In Defense of Gold

If night follows day, and the US economy falls into a post-monetary tightening recession, gold may prove to be a big winner points out CME Groups economist Erik Norland.

Contact Information:

Email: erik.norland@cmegroup.com;

Web: www.cmegroup.com

Summary – IBKR Podcasts Ep. 84

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

This is Andrew Wilkinson for Interactive Brokers podcast. Welcome to this edition. My guest today is CME Group economist Erik Noland, who’s joining us this week from London, England. How are you, Erik?

Erik Norland

I’m doing well. How are you?

Andrew Wilkinson

Doing great, thank you. Looking forward to a sunny summer. We’ve got new interns joining us and all sorts of things going on at the company. It’s keeping me busy. So, today’s subject is going to be gold. I thought it would be an interesting time to get back into a discussion about it, since we’re probably at a monetary policy plateau, at least here in the United States, brought on by, dare I say it, Erik, rampant inflation. So, I thought it would be a good idea to check in on the price of gold and I believe it was that British economist John Maynard Keynes who coined the term about gold, that barbarous relic; tell us, Erik, how does gold generally relate to the macro economy?

Erik Norland

So, gold relates to the macro economy primarily through two avenues. First interest rates. And secondly, the US dollar. So, when it comes to interest rates, gold is still a currency which would horrify John Maynard Keynes, who is the one who called it a barbarous relic. But it is a currency that pays zero interest, and so when central banks lower their interest rates, gold tends to go up. And when central banks raise their interest rates, gold tends to go back down. The second thing it relates to is the US dollar. Gold, like most commodities, or almost all commodities around the world, is priced in U.S. dollars. So, it tends to trade opposite to the dollar. And the dollar strengthens versus foreign currencies like the euro, the pound and the yen, gold prices tend to decline along with those foreign currencies. By contrast when U.S. dollar sinks versus foreign currencies, gold tends to prosper.

Andrew Wilkinson

Personally, my take on it, I’ve never had a great deal of confidence in gold’s interpretation of inflation. If gold is so good at predicting inflation, why hasn’t its price moved substantially since, say, July 2020?

Erik Norland

So, this is a really good question. Gold had this huge rally from early 2019 when it was around $1200 an ounce up until July 2020, when it got to $2080 per ounce. During that time, the US and most other countries had low stable rates of inflation, but it wasn’t until about nine months after gold hit its initial peak in April 2021 that we started seeing the first really strong inflation numbers. And then gold in the last two years in which we’ve seen core inflation regularly running at around 5.5%, 6% headline inflation peaking at 8.0-9%, gold prices have basically gone nowhere.

They’ve tripled, peaked: So, we had that peak in July 2020, a peak in early 2022, and then apparently another peak, I suppose early May this year. So, the problem for gold is that as inflation struck, it created this expectation in the market that the Federal Reserve was going to massively increase interest rates to deal with that.

So, on the one hand, inflation probably was positive for gold. On the other hand, the Federal Reserve has done so far 500 basis points of rate hikes, and it might even go a little bit further, maybe do another 25 basis points sometime this summer. So, none of this has been particularly good news for gold. In gold’s defense, however, from the end of 2018, up until around March 2020, the Federal Reserve slashed interest rates to zero, and they began this huge money printing program where they printed at the beginning of the pandemic $3 trillion in three months, and they continued to print an additional $120 billion every month for almost the next two years, bringing their total monetary expansion to nearly $5 trillion. And so gold during this time rallied from $1200 to over $2000 an ounce, that’s a 60- something percent increase. So, you could argue in gold’s defense that it anticipated the inflation with its huge rally in 2019 in the first half of 2020 and that inflation did in fact happen later on much as gold anticipated it would do.

Andrew Wilkinson

Tell me about how gold typically relates to US monetary policy and also then to the US dollar.

Erik Norland

So, with respect to US monetary policy, what really matters for gold is not what the Fed is actually doing, but what rather the Federal Reserve is expected to do in the future. So, if you look at the correlation between gold and say Fed funds, correlation is close to zero. On the other hand, if you take a look at the correlation between gold futures and CME’s, Fed funds futures, especially the Fed funds futures about 12 or 24 months out in the future or the SOFR futures 12 or 24 months into the future, the correlation becomes very strongly negative. So, when traders start expecting the Federal Reserve is going to lift rates more quickly than they had previously expected, gold prices usually go down and when traders de-price rate hikes or when they start pricing rate cuts, gold prices usually go up.

Andrew Wilkinson

And of course, we’ve had that big inversion of the yield curve all year and even prior to that and SOFR futures are discounting big interest rate cuts by the end of this year, right?

