear to be highly inflationary. Considering the US is close to full employment, inflation pressures should be expected. The bond market has sold off in anticipation of this as nominal yields have increased at a faster pace than inflation expectations, driving up real rates in the near term – a negative for gold. In essence, the market appears to be discounting the negative implications of an aggressive fiscal policy faster than inflation expectations. The big components of the fiscal stimulus are tax cuts, increased defense spending, and infrastructure stimulus which should drive wage growth and wage driven inflation. 

The Big Question is how will the Fed react to an increase in the rate of inflation? The big fiscal stimulus components will likely not be implemented until the second half of 2017. There is a possibility of a clash between Fed policy (price stability) and Trump policy (aggressive growth stimulus, highly inflationary). Considering the past number of years which have seen sluggish economic growth and that the Fed has explicitly stated that they will not react to the first signs of inflation, the Fed may allow a higher level of inflation than their targeted 2% level. Certainly there will be enormous political pressure to allow the economy to run hot. 

Unlike the Fed, the BoJ and the ECB are still maintaining negative rate policies and active QE programs which are keeping their yields contained. US relative yield spreads versus German (near all-time highs) and Japanese yields are gapping higher and pushing the USD higher. Runaway USD strength can mitigate the economic benefits of any fiscal stimulus plans. There will be a limit as to how aggressive the Fed can be in terms of hiking interest rates. 

Movements in capital markets are so extreme that reversion to the mean is highly likely by January and we are beginning to see multiple signs of this in the indicators we track. Gold bullion and equities are extremely oversold and will likely bounce. The strength, breadth and duration of the coming bounce will be important. 

It is worth taking a look at the last bull market in gold. Gold equities are not for the weak of heart, however, the rewards from staying the course are fruitful. The rally in gold equities tends to be unpredictably violent with equities turning higher on a dime, followed by a period of consolidation which shakes away the weaker hands. We often see a massive change in sentiment as the sell-off brings out the bears. We are in the midst of such a sell-off. The lesson to be learned from this is to stay the course and to use the sell offs to average in. 

The Gold Team 

Paul Wong, Jason Mayer, Maria Smirnova, and Shree Kargutkar