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Timely perspectives from financial industry experts.

Gold: where are we headed?

6/26/2019

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Gold: where are we headed?
Key points:
* Gold breaks above a 5-year trading range 
* Fed should not react to low inflation figures
* Negative yielding government bonds at a new high ($13 trillion)
 
The big question people are asking now is if we are at the beginning of a significant long-term trend up in gold, especially after so many false starts. The market seems to think it is. Why? There a couple of key reasons. 
For one thing, we now have expectations of a change in the dot plot, from a gradual raising of rates, to at least 1 rate cut this year. Despite demands from Trump to see lower rates from Powell, we should not expect anything more than 1 minor rate cut this year, and here is why:

In a Bloomberg News interview this week, the typically dovish James Bullard indicated that market expectations for a 50-basis point interest rate cut next month are "overdone." Some facts to support his comment: economic growth continues to chug along and unemployment remains low. Moreover, there are a lot of economic uncertainties out there, such as deteriorating trade relations with China, conflict with Iran, etc. The Fed needs to keep its options open, so why would they systematically decrease rates when there is close to full employment and inflation remains in the 1.5% to 2% range? It doesn't really make much sense.

Much of the talk of late has been about low-inflation figures, with the core personal consumption expenditures index - what the Fed looks at closest - comfortably below 2% since December 2018. But one should not expect the Fed to respond to low inflation, after all, their mandate is to maintain price stability and full employment. Prices are stable and the employment situation remains strong. If inflation were to go below 1% for 2 consecutive quarters, then it might be considered an issue, but at its current level? No. 

The most critical event propelling gold further at present is the negative yield on bonds:


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Gold responds to the opportunity cost of money, more than anything. When the cost of holding gold is minimal, as it is now, this is what you should expect. It would be strange to see these yields bounce back quickly. If one considers that the global economy is not in a recession and Central Banks are talking lower rates, then this becomes a serious concern. 

What tools will Central Banks have at their disposal if we do enter a recession, or if geopolitical risk and tariffs begin to affect the economy significantly? It seems the market is pricing all that in right now, in which case we might be due for a relief rally (or retracement on bonds and gold). Longer term however, it is clear the market has little confidence in either the Euro or The USD, which becomes a strong case for holding gold.

Will the USD remain weak over the next year? That is far more difficult to call. Gold has had a good run the past few weeks, but it's come too far too fast. At the same time, the critical level of previous resistance at $1350 USD has been breached. Any move back to or near that level should be considered an opportunity to go long again. 

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