AGE Gold Commentary is our regular report analyzing trends in precious metals and rare coins. We monitor domestic and international markets and extrapolate from our 30 years in metals to place current events into a hard asset perspective. View archives.
7/7/2021: Gold, debt, and real yields
Negative real yields
Our debt trap
Slower growth, Weaker dollar
Physical gold and silver
The re-opening of the US economy after Covid closures has ignited the strongest inflationary pressure since the 1970s. In addition, with the budget deficit projected to be $3 trillion this year, our national debt is exploding at the fastest pace since WWII. And real bond yields are hovering near their lowest levels in decades. In this Gold Commentary, we drill down on inflation, debt, and real yields to analyze their ramifications for the dollar and precious metals both now and in the future.
The Federal Reserve's preferred inflation gauge, the so-called PCE prices index, climbed 0.4% in May to post a 12-month rate of 3.4%, the most since 2008. Prices are rising quickly everywhere you look. While the Fed has been sticking to its official mantra that this burst is transitory, we see reasons why high inflation may be stickier than the central bank is willing to admit.
Below is a Personal Consumption Expenditures chart going back to 2000 that puts the current surge into perspective.
As you can see, the headline reading PCE (red line) surged in 2008 but sharply declined going into 2009, while the core reading, factoring out volatile food and energy prices (blue line), never surged in sympathy. Today, both are sharply higher, with the core reading hitting its highest level on this 21-year chart today.
It's important to understand that inflation is not monolithic but multifaceted. There are several types of inflation. Supply and demand imbalances are one factor; wage inflation is another; monetary inflation (an increase in the money supply) is a third; and monetary velocity, or how quickly dollars change hands is a fourth factor that drives inflation. All are in evidence today and that means inflation may have some real staying power.
1. Supply and demand inflation
Fundamentally, supply and demand imbalances tend to work themselves out over time. Higher prices incent producers to make more goods to meet stronger demand. As prices rise, cheaper alternatives (where available) are sought as substitutes, deepening the supply chain. Eventually higher prices diminish demand, supplies rise, and the imbalances even out. In the short-term, however, commodity prices can surge substantially, which is what we have seen over the last 12 to 15 months.
For example, oil was $63 per barrel pre-Covid; today it is $75, or 19% higher. Copper has jumped from $2.87 pre-covid to $4.25, 48% higher. Lumber went from $474 to $775 for a whopping increase of 64% higher. Food prices are rising as well. In the last 12 months soybean and corn prices have surged 86% and 111%, respectively.
Almost everything we consume is in higher demand than supplies can fill for a variety of reasons, some that are transitory (supply chain bottlenecks), and some that may be structural. Global food prices, for example, were already rising before Covid.
In addition, the median national rent climbed 9.1% in the first half of 2021, according to Apartment List data, and is projected to rise another 7% to 10% this year. While some of this increase was bounce-back from pandemic bottoming, much is driven by record-high home prices. Indeed, rents are now rising above their pre-Covid track. High rents are form of sticky inflation, hard to reverse once they've taken hold.
2. Wage inflation
While commodity prices can surge and fall, wages are a much "stickier" component of inflation. When employers are competing for workers, they offer higher wages. Wage growth in the first quarter, when employers were struggling to find workers, was 3%, the strongest rise since the 1990's.
Even now, with the threat of Covid decreasing because of vaccines, companies are having difficulty finding workers they need. Why? Many report that they are still worried about Covid. Some are waiting for schools to reopen before they can reenter the job market in earnest. Working mothers have been particularly affected by the pandemic.
The hiring problem is happening across all sectors of the economy. As workers earn more, they have more spending power, which is fundamentally inflationary and tends to keep the inflationary ball rolling once it gets started. And once wages rise, they are hard to reduce, unlike commodity prices that can rise and fall much more quickly.
3. Money supply inflation
Increases in the money supply are highly inflationary. Through quantitative easing (QE), the Fed has flooded the financial system with $4 trillion in new dollars since the pandemic started. Tantamount to printing money, QE is fundamentally inflationary because it dilutes the value of all dollars in the money supply, reducing the purchasing power of each one.
However, the creation of new dollars is not always directly inflationary if the speed at which money changes hands, or its velocity, is low. For example, the Fed created $4 trillion out of thin air following the 2008 financial crisis. But the velocity of money declined steadily from 2008 into 2021, keeping inflation persistently under 2% despite all those new dollars. The economy may have been flooded with cheap cash, but people were not spending it quickly, so prices did not rise.
