After gold’s spectacular rally from $280 per ounce in 2002 to $1,900 in 2011, the past seven years have been a lackluster period for its investors. Gold’s nine-year rally closely tracked the 2002-2011 bear market in the U.S. dollar (USD). Moreover, expectations of gold investors that the Fed’s post-crisis quantitative easing (QE) programs would trigger high rates of inflation went unrealized. So far as we can tell, QE didn’t spark much of anything, least of all consumer price inflation.
Gold’s bear market coincided with the bull run in USD, the end of QE and the Fed’s tightening cycle. Increased gold mining supply hasn’t helped either. Indeed, gold and the Bloomberg U.S. Dollar Index still have a strong negative correlation (Figure 1). Although gold’s negative correlation to Fed funds futures has diminished somewhat, anticipation of higher rates is not good news for gold.
As such, the big questions for gold investors is how much longer will the USD bull market last and how far will the Fed’s tightening cycle go? The answers to these intertwined questions will play a major role in determining when the next gold bull market will begin.
Monetary and fiscal policy are pulling the dollar in opposite directions. Relative to the rest of the world, U.S. monetary policy is tight and becoming tighter. The Fed has already hiked rates seven times and will almost certainly go an eighth time in September. (The Federal Open Market Committee (FOMC) meets on September 25/26). Moreover, its “dot plot,” a forecast survey of FOMC members, suggests that it will go another six times between December 2018 and the end of 2020. No other central bank is undertaking a similar trajectory of rate increases. The Bank of Canada and the Bank of England are hiking rates about once or, at most, twice per year. The European Central Bank and the Bank of Japan won’t likely hike rates for years, although they may halt their QE programs by the end of the decade. Tighter U.S. monetary policy is sending the U.S. dollar higher versus most other currencies and against gold, which has the disadvantage of paying no interest on holdings.
By contrast, U.S. fiscal policy is becoming looser just as most other countries continue to reduce deficits. Since the end of 2016, the U.S. budget deficit has expanded from 2% to 4% of GDP (Figure 3). Normally, an expansion of U.S. budget and trade deficits bodes poorly for the U.S. dollar (Figure 4) and is supportive for gold.
The December 2017 tax cut and the March 2018 spending increases were bearish for the U.S. dollar and supported gold for a while, but U.S. fiscal policy appears to be on a stable trajectory. Further tax and spending legislation is unlikely until after the midterm elections in November (at the earliest) and more likely not until after the next presidential election in 2020. As such, monetary policy has been left to drive the dollar higher over the past six months as continued Fed tightening appears to have sparked the debut of an emerging market currency crisis (Figure 5).
While monetary and fiscal policy may be in a tug of war currently, this won’t last forever. Eventually, the Fed will stop tightening. That alone could be bearish for USD and bullish for gold, as it will allow investors to focus on the widening U.S. fiscal deficits. Moreover, if the Fed hikes too much, resulting in a recession, it will not only have to stop hiking rates, it would have to ease monetary policy in a hurry. Plus, when the economy goes into a recession, budget deficits typically explode, rising by 4% of GDP on average. That could potentially explode the deficit from 4% of GDP currently to 8%. The combination of wider fiscal deficits and easing monetary policy would be toxic for the U.S. dollar and would likely be a godsend for gold investors.
As such, so long as the Fed keeps tightening, gold is more likely than not to remain under downward pressure. This will be especially true if the emerging market currency crisis broadens to include more countries, sending USD higher. However, if the Fed overtightens, it could prove extremely bullish for gold when the central bank is forced to reverse course and ease policy. Watch the Fed’s dot plot forecast closely for hints as to where it believes it can take monetary policy in the future.
Lastly, there is the issue of China and the trade war. So far, the trade war has been bullish for the U.S. dollar and probably, on balance, not good news for gold. Typically, foreign currencies react to news of higher U.S. tariffs by selling off, and a stronger USD, as we have seen, is usually bad news for gold. However, if the U.S.-Sino trade dispute sparks a slowdown in Chinese growth, this could ultimately prove to be bearish for every commodity in the world save one: gold. China’s GDP growth rate correlates negatively with gold prices: stronger Chinese growth is often bearish for gold, whereas weaker growth is often bullish (Figure 6).
Chinese growth is burdened by high debt levels, trade uncertainty and an increasingly overvalued currency. If Chinese growth slows, it may have to devalue its currency at some point. The moment of devaluation, if and when it happens, will probably be bearish for gold. However, the aftermath could be quite bullish. A stronger dollar could force the Fed to stop tightening and could expand the U.S. trade deficit, setting the stage for eventual dollar weakening and gold strength.
Fed tightening has been a difficult experience for gold investors but each time the Fed hikes rates, it increases the likelihood of a downturn in the U.S. economy. For gold, it’s difficult to imagine what could be more bullish than a U.S. recession.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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