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What the Gold Rally is Telling Us

Written by Geoffrey Pike
Posted July 8, 2016

Gold recently surged past $1,350 per ounce, while silver broke the $20 barrier. While we can’t be certain that this run will continue in the short term, it is a promising sign for gold and silver bulls who suffered from 2011 to 2015 after a decade-long bull run.

Gold went past the $1,300 mark with news of the Brexit vote, but it hasn’t reversed course as the news has settled in. Stocks were hammered after the Brexit results, but they have recovered to a large degree.

The other interesting investment that is probably not getting as much attention as it deserves is long-term bonds. Bonds have done quite well, as prices go up with decreasing interest rates. The 10-year yield recently went below 1.5%, and some are wondering if it will break the 1% barrier.

This has already happened around much of the world. In fact, interest rates are negative in many places. The 10-year yield on German bonds has gone negative, and the 10-year yield on Japanese bonds has gone deeper into negative territory.

What does all of this mean?

There is no question that some investors are fleeing to safety. The U.S. dollar — still considered the world’s reserve currency — is strong due largely to the weakness of the euro and the British pound.

Yet despite the strong dollar, gold and silver are doing well, even in dollar terms. Precious metals tend to be used as hedges against inflationary environments and disaster.

But lower long-term interest rates, especially in the U.S., are a sign that investors are locking in long-term rates due to fear, or at least in looking for some safety. It makes sense that rates are going down in Japan and Europe due to central bank monetary inflation. But in the U.S., the Fed has kept a tight monetary policy since October 2014, despite its low federal funds rate.

And while gold and long-term bonds are doing well, stocks, at least in the U.S., are holding up really well so far too. So there is no shortage of investors willing to take on some risk as well.

A Flattening Yield Curve

The best and most reliable predictor of a coming recession is an inverted yield curve. When you see an inverted curve — where short-term rates are higher than long-term rates — you should run for the hills. It is a sign to sell stocks and prepare yourself for a major economic downturn.

However, there has been little possibility of an inverted yield curve since the last major recession because short-term rates have been near zero. They are still close to zero, but have ticked up a bit, now around a quarter of a percent. Meanwhile, long-term rates have come down.

We don’t have an inverted yield curve, but it is flattening, as long-term rates come closer to short-term rates. This is a potential sign of a weakening economy, or even a coming recession. It is generally not wise to bet against the bond market.

When investors are fearful of a recession, they will often seek to lock in long-term rates. This drives down long-term rates as the demand for long-term bonds increases. And there is nothing safer than a U.S. Treasury bond, at least from the perspective of most institutional investors.

In terms of an outright default, there really is nothing safer than U.S. debt at this point. It is not to say that the U.S. government could never default, but we can be reasonably sure that it is not on the table in the near future.

The bigger threat is an indirect partial default through inflation. If the currency depreciates, then the bondholders get paid back with money that has reduced purchasing power.

This is why, in an environment of high price inflation, bond investors will demand a premium in the form of higher interest rates. If your money is going to be worth less in 10 years, then you want to be compensated for it. So it is not just about the current price inflation, but also the expectations for future price inflation.

In the 1970s, even during periods of stagnation or recession, interest rates were high. It was a reflection of the inflationary environment.

Gold as a Hedge Against Inflation

Gold also tends to be in favor during times of bad economic conditions. But it tends to be during times of higher price inflation. A recession with relatively low price inflation is typically not good for gold investors. Remember that gold fell sharply, even if it was relatively brief, in late 2008 and early 2009.

It gets a little tricky with gold because we can’t just rely on the Consumer Price Index (CPI) to tell us about inflation. Consumer prices were rising by double-digits annually in the late 1970s when gold was spiking.

But gold also did really well in the 2000s when consumer prices were not going up as much. Still, it was a time of a loose monetary policy and low interest rates. This was a contributing factor to the stock bubble and then the housing bubble.

The CPI measures consumer prices, but it does not do a good job of capturing asset price inflation. If you have asset price inflation without high consumer price inflation, it can be good enough for gold investors.

While the CPI is being reported as relatively low these days, it does not change the fact that gold prices are doing well. Something is driving this upswing, and it isn’t just Brexit.

A Contradiction?

Bond investors are telling us to watch out for an economic slowdown or even a possible recession. Gold investors are telling us to watch out for a possible uptick in price inflation. Stock investors are not telling us much of anything these days, but they are still generally holding up.

We shouldn’t trust stock investors, though. There are a lot of Americans just throwing money into some mutual fund in their 401(k) accounts based on an allocation determined by their targeted retirement date.

This isn’t to say all stock investors are stupid. This is obviously contrary to reality. It is just to say that we shouldn’t rely on the stock market as any kind of a predictor of what is to come because it is often behind the curve.

Bond investors and gold investors, at least in general, tend to give us a better picture of the economic environment we are in and what we are facing. Again, the bond market is probably the most reliable indicator there is of a coming recession.

Is this a contradiction, though? The bond market, with lower long-term rates, is signaling a possible recession and low price inflation ahead. The gold market is signaling higher price inflation ahead.

It is quite possible that one of these markets will quickly reverse course and send a clearer message. However, maybe this isn’t a contradiction. Instead of predicting what the economy is going to do, maybe it is more of a prediction of what the Federal Reserve will do.

What is the one thing that could be bullish for gold prices and long-term bonds at the same time? The answer is more monetary inflation by the Fed.

Are the bond and gold markets seeing QE4 in the future? Could we see an economic downturn quickly followed by a Fed announcement of more digital money printing? This would mean the Fed would be buying up assets (more demand for long-term Treasuries) and blowing up its balance sheet (more demand for hard assets and inflation hedges).

We will have to wait and see in the coming months how this plays out. Maybe this is a contradiction and one of these assets will win out. Or maybe both markets are seeing more loose money from the Fed coming.

Either way, it is hard to bet against either market at this point. If there is anything to be extra cautious about right now, it is stocks.

Until next time,

Geoffrey Pike for Wealth Daily

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