Since reaching multi-year highs in July, gold has plummeted 17%. Having risen 22% in the first seven months of 2016, many believed the yellow metal had moved too far, too fast.
They were right.
Gold’s fall quickened post-election, caused by an uptick in optimism about America’s future. The economy was seen as ready to “take-off” in 2017 once Trump’s pro-growth policies kicked in. The Fed’s December rate hike just added fuel to the fire.
But I wonder, how solid is the reasoning behind the rose-colored glasses?
Let’s start with a look at the Fed’s rate hike.
The quarter-point rise was seen as a vote of confidence in the economy from the Fed. Though the increase itself is tiny, it was the Fed’s projection for three more rate hikes in 2017 that moved markets higher.
However, it will be very difficult for the Fed to “go-it alone” on monetary tightening. Although the economic picture in the US is improving, weak global growth looks set to continue. This is likely to weigh down the Fed’s plans for 2017. Divergent monetary policy would create large premia between US yields and those offered by Germany or Japan. This will cause massive inflows into US assets, thus sending the dollar soaring higher.
Higher rates also mean the cost of holding gold is higher as it earns no yield. This is certainly a negative for gold. Long term, though, higher rates could actually be positive for gold.
The yield on the 10-year Treasury has risen 85% from its July lows, and many now believe the 35-year bull market in bonds is over. All signs seem to point in that direction, but there’s a problem.
US government debt is fast approaching $20 trillion, which equals 105% of GDP. Even with record-low interest rates, 6% of 2015’s budget was spent on just interest payments. Given its elevated debt levels, the government can ill-afford to have its budget deficits blown up by rising borrowing costs. If the Government’s fiscal-follies come to the forefront as they did in 2011, the Fed could be forced to reverse course.
This is closely linked to the second reason for optimism—fiscal stimulus.
A Proposal Too Far
If rates continue to rise, it would greatly boost the cost of funding Trump’s proposed $500 billion infrastructure package. Given that markets have already moved based on this, if it failed to happen, it could be very negative. It would also pass the growth-baton back to monetary policy. If we learned anything in 2016, it was that unconventional monetary policy alone cannot spur meaningful growth.
The two other policies to complete Trump’s “growth-trifecta” are tax cuts and scaled-back regulation.
The regulatory cuts shouldn’t be too hard to enact and will be very good for economic activity. However, if higher interest rates cause government deficits to explode, tax cuts would be out of the question.
As you can see, many of the reasons behind the cheery outlook are unsound and may not come to fruition. If they don’t, Trump’s term in office could echo that of the man he had hoped not too—President Obama. Obama enjoyed a honeymoon period based on the “Hope and Change” he promised. When the changes failed to arrive, confidence was lost.
For Trump, a loss of faith in the ability to make good on his promises would have an adverse impact on business and consumer confidence—and the markets.
In light of the reasons behind gold’s fall, is the logic for owning it still valid?