Gold’s day will come, but markets are wrong to bet on wild inflation
A fresh bout of economic fear will trigger a spike in real yields and set off an exodus of cash from gold
Gold was “wrong” a decade ago. Prices surged to an all-time high on breathless talk that dollar debasement and promiscuous printing by the US Federal Reserve would ignite roaring inflation.
I still have a currency note for 1,000,000,000 Zimbabwe dollars kindly sent to me by a reader at the height of the gold bug fever in 2011.
But the great inflationary blow-off never happened. Those who held on to their gold bars with sacred conviction watched gold prices drop 40pc over the next three years, even as equities marched higher in the BernankeDraghi-Carney bull market.
The US dollar did not collapse. The Fed’s broad dollar index touched bottom in May 2011 and then embarked on a vertiginous climb to a 30-year high. It was the Chinese yuan that instead ran into trouble, forcing the People’s Bank to burn through
$1 trillion of foreign reserves to defend the currency.
So, is it different this time as gold closes in on $2,000 an ounce? Goldman Sachs seems to think so, warning clients that “real concerns around the longevity of the US dollar as a reserve currency have started to emerge”.
The argument is a mind-twisting paradox. “Ironically, the greater the deflationary concerns that policymakers must fight today, the greater the debt build-up and the higher the inflationary risks in the future,” it said. The bank forecasts the gold price to hit $2,300 over the next 12 months. Are the hypothesis, timing, and sequence correct? Yes and no.
One can argue that the global dollar system of the last half a century is in its death throes. There are echoes of the early Seventies when a compliant Fed accommodated the fiscal overreach of the Vietnam War and the Great Society, culminating in the inflationary collapse of the Bretton Woods system.
One can argue too that the mishandling of Covid-19 by the US (and Europe) has accelerated the shift in economic power to Asia, bringing forward a Chinese economic sorpasso by a decade. But be careful of instant impressions. It was said in 2008 that the Lehman crisis had taken the US down a few geostrategic pegs, exposing the Achilles’ heel of the American model. China’s politburo certainly reached that conclusion and this tempted them into error. They doubled-down on Leninist capitalism, flattered by indiscriminate credit bubbles. We now know that China suffered the greater structural damage from the Lehman crisis, and the greater fall in productivity growth.
The trigger for the latest jump in gold has been the spectacular fall in real 10-year US bond yields to minus 0.92pc. Inflation expectations are shooting up, but at the same time the Fed is holding down nominal rates by financial repression.
“That is what has prompted the speculative moves over the last two weeks,” says Adrian Ash from Bullion Vault. “There is a sense of incipient inflation, and hedge funds are piling in. You have also got private Swiss banks recommending a 10pc allocation in gold.”
Behind this move lies a powerful slower-moving force. Central banks are no longer selling gold. Gordon Brown’s give-away sales of British bullion seem extraordinary now.
Russia, China, India and Turkey have been accumulating, but so have Poland, Hungary, Bulgaria and the Czechs. Central banks bought a net 656 tons in 2018 and another 650 in 2019, the highest levels in 50 years. “It has been phenomenal, but right now gold has got ahead of itself and needs to catch its breath,” says Ross Norman from Metals Daily.
Needless to say, the Fed denies that it is debauching the dollar, insisting that the Covid shock has left rampant over-capacity and will be
“disinflationary” for years to come. Former Fed chairman Ben Bernanke says markets were wrong to bet on inflation when QE was first launched, and they are wrong now.
He has a point. Real rates collapsed in much the same way in 2012. It proved to be a false alarm. Equities did inflate but consumer prices did not. Inflation fell for the next three years. So the question is whether something has changed in monetary dynamics since then.
Professor Tim Congdon, from International Monetary Research, says QE did not catch fire last time because the Western banking system was broken, and Basel regulation made matters worse by forcing lenders to raise capital buffers. Central banks had to ramp up QE to offset the ensuing destruction of broad M3 money.
Lenders are now in better shape and the Fed’s $3 trillion (£2.3 trillion) blast of QE since March has led to a 27pc rise in M3 year on year, the fastest rise in the US money supply since 1943. The money sits in bank accounts waiting for inflationary ignition once life returns to normal. The Fed could hoover up the liquidity before this happens but clearly has no intention of doing so.
The Powell Fed is openly aiming to “run the economy hot” as an insurance policy. It faces pressure from Joe Biden and the Democrats to fight inequality, deploying stimulus to close the wealth gap rather than driving up asset prices. The fiscal picture is infinitely worse today than a decade ago. The International Monetary Fund forecasts a federal deficit of 24pc of GDP this year, lifting the debt ratio to 141pc. That estimate was before the Covid-19 second wave caused the recovery to stall.
Fiscal dominance now hovers like Banquo’s ghost in the Fed’s Board Room. There must be a powerful temptation to dabble in Modern Monetary Theory and to start injecting QE stimulus directly into the veins of the US economy. Indeed, I am sure this will eventually happen.
What I doubt is that Reichsbank monetary financing of the US government is imminent. Nor is it that easy to reflate. The process can short-circuit quickly if bond vigilantes awaken from their slumber and take fright, precipitating a credit crunch.
My presumption is that the recovery will be slower and more painful than markets expect. The latest relief packages on both sides of the Atlantic are too small and poorly designed to avert a creeping insolvency crisis in the autumn. State and local governments in the US are being forced into austerity cuts.
If so, a fresh bout of economic fear will cause inflation expectations to fall again, triggering a spike in real yields and setting off an instant exodus of hot money from gold.
So, yes, Goldman Sachs is right in a sense. We have to revisit the deflationary quagmire one last time before the Fed and fellow central banks turn on the printing press as the lesser of policy evils. Gold will have its day of glory but don’t jump the gun.
Goldman Sachs forecasts the gold price to hit $2,300 over the next 12 months