Since the Russian invasion of Ukraine, gold had touched $2,000 and then dropped down to $1,700, down 15% from the highs. This has shocked a fair few, as gold is believed to be the perfect inflation hedge. Yet, it is down.
Let's see what's going on here.
First, know that what matters with gold is not just absolute performance. It is also gold's relative performance. On that latter front, gold has certainly outperformed most asset classes; it is still an asset, after all, and is vulnerable to the U.S. dollar, liquidity and flows. The dollar has been a massive performer against every single currency, as the market prices in a collapse in global gross domestic product economic output globally. Institute for Supply Management and Purchasing Managers Index new order indexes are all collapsing, as the global economy runs out of the central bank stimulus pump over the last two years, and the Fed is on a mission to raise rates. It has no choice -- lest we are stuck in hyper-inflation forever. Safe haven flows, together with interest rate parity differentials, is what is driving the dollar higher and subsequently gold and silver lower.
Another key factor that plays a factor in the price of gold is real bond yields. These have been rallying as gross bond yields have tried to play catch up with inflation that is averaging closer to 9% year-over-year for now. Silver is not only an inflation hedge, but it is also exposed to industrial demand, which we know is falling and so silver tends to get hit by a much larger amount than gold does. As silver has fallen 30% from its April highs, silver miners are down 40%-50%. The miners are a much more levered play on the same theme, but they are longer-term instruments, so of course discount a lot more on the way up and more on the way down. Also, not all stocks get to benefit from the higher price environment as we saw with Newmont Mining today whereby its top line rose, but its cost estimate rose even more causing it to miss on its earnings per share.
As we head into the key FOMC meeting this Wednesday, many investors are hoping for some sort of reprieve from the Fed, purely because that is what they are used to. The Fed has always printed its way out of a problem. This time, unlike the past 10 years, inflation is close to averaging 9% year-over-year. Given that input prices have dropped, price pressures will be lower, which should be reflected in the data in the months to come, but it is nowhere close to bringing the annual consumer price index closer to 2%-3%, which is where the Fed would be comfortable. Until then, it is in a bit of a catch-22: It can just buy some time, raise rates, and hope that inflation or the economy cools off fast enough before there is a systemic collapse.
The market is pricing in about three-quarter a percentage point rate increase as being a done deal for this Wednesday, with even a glimmer of a 1% rate increase. Even with that increase, we would only be at around 2.5%, nowhere close to pricing in the real level of inflation. But the system is so levered that it will not be able to take in more rate hikes for much longer. The forward curve is now pricing in rate cuts for the first quarter of 2023. At the rate at which the data is coming in, we may even get a rate cut by the end of this year. For now, one thing is certain, the bond market had it right all along, the Fed has lost control of its modern monetary experiment.