10 Sep 2021
Ned Naylor-Leyland, Head of Strategy, Gold & Silver, says gold looks interesting at the moment as prices reign much below the peak seen a year ago amid uncertainty posed by new variants of coronavirus.
Central banks around the world have responded to the Covid pandemic by pumping in more money and easing interest rates to revive growth. A series of lockdowns to contain the spread of coronavirus has disrupted economic activity in a major way. But strides made on the vaccination front, particularly in the developed world, may potentially spur yet more inflation.
Still, the macro-economic environment is uncertain, as the emergence of new variants of the virus threatens to delay a faster return to normalcy. The monetary policy landscape remains largely unchanged over many months despite some hawkish overtones from the US Federal Reserve (Fed), which are contradicted by dovish noises by officials of the very same central bank.
In this complex scenario, it is important to assess the options in front of investors. Any talk of inflation immediately brings gold into play as it is considered a natural hedge. Gold and silver are considered to be safe-haven assets and portfolio diversifying assets. But gold prices are much below the peak seen a year ago.
Fund managers typically try to buy assets that are cheap and benefit from any repricing. Right now, the opposite has taken hold in investment markets, with momentum becoming the greatest part of performance and investor behaviour.
But if one considers buying an asset in anticipation of its rise in future, gold looks especially interesting at the moment, where silver carried the story in the first half of 2021. The reason: the divergence between real interest rates – the rate of interest excluding the effect of expected inflation – and the price of gold. The two are inversely correlated.
Source: Bloomberg, as at 18.05.2021.
In the past, this kind of divergence had lasted for either a quarter or at the most six months. If history is any guide, either real rates or gold must give way. Gold must rally strongly or real rates are predicting a deflationary sell-off event. We saw a similar divergence in 2019 that culminated in a strong move higher for USD gold prices.
One of the reasons why this divergence remains is because the bond market believes inflation will be transitory. But if one looks back at the massive expansion in central bank balance sheets since last March alongside the uptick in inflation, one might have expected the current macro picture to form a perfect basis for a rise in gold and silver prices. But that hasn’t happened. We think that’s an opportunity rather than a problem. Transitory rather than sticky inflation is priced in, as is a tightening and tapering narrative. If one, or both, of these assumptions falls away then much higher ground lies ahead for gold and silver prices.
Bond market prices reflect the optimism of market participants regarding how much tightening central banks can do, particularly the Fed. They believe there are going to be a few rate hikes and tapering of asset purchases. The Fed has been slightly hawkish for about ten months. The June `dot plot’ was a surprise as it brought forward interest rate increase expectations, giving rise to expectations that inflation will be suppressed.
Given this background, gold’s lustre has stayed dim. In a hawkish environment credit money looks slightly better in the future. So, what will turn the balance in favour of gold? One factor could be if inflation becomes more obvious and the markets start to believe that it is getting stickier. Any sharp rise in inflation is difficult to predict and rarely announces its arrival. Another factor could be a change in the Fed’s narrative. The highly contagious `Delta’ variant of coronavirus, which has even cast doubt on the efficacy of vaccination, could prompt the Fed to print even more. At present, it’s a waiting game for gold investors.
Interestingly, the idea that inflation is transitory, as well as tightening of policy, are priced in bond markets. If either are wrong or both are wrong, then both of those two things are positive for gold.
One reason inflation could prove to be stickier than perceived by many is that we are in a monetary super cycle rather than a commodity super cycle. As central banks pump in more money, investors may turn away from cash and bonds and rotate into real assets.
We have seen additional weakness in silver, as well as gold and silver miners, in recent weeks as retail investors capitulated about three months ago after refusing to accept the bond market’s view of the world for long. Institutional investors had left their posts in the fourth quarter of last year. This kind of behaviour of retail investors could also suggest a turnaround in gold and silver.
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