By Stefan Wieler from Goldmoney. The full text with additional charts can be accessed as PDF here
Since the recent US elections gold prices in USD have sold off 7% and prices are down 13% from the year’s highs. This has led some market commentators to declare this as a turning point in the renewed upward trend in gold prices that began last year. In this note we analyze the recent move in prices within our gold price framework with specific focus on three questions:
1. Have gold prices moved in line with changing fundamentals (change in long-dated energy price, central bank net purchases and most importantly, real rates)?
2. If not, what is the market pricing in? And more importantly, if prices are in line with fundamentals, what is priced into fundamentals?
3. How far can this go if fundamentals move further against gold?
Within our gold price framework, we find that the decline in the gold price was in line with the rise in real rate expectations. The recent move in the gold price came mainly on the back of rising real-interest rate expectations (measured by 10 year TIPS yields) as longer dated energy prices remained roughly at and central banks in aggregate have continued to increase holdings (the Russian central bank was a large buyer again in October). TIPS yields had dropped to negative territory again in summer this year as the FED kept delaying the promised interest hikes. Heading into fall, TIPS yields began to gradually move higher to around 10-15bps in October in anticipation of a FED hike in December. However, the day after the election, TIPS yields rallied sharply to currently 50bps. The move in real-interest rate expectations came on the back of a move in nominal rates. 10 year Treasury yields climbed 100bps since the trough in July, half of that post-election alone (see Figure 1).
In the context of our model, the move in gold prices is slightly larger than what would have been predicted. Our gold price model predicts roughly a USD120/ozt drop in price from the recent peak on the back of the 60bp move higher in real-interest rates. However, prices declined by around USD170/ozt. Consequently, current prices are roughly 5% below our model predictions (see Figure 3), roughly 1 standard deviation of the model error. While this is within the normal error margin of the model, we also believe that the model might also not pick up the full extent of move in rates. For example, we use 10 year TIPS yields as input variable for real-interest rates expectations. Gold prices however likely reflect information over the entire rate curve. We believe that expectations further out in the future carry more weight, but the short end of the curve does matter as well. And the move in shorter maturity bonds was nothing short of spectacular, with 1 year yields reaching levels not seen since 2008. Hence we conclude that the sharp move lower in gold prices is more or less in line with fundamentals.
This market reaction to the election outcome tells us that expectations are now for a goldilocks scenario of stronger economic growth, stable inflation and partial normalization of interest rates. One can argue that the economic agenda of president elect Trump – deregulation, tax cuts, and infrastructure spending – will promote economic growth. But the latter two will also – all else equal – increase the budget deficit and thus lead to a higher debt burden. A higher debt level combined with higher rates would put further pressure on the budget deficit. This, combined with potential government spending spree, should get market participants worried about inflation. Yet while nominal rates have rallied sharply, breakeven inflation expectations have only moved toward the FEDs target of 2%. Hence, it appears that the market is currently pricing in a perfect outcome, where the interaction of all involved factors cancel out all negative effects:
1. The shift to fiscal stimulus, lower taxes as well as the boost to business confidence will lead to high economic growth for years to come;
2. The resulting increase in tax revenues will be large enough that the increase in spending (infrastructure) and loss in revenues (taxes) doesn’t’ meaningfully increase the budget deficit and thus debt issuance. The increase in nominal GDP will ensure that government debt/GDP actually shrinks;
3. This allows the FED to raise rates despite the higher debt servicing costs…
4. Which in turn keeps inflation pressures at bay that would otherwise arise from increased debt issuance and infrastructure spending1
The result of this is that real-interest rate expectations can rise which is negative for gold prices. The problem with this scenario is that it is also the only scenario in which real-interest rate expectations can move significantly higher and thus gold lower.
Aside from the obvious inconsistencies how the four arguments could interact with each other, this scenario does not allow for any exogenous shocks. Importantly, even under the Goldilocks scenario, the downside for gold would still be limited. Assuming that economic growth plays out in a way that allows the FED to raise rates as planned, the FEDs own forecast is currently for terminal rates of only a mere 2.85%. According to the FEDs own forecast, it will take several years to get there. Arguably FED funds rates are currently 2% below the 10 year Treasury yield and thus as the FED continues to raise rates, 10 year Treasury yields could go much higher. But historically, when FED Funds target rates peaked, 10 year Treasury yields were roughly at the same levels. FED funds rates went through six cycles over the past 30 years and on average, FED Funds target rates were just 0.25% below the 10 year yield when they peaked.
Even if economic conditions allow the FED to raise rates to its current target of 2.85% while maintaining its inflation goal of 2%, realized real-interest rates will most likely not exceed 1% much. All else equal, that would imply a gold price of USD1100/ozt. Hence, fundamentals would have to improve to the extent that the FED would raise rates well above its current target rates in order for gold prices to drop significantly below USD1000/ozt that some bearish commentators claim is now highly likely.
But how likely is that? The current federal budget deficit will be around USD540bn in 2016. Of that, USD260bn will be federal debt servicing costs. The congressional Budget office estimates that federal debt servicing costs will rise to around USD440bn by 2020 rise further to USD690bn by 2025 as cheaper debt rolls over and needs to be replaced with higher interest-bearing debt. We find the Bureau’s FED funds rate expectations of 3.5% by 2019 too high. Using the FED’s own guidance of 2.85% terminal rates implies that debt servicing costs by 2020 are likely around USD400bn per annum but will still be rising therefore as cheaper debt rolls over.
The estimates for the budget impact of Mr. Trump’s plans for tax cuts and infrastructure vary between USD4-6bn over 10 years. We go with the estimate of the Committee for a Responsible Federal Budget, a bipartisan non-profit organization, of USD5.3tn. In order for Federal Debt/GDP not to increase further, these policies need to generate enough economic growth to boost tax revenues as well as the denominator (GDP). A simple back of the envelope calculation using the FED’s 2% inflation target and the US census bureau’s population growth estimates reveals that even the very optimistic prognosis of 3.5-4% growth would still lead to an increase in the Federal debt/GDP level for a number of years before leveling off. In order for the FED to raise rates significantly above its current projections of 2.85% to let’s say 4%, without pushing the federal debt level much higher, real GDP growth would most likely have to be over 5%, for a full decade. This growth would have to be achieved not just as government debt servicing costs go up, but private debt costs would raise as well.
While there have been periods of prolonged extraordinary growth in the past, those periods were either associated with the industrial revolution or the recovery from the great depression and the US entering WWII. The chances for achieving these kinds of economic growth rates look rather dim at the moment. But that is exactly what the market seems to be pricing in now. In such a scenario, gold prices could fall below USD1,000/ozt. It would pose a major problem for producers. Most would produce at a loss and gold mining output would fall sharply. But then again, the Goldilocks scenario implies that people would want to hold less gold and more at currency. In all other scenarios, gold prices will continue their multi -decade upward trend and likely set new highs over the coming years.
This doesn’t mean that gold can’t trade lower over the short run from here. What the election result has really changed is business confidence. The markets’ euphoria over Trump’s election has been the match to the tinder that was the expectation for a second – and currently highly likely – rate hike by the FED in December. A mere two rates hikes in two years falls far short of the FEDs original optimistic outlook. But in the land of the blind, the one-eyed is king. Compared to the central banks of all other developed economies, the FED looks like a superstar which has boosted US rates and thus the value of the USD. This might last for a while, keeping downward pressure on gold price. But eventually it will become clear current rate path predictions are still overshooting the more probable reality.
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