4. Money velocity inflation
As you can see in the St Louis Fed's money velocity chart below, the number of times one dollar was spent on goods and services per unit of time declined steadily since 2008, then plummeted in early 2020 to an all-time low. Unfortunately, this chart only includes data through Q1 of 2021, and does not yet include data for Q2 of 2021, when the US economic reopening blossomed in earnest.
The Fed's insistence that inflation is "transitory" may be related to low M2 velocity through Q1 2021. But consumer confidence and retail sales have been surging in Q2, which means money is--and will be--changing hands at a much faster rate.
Time will tell, of course, but what we do know today is that both commodity prices and wages have risen sharply, the money supply is through the roof, and its velocity is accelerating.
Doug Duncan, the Senior Vice President and Chief Economist for Fannie Mae, forecast in a private seminar I attended two weeks ago that inflation in the US will most likely be 5% in 2021 and 3.5% in 2022. This is far above the Fed's 2% target.
Mr. Duncan won the prestigious NABE Outlook Award for the most accurate GDP and Treasury yield forecasts in 2015 and 2016, the only recipient to capture the honor two years in a row. He has a dedicated staff of 50 at his disposal who continually survey markets collecting data. We highly respect Mr. Duncan's abilities.
Assuming he is correct, this year's astronomical inflation will diminish somewhat in 2022, but still be 3.5% next year, 75% higher than it was in 2019. This is not an insignificant increase! Whether it is transitory remains to be seen.
One thing seems clear: with all facets of inflation pointing higher, perhaps for a sustained period, gold should be well-supported as investors seek ways to preserve purchasing power.
Negative real yields
In recent years, gold prices have moved sharply higher when the real yield on US Treasurys has turned negative. We saw this is 2009 through 2011 and again over the past year. Both times, the gold price surged to all-time highs.
A negative real yield is when the rate of inflation is greater than the rate of return on an investment, most frequently measured against benchmark 10-year US Treasury yield. If the 10-year Treasury yield is 1.5% and the inflation rate is 2.0%, the real yield is a negative 0.5%.
Both the 2011 and 2020 gold peaks of $1,900 and $2,069, respectively, have this in common: they coincided almost perfectly with the largest negative real yields in recent history, as measured against 10-year T-Bill yields. If this trend holds, gold is due for another major rise.
As you can see on the chart above, the current negative real yield on the benchmark 10-year Treasury is minus 1.77%. This is more than double the negative real yields in 2011 and 2020, when gold hit those record highs! Obviously, there are many variables that are changing quickly. But the fundamental imbalance between this record low yield and the current gold price of around $1,800 leads us to one simple conclusion. Gold is vastly undervalued by this measurement today!
Remember, the Fed has pledged to hold interest rates to historically low levels in support of full employment. And gold has yet to respond to the current inflationary surge that has pushed this negative real yield to record lows. With inflation projected to be 5% in 2021 and 3.5% in 2022, negative real yields--already at extreme lows--could drop by another order of magnitude. This would put a higher floor under gold than it might otherwise enjoy, reducing downside risk when the Fed talks about monetary tightening.
Considering all the ways in which inflation is marching higher, plus the additional driver of record-low real yields, gold has potential to explode much higher in price, spiking well above the previous record of $2,069 and toward $2,250 in coming quarters.
Our debt trap
What if interest rates rise, narrowing the negative yield or pushing the yield into positive territory? What will that do to gold's prospects. The answer can be summarized in two words: debt trap.
Our governmental debt is exploding in response the second major global economic shock in 10 years. The mismatch between government revenue and spending has gone from irresponsible to potentially reckless as our national debt, now approaching $30 trillion, spirals out of control.
Asked about our current debt in a May interview, former Dallas Fed President Richard Fisher had this to say:
I do think we're in a trap. I shuttered when I heard my dear friend Janet Yellen say the other day, 'Well, rates are low, and we just need to finance all we can.' That's a trap, because eventually you're going to end up as we all know, being stuck with the cost to carry, interest payments, as rates rise, that will swamp everything else in the budget, including the defense spending, we've seen the numbers.
The reality is, the US will never pay down its debt in a meaningful way. And as interest rates rise, the interest payments to service this debt may well become unmanageable. Our national debt service was a record $585 billion in 2019. This record was when our debt was under $24 trillion and interest rates averaged about 2%. Today, our debt is about 25% higher but interest rates are lower, which is mitigating the debt cost. For now.
