Gold Loses Its Luster

Gold continues to get pummeled in terms of a strong dollar. The dollar is one of its chief competitors and bonds denominated in the USD now sport fat yields. Gold typically does best when investors believe prospective real bond yields are too low. Recall gold prices soared alongside Treasuries in mid 2020 as the Fed slashed rates to zero. This dynamic has shifted into reverse.

Many investors are having a hard time reconciling gold’s reputation as an inflation hedge with its dismal performance in recent months. Even as we’ve seen near double digit annual bounds in the CPI gold prices have sunk by double digits. This cognitive dissonance simply flows from a faulty assumption … that the CPI is an index of inflation. Let go of the invalid premise and it all starts to make sense.

The inflation now reflected in the CPI has been happening for years, capped by a final surge in 2020. And gold prices have responded dutifully. As we pointed out a few weeks ago, deflation has taken center stage. Consumer prices are near the end of the price inflation bucket brigade … once inflation is making headlines the early birds have already gotten the worm.

But how does that help us to anticipate what happens next? Deflation – and by that I mean an appreciating currency – is in force. But it has not yet made the headlines. Most of the financial world remains obsessed with inflation, as it watches its exhaust fumes in consumer price measures. With yet even more dollar-supportive monetary tightening in the pipeline, we don’t yet know, but it’s unlikely the system can sustain yields across the curve nearing 4.5% for long. Just for instance how long do you suppose housing prices can hold up with over 7% mortgage rates, after having been priced for years with rates under 3%?

SS thinks a turn could come at any time, having pegged the beginning of this quarter with about a quarter’s leeway. Gold has been a pain trade for investors who do their accounting in US dollars, and we have no crystal ball to tell us in advance the exact date that will change. But we can be prepared for when it does. Accumulating deflation will break something as dollar denominated debt rises and becomes unserviceable somewhere that will catch the financial world’s attention, and prompt the Fed to reverse its tightening program and go into deflation fighting mode. We will know it when bond prices break out of their practically ruler-straight downtrend (below). Gold will confirm by following suit. When the turn comes, though, it will have a long way to run.

15 thoughts on “Gold Loses Its Luster

  1. jk says:

    for people who don’t do their accounting in dollars [i.e. europeans, asians, etc] gold has done just fine. as you say, it’s the strength of the dollar keeping a lid on gold, even as physical gold continues it’s migration from global west to global east.

    the boj caved by intervening in the yen/dollar market, although the yen has dropped through the 145 level at which they intervened. the bond vigilantes were resuscitated in the uk, where they took the printer away from the new gov’t. the ecb is the only buyer of spanish and italian bonds, and will be selling bunds while buying southern european paper to prevent “fragmentation” of the eurozone bond market.. i question the strength of bunds given the energy and natural gas chemical feedstock situation germany finds itself in, partly the victim of circumstance, partly a victim of its own policy decisions.

    but it’s hard to picture gold going up much in dollar terms while the dollar continues to strengthen.

    it seems like illiquidity in the treasury market will be the key to change in the u.s. foreign cb’s were major buyers of treasuries as they recycled their trade surpluses- they’re not buying anymore and in fact are selling to defend their currencies. the fed was a major buyer of treasury paper in recent years- no more, plus they’re not rolling over a good chunk of what holdings mature each month, thus increasing supply. the banks are stuffed with paper and put it in the rrf. they’ll only buy if the fed changes the slr rules again, which would constitute a backdoor qe and undermine the fed’s tightening.

    who is left to buy treasuries? foreign individuals might buy some but the cost of the currency hedge is prohibitive, so if they buy it has to be with the hope that the dollar continues going up. pension funds and insurance companies are mandated to hold some treasuries for liability duration matching, but it’s hard to believe that they have a big enough balance sheet to hold the avalanche of paper we can expect from the treasury.

    will private pension funds [ira’s, 401k’s] be mandated to buy treasuries? could happen. will short term bills be converted into non-tradeable long term bonds? could happen.

