April’s sharp decline in gold got people’s attention. Plunging from $1,561 to $1,347/oz on April 12 and 15, it was a staggering decline of 13.7% the biggest 2-day drop since 1983. Is anything significant going on behind the scenes? We believe this price action is not a new phenomenon for gold, but a continuation of a much bigger trend that has been in place since the third quarter of 2011.
Underlying this trend are strengthening fundamentals such as a declining U.S. equity risk premium (the risk of investing in equities), the possible start of a U.S. dollar (USD) bull market, and expectations of tighter Fed monetary policy.
Inflation vs. Deflation Hedge
For decades, investors have viewed gold as an inflation hedge. Gold prices surged during the late 1970′s and again during the mid-2000′s in an environment of accelerating inflation in the U.S. Gold lost its luster as inflation retreated during the 1990′s (chart below). However, I believe gold became a deflation hedge after the Great Financial Crisis (GFC) of 2008 when markets worried about deflationary pressures brought on by government and household deleveraging. This contributed to a rising U.S. equity risk premium, declining real interest rates, and the U.S. dollar bear market all instrumental to the gold bull market. In addition, the emergence of gold ETF’s provided an investment vehicle (particularly for retail investors) into which to pour money into the shiny yellow commodity.
Factors Supporting the Gold Rally Appear to be Reversing
- Declining U.S. equity risk premia. Not only U.S. Treasuries but also gold have benefited from a flight to quality. A flood of global liquidity, a rebound in world economic growth and a reduction in tail risks have bolstered risk appetite. We believe this is leading to a rotation from safe-haven assets, such as fixed income and gold, into equity markets.
- Start of a USD bull market. Historically, there has been a negative correlation between gold and the U.S. dollar. The USD trade-weighted index, which measures the value of the dollar against other world currencies, bottomed in mid-2011 and has been trending gradually higher (chart below). We believe factors are emerging for a USD bull market rally as we discuss in our Pioneer Blue Paper The U.S. Dollar: Awaiting the Upcoming Bull Market.
- Expectations of tighter Fed policy and elimination of negative long-term rates. There is a tight relationship between real long-term interest rates and gold prices. As the Fed aggressively eased monetary policy, long-term real rates turned negative. The persistent downward trend in real rates increased the attractiveness of gold.
Gold began to roll over as the Fed began to debate the merits of QE and contemplated potential exit strategies. In recent minutes, debate has risen over the prospect of tapering purchases of fixed income securities later this year – a move the markets will rightly interpret as tightening policy. If the Fed exits QE, we would expect yields to climb much higher along with real long-term interest rates.
Size of Gold ETFs Could Highlight a Risk
Deutsche Bank Research believes one of gold’s distinctive characteristics is the high share of investor money and physical hoarding that occurs in the market. The emergence of gold ETFs led to a surge of retail buying. Inflows into Gold ETFs peaked in December 2012 and have begun to roll over. We would caution that if our view on gold materializes, we could see more liquidation occur.
According to BCA Research, the price for gold has averaged between $600-$800/oz since 1975 in today’s prices. Long-term calculations spanning 150 years of data arrive at a similar result. They conclude that at $1600/oz the level that prevailed early in April gold appeared to be severely overvalued. They make another compelling argument that at today’s price of $1425/oz, U.S. headline inflation would have to rise by 8% for a decade in order for gold to be fairly valued today.
The recent price action in gold has raised expectations of whether this is a short-term move or something more long term. We believe it is the latter. In fact, with potential for a rotation from fixed income into equities, a stronger USD, and expectations for tighter monetary policy, gold is likely to continue its weakening trend.