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Always believe in gold?

Jan 14, 2021
Gold is on a rollercoaster ride this year after recording its best annual gain in a decade in 2020.

Markets have been whipped up by potential ‘Blue Wave’ reflation, rising inflation and bond yields causing strong two-way price action.

While the dash to risky assets like oil and copper, together with global equities, has pushed these markets to new cycle and record highs, gold had been left floundering in the glow of positive vaccine news in November. But the last few days of 2020 saw upside pressure building and prices rose for five straight sessions through the new year towards the post-US election high of $1965.

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Democratic control of Washington

By capturing the Senate and controlling both houses of Congress, the road is now clear for Joe Biden to push for a larger stimulus package that could fuel economic growth and inflation. More money is likely to be seen for infrastructure and households which is undeniably positive for growth, and markets have reacted impressively over the last few days.

Measures of inflation expectations over the next decade have breached 2% a few weeks ago, a level last reached in late 2018, while nominal yields have pushed higher with the US 10-year Treasury hitting the magical 1% level. Aggressive fiscal policies by the new President could weigh on bond markets through more debt issuance and higher inflation.

Real bond yields and the Fed

The key for gold lies in real yields, that is those adjusted for the effects of inflation. Gold pays no income so it follows that the appeal of the precious metal will be greater as real yields fall. When they are negative (and at record lows around -1.1% earlier this week), we should expect gold to be historically expensive.

Importantly, nominal bond yields had flatlined since early December, a clear sign that investors expected the Fed to continue to suppress yields even as inflation expectations normalise. This rationale works fine if the Fed only begin to hike interest rates in 2023 or 2024. However, the risk is that yields move more swiftly higher as markets price an earlier Fed lift-off. Are we now in the zone where we find out if the Fed is serious about yield curve control?

Declining dollar helps

The greenback has suffered losses this week as economic recovery hopes and more government spending increase the prospect of larger US debt and deficits. But perhaps the real issue now for the dollar may in fact be that more stimulus continues to lift inflation expectations and weighs more on real yield prospects.

A few weeks ago, the largest amount of inflows into the biggest gold ETF since September was seen. A recovering global economy battling with a potential double-dip slowdown in the coming months will be the backdrop for gold bulls and bears alike. 

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