    less dramatically, treasury secretary yellen has talked about having the gov’t buy off-the-run long dated paper and selling an equal dollar amount of short term bills. this would make the market more liquid, but means the gov’t will be paying 4% on more and more of its debt. tax revenues barely cover interest payments, defense and entitlements now. if interest payments have to rise, deficits will rise and the gov’t will have to borrow to pay the interest on what it has already borrowed. this sounds like minsky’s ponzi finance. and this would put the gov’t in a spiral of compounding deficits. and, again, who will buy the paper? and at what price? will we play out the scenario we’ve just witnessed in the uk?

    it seems the only solution will be yield curve control, and financial repression, repeating the 1940’s-50’s playbook, promoting inflation to shrink the ratio of debt to gdp. if you look at charts of inflation in the 40’s-50’s it was a wild ride. i suspect we’ll be on a similar roller coaster. buckle up.

    1. Bill Terrell says:

      Thanks JK … insightful analysis. FWIW I agree with virtually of it except for certain details. One is the necessity of yield curve control. The Fed rebates to Treasury most of the interest it collects on its Treasury holdings, so as far as the fiscal picture goes rate targeting out the yield curve doesn’t accomplish much. The Fed can QE to its heart’s content, monetizing federal debt and assuring Treasury a “market” for everything it issues, and debase the dollar in the process even while rates normalize.

      Of course that doesn’t mean it won’t try YCC, just that it doesn’t have to in order to inflate or subsidize federal debt. The main difference would be to the private sector. If it wants to go back to playing reverse robin hood and enriching the financial elite at the expense of the working and middle classes, interest rate repression is just the ticket.

      There’s no getting around that some fiscal restraint will be involved too. We just had a massive experiment in MMT and the verdict is definitive. On one end of the spectrum the Fed could remain tight for years and leave it solely up to fiscal policy to restrain federal debt. On the other, it could accommodate politicians’ every whim and inflate the nation into hyperinflationary collapse. I think it will try to steer somewhere between the extremes … it will inflate to ease the debt burden but not enough to relieve fiscal policy of some necessary belt tightening. There is merit in the forties analogy but danger in taking it too far. We have not just been through the thirties and don’t have the same war financing imperatives. After years of rate-repression-encouraged fiscal excess, there’s a lot of room for the pendulum to swing the other way.

      On the Treasury front, it’s rapidly becoming clear how foolhardy Treasury has been not to lock in more financing at historically low long term rates. This is no mere hindsight … I said so at the time and am being vindicated in spades. Instead of using basic common sense and working for the American people, Mnuchin polled his Wall Street cronies and whiffed on the 50 year bond as well as not making more use of the existing 10-20-30 year instruments. This cost the US the opportunity to buy some much needed time for entitlement reform. Social Security could have been secured for the twenty first century.

      Now Yellen is actually considering doubling down on this by swapping more long term debt for short? So first she blows out the wealth gap and sows the seeds for our present inflationary plight as Fed chair and now wants to compound the disaster as TSec. Policy that bad requires either idiocy or malice or both.

  2. shiny! says:

    Lyn Alden agrees with you, jk. She’s been saying all along that we’re in for a repeat of the 1940’s , not the 1970’s.

    1. Bill Terrell says:

      A murky point … since she’s not here can you summarize her reasoning?

      1. shiny! says:

        Hi Bill. Please accept my apologies for not backing up my earlier comment.

        Alden has talked a lot on the similarities between the 1940s and and our current economic situation. Some tweets:

        “A lot of people reference the 1970s, but the 1940s continue to be a closer analogue to the fiscal and monetary environment we find ourselves in today.

        Specifically, the 1940s had a significant decoupling between inflation and interest rates, because the inflation was driven by fiscal spending rather than bank lending, so the Fed was faced with a very different situation to deal with.”

        And some highlights from her in-depth article on the subject, here:

        There are two causes for broad money supply to go up so quickly during certain periods of time. Either 1) banks do a lot of lending, which creates deposits and expands the money multiplier or 2) the government runs large fiscal deficits and has the central bank and commercial banking system buy a lot of the debt associated with that spending.