If the Fed is forced to raise interest rates substantially to combat inflation, it risks exploding the cost of carrying our enormous debt burden, creating a debt trap. Rate hikes coming out of the financial crisis had dramatically negative consequences, hammering equities markets and inhibiting growth. The last thing the Fed wants to do today is repeat that mistake and court recession.
Slower growth, weaker dollar
Over the last 100 years, nine different economies have accumulated a national debt that exceeded its GDP for 5 years or longer. In every case, those economies were unable to grow at more than 3% per year.
The US became the tenth when we crossed the 100% debt-to-GDP ratio in 2015. Today that ratio is around 135% and climbing. Since 2015, US GDP has averaged about 2.5% per year. Money that would otherwise go towards growing the economy, like infrastructure spending or R&D, instead goes towards debt service.
2021 may prove to be an exception only because 2020 saw extraordinary economic closures due to Covid. Based on recent history, however, it is likely that GDP will revert to subnormal growth sometime in 2022 or 2023 as all the pent-up demand for goods and services subsides.
Slower growth undercuts the stock market, weighs on the dollar, and makes US assets less appealing to foreign investors, including those nations like China that have subsidized our debt by purchasing Treasurys.
An environment in which overvalued equities lose their luster and the dollar drops in value is extremely bullish for gold in its dual roles as safe-haven asset and hedge against currency devaluation. This will be true even if interest rates rise somewhat off today's rock-bottom levels.
Meanwhile, deeper debt through yet more fiscal and monetary stimulus, along with low interest rates, may be the only solutions for driving higher growth going forward. A trap, indeed, that will weigh on the dollar and thereby support higher gold prices.
Higher inflation, deeper debt, surging negative real yields, a weaker dollar, and a potential reversion to slower economic growth. All this adds up to substantially higher gold and silver prices, making the current pullback in prices an excellent buying opportunity.
Let's look at the latest charts.
As you can see in the Dollar Index Chart below, the buck remains choppy within its range between 89.5 and 95. The pivotal support and resistance point within this range is 92.25. For most of the past year, the dollar has held below it. Following the Fed's suggestion in June that it might begin tapering quantitative easing later this year, however, the dollar caught a bid moving solidly higher and is now modestly above short-term resistance at 92.25.
We expect the dollar to continue to find support at the major support 89.50 and again at 91.50 in the short-term. It will encounter upside resistance at 93.50, with major, upside resistance at 95. Above 92.25 indicates short-term strength and below this level indicates short-term weakness.
The June Federal Nonfarm Payrolls Report came in slightly higher than forecast, with 850,000 new jobs created. But the unemployment rate also increased, showing that weakness persists in the labor market. If US continues to add jobs and the unemployment rate starts to fall again, the dollar may gather some additional support. But if the Fed leans into its full employment focus, as it has promised to do, monetary easing could be with us for much longer and the dollar would suffer.
In our March Gold Commentary, we discussed how rising Treasury yields had been gold's main headwind since it reached an all-time high in August 2020. Expectations of runaway inflation had driven traders to liquidate lower-yielding bonds to protect long-term returns, forcing yields higher. Higher yields, in turn, pressured gold by increasing the opportunity cost for holding it instead of bonds as a safe-haven asset.
Over the past eight weeks, however, yields have fallen as bond traders began to accept the Fed's argument that the inflation's aggressive rise will subside as pandemic-related scarcities of supply and pent-up demand normalize.
As a result, the dollar has once again become the dominant driver of gold prices, despite the deepening of negative real yields in April and May. If you compare the US dollar chart to the gold chart below, you will see that the dollar's U-shaped decline since early May, from 91 to just under 90 and then back up to 92.5, is the inverse of gold's price-action during this time frame.
The Fed' support of the economy is two-fold. One piece is monthly quantitative easing of $120 billion; the other is near-zero interest rates. If history is our guide, when the Fed decides to lessen this support, it will begin by tapering QE, gradually reducing the amount of monthly stimulus. It will not abruptly end support. And it is unlikely to raise interest rates until QE is over.
The point is that the money supply will continue to expand, if more slowly, for a long time to come while interest rates remain artificially low, and this will continue to weigh on the dollar. Indeed, all fiat currencies are losing purchase power as central banks try to reflate the world economy after the pandemic. And again, this is bullish for gold as a hedge against currency devaluation.
Following its record high of $2,069 last August and the ensuing double bottom at $1,678 in March, gold has been settling into a more defined trading range between $1,750 and $1,900. As we mentioned above, its May move from $1,750 to $1,900 and back to $1,750 is an almost perfect inverse of the recent dollar pattern.