Erik Norland

And you’ve seen how gold has been fluctuating with this. So, for example, last October and November at that time, the yield curve was not really so inverted, especially not at the shorter end of the yield curve. At that time the market was thinking the Fed might hike rates to 5.50-5.75% and keep them there for a longer time, and gold was not happy. Gold was trading around $1600 an ounce when it hit its low in late October early November. Then, as market expectations developed that the Federal Reserve was going to be done with rate hikes, it was going to launch into maybe 200 some basis points of rate cuts starting in September and gold loved that. It rallied from $1610 to about $2080 an ounce and retested that high for the third time that it had gotten to initially in July 2020. But then in the last month or so we’ve seen expectations for rates start to back up, so now the markets no longer thinking the Fed is going to cut rates to below 3%. The market is now thinking maybe the Fed will eventually cut rates to 3 1/2 percent or so after maybe they increase even one more time. In the meantime, gold has not been so happy with this. So, gold has come back down from $2080 to around $1965 or so at the time of this recording.

Andrew Wilkinson

So, Erik, from your perspective, what is the outlook for the US economy and and how might that impact the price of gold ahead?

Erik Norland

So, my outlook for the US economy is that we are in a very treacherous period that I call the lag time. So, the Federal Reserve often mentions in their discourse the long and variable lags between when they change monetary policy and when those impacts are felt on the economy. And if you look back over the last six tightening cycles going back to 1984 the Federal Reserve has had six periods in which it raised interest rates. During two of those times, it achieved a soft landing, which was very nice and not particularly great for gold. The other four times it had achieved a hard landing that put the US economy into a recession and curiously, those recessions typically begin anywhere from 10 months to 17 months after the last Fed rate hike. So, if you assume, for sake of argument, we don’t know that  May was the last hike, but you assume for the sake of argument that the last hike was a month ago on the 3rd of May, and you add 10 months to that, you might be looking at a recession beginning in March 2024.  If you add 17 months to it you might be looking at a recession around October 2024. Now, at the moment the US economy has a lot of forward momentum from huge increase of government spending, rising wages, tight labor markets, all of this is going to possibly keep upward pressure on interest rates in the short term, which is not good for gold. But if the Federal Reserve tips the economy into a recession, perhaps sometime next year, they are going to have to slash interest rates and that could generate a tremendous rally in the price of gold.

Andrew Wilkinson

But it’s not all about the US economy, is it, Erik, what about growth prospects outside, say, in China and other countries? How does that potentially impact the price of gold?

Erik Norland

Yes. And when China’s economy stumbles, the Chinese tend to do the same thing as people in other countries do, when their economy is stumbling. They tend to want to get out of their Fiat currency, the renminbi, and they want hard assets and gold is a hard asset and in particular in China, the government has a lot of capital controls on switching from renminbi into foreign currency. So, it’s hard for people in China to convert their money into dollars or euros, et cetera or yen. However, they can convert it more easily into gold by buying jewelry and things like that. So, when China’s economy stumbles, it’s often bullish for gold. And in fact, when China’s economy stumbles, it’s usually bad for every commodity other than gold.

Andrew Wilkinson

And so, your sense of how China and the rest of the world looks economically now?

Erik Norland

Well, China is in actually pretty tough condition right now. You know, they came out of the COVID lockdowns in December and there was this expectation that they’re going to see this huge pop in economic growth, which hasn’t really materialized. We have seen some improvement in Chinese consumer spending, which is good, but Chinese manufacturing is on the decline. Many countries or companies are looking to diversify supply lines out of China. China has also become an expensive producer of goods and their property market is sinking very, very quickly. So, the Chinese Central Bank is looking to cut interest rates again, I think rather soon maybe in the next few weeks they could cut interest rates again and as they cut interest rates, it makes holding renminbi look less attractive relative to fixed assets like gold.

Andrew Wilkinson

So, now I guess my final question, Erik, is about the supply side considerations, I mean we all know what’s happened during the pandemic to supply side issues for all kinds of goods, services and products, but what have we got to consider in terms of gold at this point from the supply side?

Erik Norland

So, for gold, there’s really two kinds of supply. There’s the mining supply and there’s what’s called secondary supply, which is recycling of gold. The only thing that matters, that’s really a driver of gold price is mining supply. So, when gold mines around the world start mining more of the yellow metal it increases the supply. And as you know from basic economics, when you increase supply, usually prices go downward. So gold supplies tend to change very slowly overtime, but once a trend starts, that trend can go on for many, many years. For example, back in 1980, the world was mining like 35 million ounces of gold per year. Now we’re mining something like 97/98 million. So, there’s been a huge, huge increase in mining supply over time. So, I would watch those trends in mining supply. You can get them from a lot of different sources like from GFMS or the CPM gold yearbooks. Once you see a trend developing, bear in mind that the miners, once they start mines in operation, they will continue that process for a long time. And when mines start closing, you can see a contraction in gold supply that can sometimes last seven years, 10 years, a decade or more.

Andrew Wilkinson

Erik, thank you very much. My guest today has been Erik Norland, who is the group economist at CME Group. A huge thanks for joining me to create today’s edition Erik, and please tell the listeners where they can read and watch more of your analysis.

Erik Norland

So, we have on our website cmegroup.com we have a lot of papers. They cover all asset classes, including occasionally gold, silver and other precious metals, and we also release a lot of videos on the website as well that often talk about gold and other commodities.

Andrew Wilkinson

And folks, if you enjoyed today’s edition of IBKR Podcast, please do leave us a review wherever you download your podcasts from.