Gold prices have been struggling since the beginning of the year, quoting below $1,700 per ounce, definitely indicating a downward trend. On Wednesday, the Federal Reserve raised rates by 75 basis points in another move to a range of 3 to 3.25 percent.
“As long as real US interest rates rise, I remain tactically underweight in gold.” said Jan Longeval (photo), independent consultant and author of Heavy Metal, a book dedicated to precious metals and monetary policy, in an interview with Investment Officer Belgium.
Longeval cites positive real interest rates in the United States as one of the main reasons for the yellow metal’s correction. “Over the past 150 years, the correlation between gold prices and real interest rates in the US has been -0.82. So there is a strong inverse relationship between the two.”
Gold vs (inverted) Real 10-yr Treasury yields
Against the backdrop of a mediocre-to-poor year for financial assets such as stocks, bonds and real estate, Longeval points to a key asset for gold: the absence of any counterparty risk.
“Gold cannot go bankrupt and is therefore considered a safe haven, just like US government securities. Since the United States is not only an economically and militarily powerful country, but also a monetarily sovereign country with only sovereign dollar debt, it cannot go bankrupt either, unless it wanted to. After all, it has the ‘Power of the Purse’.”
Longeval continues: “A monetarily sovereign country can basically create as much money as it wants through its central bank and does not have to first raise taxes or incur debts. This magical power is called the ‘Power of the Purse’. Countries that have given up their monetary sovereignty, like all eurozone countries, have thereby also given up this ‘Power of the Purse’.”
“They no longer have their own currency and therefore cannot create money at will. They are completely dependent monetarily on the European Central Bank, which has a more limited monetary leeway than the Fed.”
Policy failure
Gold, which has been on the defensive for the past five weeks in response to stubbornly high US inflation driving up the dollar and US government bond yields, fell below the resistance level of $1,680. This happened as the market was overwhelmed by momentum and technical selling related to the risk of a rate hike. Moreover, the market continued to raise expectations on how high the Fed Funds rate will rise in the coming months. On Thursday, the Fed took another step in that perspective.
Ole Hansen, head of commodity strategy at Saxo Bank, mentioned in a research paper that the reasons to hold gold against a policy failure have only grown stronger with recent developments. The risk of the FOMC plunging the US economy into recession before getting inflation under control is increasing, and once that happens, the dollar is likely to fall sharply, supporting renewed demand for precious metals.
Weakened technicals
“Before that happens, however, gold could continue to suffer from the weakened technical outlook, with a weekly close below $1,680, potentially causing the market to aim for the 50 percent retracement of the 2018 to 2020 rally at $1,618,” Hansen said.
Near a 2.5-year low, gold is struggling to find a defence against the hawkish tone of the Fed’s policy-setting committee (FOMC), and along with other investment metals such as silver and, to a lesser extent, platinum, it may continue to struggle until some bullish drivers reassert themselves.
The focus remains on interest rate hikes by the FOMC rather than the increasingly inevitable economic consequences - a risk highlighted this week by FedEx and the sharp falls in the cost of shipping goods around the world. According to Saxo Bank, recent CPI prints may point to difficulties in bringing US inflation below 5-6 percent.
“If the market reaches the same conclusion, we are likely to see a sharp upward - and gold supportive - correction, with forward inflation swaps still pricing in a fall to around 3 percent,” said Longeval.
Dollar headwind
The US Treasury can therefore print dollars at any time to repay its outstanding debts. In other words, the US government can only go bankrupt if it wants to. Longeval: “The bottom of US long-term real interest rates was reached in August 2021 at -1.19 percent. It coincides perfectly with the peak of the gold price then, around $2,000 per troy ounce.”
Meanwhile, the financial landscape has changed considerably: Russia invaded Ukraine, US real interest rates have continued to rise and are currently trading comfortably above the 1 percent mark. “The dollar has risen 13 percent against the euro since the beginning of the year, and that too is a headwind for the gold price, at least in dollar terms,” said Longeval.
Not negative
In the tactical allocation of the clients he advises, Longeval recommends going underweight in gold at the moment, but not too heavily underweight either. “After all, gold is and remains an insurance policy against calamities and, as cited earlier, has no counterparty risk in physical form.”
With the risk of recession rising every day, Putin becoming a cornered cat that can make strange leaps, and the threat of arm-twisting in Taiwan, the risk of chaos and military unrest increases. “The past has shown that war and an economic recession make gold perform well,” said Longeval.