Gold certainly has a way of getting investors' hopes up. Most recently, it neared US$1,300 per ounce in early June, prompting optimism among bulls about a meaningful breakout to come. Alas, gold failed to push through that level, and now sits around the US$1,250 mark. There are, of course, bullish and bearish arguments to be made but, on balance, gold is currently facing serious headwinds.
That's not to say, however, that there isn't a long-term bullish case for gold. There is, but it may take years to play out. Simply put, the world is awash in too much debt, be it household, corporate or government.
Just how much? According to an October 2016 report by the International Monetary Fund, gross global debt (excluding that of the financial sector) stood at US$152 trillion, representing an all-time high 225% of world GDP. This overhang risks prolonged economic stagnation, if not a worse outcome. At some point, central banks will be forced to engineer higher inflation rates to lessen the burden of all this debt. Realizing this, investors can be expected to embrace gold as the ultimate safe haven.
The case for the bulls
The bullish case rests largely on real (i.e. inflation-adjusted) interest rates. This is a key driver of the gold price. When real rates are very low or negative, there is little or no opportunity cost in owning gold. When real rates are positive, however, investors tend to shun gold in favour of investments that earn a return once you factor in inflation.
Real interest rates help explain why gold suffered (despite expectations to the contrary) after Donald Trump was elected U.S. president and why it has bounced back this year. After the election, long-term interest rates soared, as investors started pricing in a surge in government borrowing and spending by the incoming administration. Inflation barely budged during this time, so the spike in nominal rates led to a corresponding rise in real rates. Government bond prices tumbled and gold followed suit, plunging toward US$1,130 near the end of 2016.
But as 2017 has progressed, the bond market has had a dramatic change of heart. Increasingly, investors have realized that much of Trump's proposed economic plan (such as a big boost to infrastructure spending) does not have a realistic chance of being enacted. As a result, U.S. interest rates have come back down to earth. Having reached 2.58% in December, the yield on the benchmark 10-year U.S. Treasury bond now sits at 2.14%. Gold has followed suit, bouncing strongly in the same timeframe.
What could cause real interest rates to keep falling, sending gold even higher? For one thing, U.S. inflation could start to surprise on the upside, perhaps driven by wages, given the tight labour market. If nominal rates don't keep pace, then the real rate will, by definition, fall.
Alternatively, it's quite possible that the U.S. economy might start to slow noticeably. Certain sectors of the economy look problematic to say the least, and this could feed through into weaker growth. Subprime auto loans, pricey commercial real estate and soaring corporate debt are all potential risks.
A slowing U.S. economy could send long-term interest rates sharply lower. The Federal Reserve, for its part, would probably respond to a slowdown by ceasing its campaign of raising its overnight policy rate. Depending on the severity of the downturn, the Fed could even start cutting interest rates once again. In this scenario, gold would probably benefit not just from lower real rates, but also a falling U.S. dollar.
Granted, there are reasons to be bullish on gold other than the path of real interest rates. Christopher Louney, commodity strategist at RBC Capital Markets in New York, told Morningstar that his team still thinks "political and geopolitical risk can drive bids for gold either in a sort of risk-off trade, or because of the repricing of economic expectations as the political and/or geopolitical landscape shifts."
As it relates to the repricing of economic expectations, Louney points to the example of the original U.S. health-care bill that was pulled earlier in the year. The bill's failure underscored the difficulty that the Trump administration was having in pushing through its legislative agenda. This contributed to a pullback in bond yields, and hence a rise in gold. RBC estimates that gold will average US$1,253 per ounce in 2017 and US$1,303 in 2018.
The case for the bears
John LaForge isn't dramatically bearish on gold, but the head of real-asset strategy for Wells Fargo Investment Institute certainly isn't hopeful either. "I've been long-term bearish on gold since 2012-2013," he says. He points to research he did in the summer of 2012, which concluded that commodities as a group would begin crashing. But at present, LaForge believes gold has seen most of its price downside. "That said, I also believe that gold will trade down/sideways for the next five years or so, like it did after the 1980s crash."
LaForge's bearishness is based in part on his research which shows that gold tends to track commodity prices generally. He believes that the unwinding of the commodity "super-cycle" still has years to run after having peaked in 2011. "Gold should not return to US$1,900-plus for at least five years, if not 10, based on the history of commodity-price super-cycles."
In the shorter term, LaForge is also bearish on gold because the long gold-price boom has resulted in higher global mine production. "For the remainder of 2017, we suspect that extra supply will continue to pressure gold down toward US$1,050," he says.
The bottom line for investors? Gold will eventually have its day, but that day could be some time off. Gold bulls should be prepared to be patient.
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