After bumping up against short-term resistance at $1,900 in late May and early June, gold began to erode lower towards $1,860 in the days leading up to the Fed's June meeting. Hotter-than-expected inflation boxed the Fed into a corner. Acknowledging the rapidly growing elephant in the room, the central bank changed its forecast for the initial rate hike to 2023 from 2024. This mild change of course boosted the dollar and caused gold's selloff down to short-term support at $1,770.
The last time the Fed changed direction from dovish to hawkish like this was in 2013, and gold fell quickly from $1,550 down to $1,200. The difference between then and now is our national debt has almost doubled since, and inflation then was not a cause for concern. Meanwhile, real yields were positive and rising towards short-term highs instead of plunging to short-term lows.
With negative real yields at their most extreme level today, gold should enjoy a very solid floor at $1,750. While the summertime can be quiet, we may already have seen a bottom at $1,763. The downside for gold from today's $1,800 level is quite limited while the upside potential is much, much greater.
In the short-term, gold should find support at $1,760 and $1,720, and long-term support at $1,680. It will encounter short-term upside resistance at $1,840 and at $1,900. Long-term resistance will be found at $1,950 and again at $2,050.
Silver continues to trade in a wide range between $23 and $29.50, with the pivot point at $26. After surging from under $19 to over $29 last summer, it settled down and traded below $26 for most of the remainder of 2020. Last December, silver broke back above $26 and has remained there for most of the last six months. As the blue trend line indicates in the chart above, the bottom has risen since late last year and the bias is towards higher prices.
Like gold, silver sold off following the Fed's hawkish turn in June and is now firming up again. As we said in our last Commentary, buy silver under $26 if you can. It remains undervalued relative to gold by 10% to 20%, in our opinion. When silver plays catch-up, it tends to do so with a vengeance. With gold at $1,800 we think silver should be $35 per ounce.
Silver will find major support at $23 and again at $24. Above these levels, short-term support is at $25 and again at $25.75. Short-term resistance is at $27.50 and again at $28.50, while major resistance remains at $29.50. If silver can break past $29.50, it has the potential to move rapidly towards $35. Add to your positions while silver remains under $26.50. The opportunity may not last long.
Physical gold and silver
Premiums for most modern bullion coins and bars, excluding US Gold Eagles and US Silver Eagles, have declined over the last two months. Demand has receded from record levels as the pandemic has subsided over the last two months, giving producers a modest window to refill supplies. Most physical items are once again available for immediate delivery or with small delays. While the market is still not quite back to normal, premiums and delivery times are as close to normal as they have been since the late fall of 2020.
Beginning July 1, the US Mint started allocating its redesigned Type 2 2021 1-ounce US Gold Eagles and Type 2 2021 US Silver Eagles to dealers, with shipments starting this week. Demand for the lovely Type 2 Eagles continues to exceed supplies and probably will for the next few weeks if not months. Premiums on these coins are abnormally high today, and probably will remain high for the next month or two. We hope supply lines will be fully reloaded and premiums will return towards normal levels by summer's end.
Pre-1933 US gold coins
Demand for all physical gold and silver coins has been extraordinarily strong over the last six to twelve months. As result, premiums on pre-1933 US gold coins have expanded back to their 10-year averages. Some of you will recall, premiums fell to extremely low levels in 2018 and 2019, when the US economy was firing on all cylinders and unemployment was low. Today, premiums have risen but remain well below all-time highs. And ironically, overall supplies in the national marketplace are lower today than three to six months ago.
If we get another gold run, prices and premiums for pre-1933 US gold coins could surge sharply higher as demand overruns the meager supplies in the market. Indeed, we may look back at the summer of 2021 and see that it was one of the best buying opportunities this market offered. Unlike gold bullion coins, which can be produced in virtually unlimited numbers, these historic vintage coins are extremely limited in supply.
While the market remains relatively quiet, we continue to recommend the greatest scarcity you can acquire at the lowest premium and prices available. Scarcity is the most important factor in price-appreciation during a rising gold market. If the factors we have outlined in this Commentary play out in the way we expect, we should see a very strong market in coming quarters.
For those who want more bullion-related pre-1933 US gold coins, our AU $20 Liberty special cannot be beat! Seriously, these coins are a steal at our current special offering prices!
That's all for now. Thank you for your time and your business. Best wishes for a great summer as our wonderful country resumes normal life following one of the most unusual times in a century.
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