        The 1940s money supply growth was entirely due to massive fiscal deficits rather than bank lending. Inversely, the 1970s money supply growth was mostly due to high levels of bank lending, which was compounded by gradually rising fiscal deficits.

        The US Federal Reserve responded very differently to the fiscal-driven inflation of the 1940s vs the loan-driven inflation of the 1970s.

        In the 1970s, public and private debt as a percentage of GDP was low. Money supply was increasing more-so due to bank lending than due to fiscal deficits, which means the inflation was mostly in the Fed’s court to stop. Thanks to low debt levels throughout the economy, the Fed was able to raise interest rates all the way up to double-digit levels in order to slow bank lending and reduce inflation. However, they were not very aggressive in doing so until the end of the decade, which resulted in inflation running higher and longer than they anticipated during most of the decade.

        On the other hand, public debt as a percentage of GDP was very high in the 1940s. When the government’s debt as a percentage of GDP is over 100%, interest rates of even mid-single-digits would result in monstrous levels of interest relative to GDP and tax receipts, resulting in a fiscal spending spiral. Consumer price inflation was coming in periodic spikes from fiscal spending and changing wage/price controls, but with high public debt levels, the Fed held rates low and even capped long-term Treasury bond rates with quantitative easing, and let inflation burn hot and inflate part of the debt away. Anyone holding physical cash, cash in a bank, T-bills, or T-bonds lost 30-50% of their purchasing power between 1941 and 1951.”

        1. Bill Terrell says:

          Oh, my apologies to you. I didn’t mean to demand a full exposition and probably wouldn’t have mentioned it at all except your comment appeared as a reply to my post and it looked like an interesting sidebar. But I much appreciate the clarification … above and beyond … good food for thought.

          As they say, history doesn’t repeat, though it may rhyme. Certainly in the respects discussed here there are strong parallels with the financial environment of the forties. My only reservations have to do with the risk of implicitly comparing recent discretionary fiscal deficits with the wartime imperatives of the 1940s. Then the deficits were primarily a product of world war to counter genocide, today’s of a decade of artificially low interest rates tempting fiscal excesses. I think the distinction important because applying the same palliative today as used in the forties – more rate repression – would be like trying to cure an alcoholic with more booze. Even in the forties the rate repression was only a temporary expedient … the true cure was ending the war. Continued rate repression today would be the analog of extending it.

          Thanks again Shiny!

  3. jk says:

    the fed does send net income to the treasury, but in fact the fed has been making losses for some time. here’s a snip from june [the first hit i got on google from however i worded the query]:

    We estimate that at the end of May, the Federal Reserve had an unrecognized mark-to-market loss of about $540 billion on its $8.8 trillion portfolio of Treasury bonds and mortgage securities. This loss, which will only get larger as interest rates increase, is more than 13 times the Federal Reserve System’s consolidated capital of $41 billion.

    1. Bill Terrell says:

      Some pundits have been making a big deal about the Fed’s losses, but they lack perspective. The Fed literally creates money from nothing. Paper losses for such an institution don’t have the same kind of meaning as they would for any other. The Fed could rebate 100% of the interest it receives in perpetuity without going out of business. It might require regulatory tweaks, but there’s nothing fundamental standing in its way.

      By no means am I suggesting the Fed should do this, but if the alternative were “yield curve control”, it would be a no brainer. It need only look how well that scheme is working out in Japan.

      Either way, purchasing power is transferred to the Treasury from the rest of the economy via currency debasement, the regressive tax of inflation. But doing it without rate repression at least allows the capital markets to otherwise function normally.

    2. Bill Terrell says:

      Hussman supports your take on the Fed’s Treasury interest rebates here:

      I haven’t fully processed Hussman’s analysis yet, but readers may want to consider it themselves.

      Hussman also has some interesting perspective on the markets in general.

  4. Bill Terrell says:

    “We will know it when bond prices break out of their practically ruler-straight downtrend (below). Gold will confirm by following suit. When the turn comes, though, it will have a long way to run.”

    We have the off: