If you agree with the logic outlined here, an environment in which the Fed is pursuing an exit may be favorable to the price of gold. And it's not because investors are fearful of another terrorist attack, it's because fear has been suppressed, yet the world is a risky place; and if market forces have it their way, fear as a healthy part of the markets will return. It also means that, all else equal, we believe the price of gold should be higher relative to equities.
Gold & Interest Rates
But all else isn't equal, as interest rates might be moving higher. At least that was the story we were told for years as the Fed was preparing the markets for an 'exit'. Given that markets tend to be forward looking, investors seemed to be fleeing the precious metal. After all, the real competition to a shiny brick that doesn't pay any interest may be cash that does pay interest. Cash, though, is an artificial construct, and investors have every right to be skeptical. Notably, investors may care more about the real interest they receive on cash, i.e. the interest after inflation is taken into account. While we are told what inflation rates are through official statistics, investors may choose their own perception of inflation in making investment decisions.
Instead of high rates, the world appears to be in a rush to go negative. Bloomberg recently wrote that one third of 47 countries in their global survey have negative 2-year government bond yields.1) Sure, in the U.S. rates are positive, but will the Fed be able to pursue its exit? Can we get real interest rates that are significantly positive? Or are we heading the other direction, i.e. is an economic slowdown coming that might take rates down further? In a recent editorial in the Washington Post, former U.S. Treasury Secretary Larry Summers "puts the odds of a recession at about 1/3 over the next year and at over 1/2 over the next 2 years." He then suggests that a "400 basis point cut in Fed funds ... is normally necessary to respond to an incipient recession."
While I don't encourage anyone to base their investment decisions on Larry Summers' musings (at least not unless he takes Fed Chair Yellen's job), I don't see real interest rates moving higher anytime soon. Larry Summers' scenario may be positive for gold, although - if we had rate cuts, it might, of course, compress risk premia once again, taking fear out of the markets...
The way we assess the Yellen Fed is a bit like an ocean tanker, i.e. it moves very slowly. The reasons for that we discussed in a recent Merk Insight, but have mainly to do with the fact that Yellen is a labor economist and, as such, typically looks at data that will lag developments in the real economy. To us, this suggests risk premia may continue to widen (causing risk assets to remain under pressure), and that any rally in the markets may be a bull trap, i.e. deceptive. In our assessment, investors are likely to use rallies to diversify their portfolios as they continue to be over-exposed to equities and other risk assets. The question is whether gold will be part of their diversification efforts. We think investors may want to consider adding a gold component to their portfolio.
Axel Merk is president and chief investment officer of Merk Investments.