Goldman Sachs has issued a report stating that the price of gold is likely to peak in 2013, ending the yellow metal’s 12 year run. The investment bank is assuming that stronger US economic growth will lead to a rise in US real interest rates, however this article looks at why Goldman is wrong.
In the short-term Goldman is bullish on gold, with Jeffrey Currie, an analyst at the bank, saying that “the combination of more easing [QE from central banks] and weaker growth should prove supportive to gold”. However the investment bank believes that an improving US economy will lead to rising real interest rates which will prove negative for gold.
Over the medium-term the outlook for gold “is caught between the opposing forces of more Fed easing and a gradual increase in US real [interest] rates on better US economic growth. Our expanded modelling suggests that the improving US growth outlook will outweigh further Fed balance sheet expansion and that the cycle in gold prices will likely turn in 2013” Goldman said.
Without additional easing by the Fed in the second half of 2013 Goldman predicts that gold may fall to $1,625 by the end of 2014.
The firm has revised its six-month gold price forecast down from $1,940 to $1,805, and its 12-month forecast from $1,940 to $1,800.
What’s driving the gold bull market?
The gold bull market is being driven by powerful structural forces such as currency debasement (which shows up as inflation), and negative real interest rates, i.e. interest rates that are below the rate of inflation. Only when central banks around the world halt their efforts to stimulate economic growth via quantitative easing, and allow interest rates to rise will the bull market in gold come to an end.
The risk free rate of return, i.e. the rate paid on a 10-year US Treasury, is currently 1.60%, however the CPI inflation rate (using figures from the BLS) is currently running at 2.16%, meaning that adjusted for inflation interest rates are negative to the tune of 0.56%.
Why real interest rates will remain negative
Under their “improving US growth” scenario Goldman is either forecasting a rise in Treasury yields, or a drop in the inflation rate, or both. However the Fed is pursuing aggressive monetary policy to ensure this doesn’t happen.
It is widely expected that in its efforts to boost growth, the Federal Reserve will soon add around $45 billion a month of Treasury purchases to the $40 billion in mortgage debt it is already buying. This would mean that the Fed will effectively be absorbing about 90% of new dollar-denominated fixed-income assets.
As Bloomberg reported on Monday, “Even after U.S. public borrowings outstanding grew from less than $9 trillion in 2007 as the US raised cash to pay for spending programs designed to pull the economy out of the worst financial crisis since the Great Depression, rising demand coupled with a drop in net supply means bonds will be scarce”.
A Bloomberg survey of 18 primary bond dealers found that the US government will reduce its net sales of Treasuries and other dollar fixed- income securities by $250 billion from the $1.2 trillion of bills, notes and bonds issued in fiscal 2012 which ended 30 September.
Zach Pandl, a senior interest-rate strategist at Columbia Management Investment Advisers LLC, pointed out 30 November, that “The shrinking amount of bonds in the market is lowering rates and not just benefiting the Treasury, but providing lower rates for private-sector decision-makers as well.”
Essentially the US central bank now IS the market for US government debt. I.e. the US government issues new debt (currently more than $1 trillion a year) and the Federal Reserve buys it, thereby almost entirely bypassing the international bond market. As a result the Fed can (at least for the time being) keep a lid on interest rates.
Longer-term this policy of debt monetisation is very dangerous, and with M3 money supply now growing at just under 5%, inflation will begin to manifest sooner or later.
Another reason that the US government and Federal Reserve are determined to keep interest rates suppressed, is that during fiscal year 2011 interest payments on US debt amounted to more than $450 billion. In March 2012 the CBO (Congressional Budget Office) calculated that a 1% rise in interest rates could add around $1 trillion to interest costs over the next decade.
The outlook for gold
As the chart below shows, gold is in a short-term downtrend, however the longer-term outlook remains bullish. Investors now hold a record amount of gold in gold-backed exchange-traded products, and nations from Russia to South Korea continue to add to their reserves.
An 8 day hourly chart of gold (Click on the chart for a larger version)
Chart courtesy of IT-Finance.com
Speaking on Bloomberg on Tuesday Rob McEwen, chief executive officer of McEwen Mining Inc. and founder of Goldcorp Inc., said “People are just looking and seeing that in the last 11 years the pound has lost 83% of its value against gold on a relative basis, the dollar has lost 85% of its value. There is a huge opportunity cost that people are incurring by not having some exposure to gold”.
Our analysis suggests that real interest rates will remain in negative territory for several more years at least, and even though we expect the inflation rate to pick up, we expect interest rates to remain artificially suppressed.
How to protect your wealth in this environment
Most investors hold gold as a form of wealth or portfolio insurance. Not only does gold protect your wealth from inflation, it also protects the rest of your portfolio from a host of systemic risks. Gold is a highly liquid asset that is universally accepted as a means of payment. It is also unique in that it is the only asset that is not simultaneously someone else’s liability.
Because gold is your insurance we advocate owning physical gold that is outside of the banking/ financial system, rather than simply buying an ETF (Exchange-Traded Fund) such as GLD. That’s because an ETF is a paper derivative of gold designed to reflect its performance, and the holders of ETFs are exposed (often unwittingly) to a host of risks, from movements in the Foreign Exchange markets, to there being multiple claims on the same metal – exactly the sort of risks you are trying to avoid when owning gold.
Those looking to capitalise on the rising price of gold should look at using companies such as BullionVault or GoldMoney, which store your gold for you in physical (and crucially allocated) form, in exchange for a small fee. We also prefer to accumulate gold on a regular basis rather than trying to time the market.