Gold: The Fundamentals Matter

Whether you are dealing with a market, sector, or stock, the fundamentals do matter. Right now gold is being pushed around by technicals, liquidation events and misconceptions. Strong underlying fundamentals in the precious metal are being ignored at the moment by investors.

One of the main “theories” that is being used to explain why the SPDR Gold Trust ETF (NYSEARCA:GLD) has been declining since August and investors should continue to shun the precious metal, is because of the strength of the U.S. dollar. With the Federal Reserve raising rates – and possibly now more aggressively – the USD has gained a significant amount of ground against other global currencies. The greenback has surged almost 8% since late September and has broken out from its 1 1/2 year consolidation period. That comes on the heels of a near vertical ascent from the lows in 2014 of ~79 to the roughly 100 level by March 2015.

On Again, Off Again

As the assumption goes, gold and the dollar have an inverse correlation. The problem is, there is no long-term bond between the two. There is an occasional short-term negative relationship, but then that always breaks and investors and television pundits are left scratching their heads looking for explanations for why they are now trading in tandem.

Case in point, from April to mid-July 2016, both gold and the USD were rallying (GLD with an 8.21% return and the USD tacking on a 2.47% gain).

Which led to this MarketWatch article last summer: “Why gold’s bond with the dollar has broken“:

The precious yellow metal often trades inversely with the ICE U.S. Dollar Index, a gauge of the dollar’s strength against a basket of six rival currencies, as moves in the U.S. unit can influence the attractiveness of gold to holders of other currencies. In other words, gold tends to rise when the dollar weakens.

However, that normally tight relationship has been under some serious stress, lately.

Some market participants point to global central-bank monetary policies and the U.K.’s decision to exit the European Union for the shift in the relationship, which has seen gold, at times, swing higher or lower, despite moves in the buck.

Separation Anxiety?

Over the last several months, we have once again seen this inverse correlation between gold and the dollar. Which is why every headline printed about the precious metal and the greenback since that time always pins the two against each other. This is one from The Wall Street Journal that I saw last week: Gold Rises as Dollar Weakens. IBD inferred the same: Gold Up, Dollar Down As Trump Rally Hits Volatility. So we are back now to the media and investors believing once again in this strong bond. It’s hard not to when you see a performance graph like the one below.

This Always Happens

In the near future, though, gold will snap out of this temporary inverse relationship and move higher, irrespective of where the dollar is trading during that time. This ALWAYS happens. Then we will start the headline cycle over again as investors and writers search for answers to this “confusing” loss of negative correlation.

Over the long term, there simply can’t be a consistent inverse relationship between gold and the dollar. This is about basic economic principles and how gold fits into our monetary system. Gold will continually move higher over time because its purpose is to protect purchasing power. In periods of extreme growth in money supply/inflation, gold will surge. In times of low inflation or very weak M2 growth, gold will cool. Where the USD trades over the long term is irrelevant.

If I told you that over the next 8 years the USD will advance by 30%, then how do you believe gold would react during that time? Before you answer that question, take a look at the performance graph below:

Money Supply Rules The Roost

Hypothetically, if the USD consistently advances to the upside year-after-year over the next 50 years, I can promise you that gold will not be lower at the end of that time period. It will be multiples higher than it is today because it will be valued based on the money supply.

It’s the growth of M2 that ultimately determines how much gold is worth (in USD). Again, the price of gold is going to be valued on basic economic principles. If the U.S. money supply doubles overnight and the amount of gold in the system (above ground stock) is the same the next day, then the price of gold in USD will surge as more money is chasing the same amount of goods.

The reason why gold always moves higher over the long term is because the money supply is consistently expanding.

At various times over the last 40 years or so, the USD Index has traded around the 85 region. Below shows where gold also traded, along with the level of M2. Where is the correlation: between gold and the dollar or between gold and M2?

There will be times when gold surges well above fair value compared to the level of M2, such as in 1980 when it went over $800 per ounce. And there will be times when it trades well under fair value, such as in the early 2000s and once again today. These are just bull and bear cycles that are occurring as gold oscillates around an ever expanding M2. In other words, over the long term, the precious metal will consistently move higher along with the money supply. A bull market will always correct the divergence between M2 and the price of gold. I expect this gap to close over the next few years.

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Rate of M2 Growth Increasing

Looking at some recent money supply figures from the Federal Reserve, you can see that M2 growth has increased at a rate of 7.8% from November 2015 – November 2016.

Growth from July 2016 – October 2016 was particularly strong, coming in at 8.1%.

The current rate of M2 expansion is well above where it has been at over the last several years. From November 2014 – November 2015, M2 was increasing at a rate of 6.2%, the year before it was 5.9%. Now we are almost at 8% growth.

I don’t envision the percent change reverting back to those previous levels. If anything, I’m expecting even greater expansion in M2, especially with interest rates rising (signaling future inflation) and factoring in Trump’s economic policies. Needless to say this is very bullish on gold.

The CBO Is Lowballing

The current debt and deficit will also greatly fuel the need for continued strong M2 growth as inflation is the only way to ease the debt burden. In the CBO’s Update to the Budget and Economic Outlook: 2016 to 2026, they included the following statement along with the graph below:

As deficits accumulate in CBO’s baseline, debt held by the public rises from 77 percent of GDP ($14 trillion) at the end of 2016 to 86 percent of GDP ($23 trillion) by 2026. At that level, debt held by the public, measured as a percentage of GDP, would be more than twice the average over the past five decades (see Summary Figure 1). Beyond the 10-year period, if current laws remained in place, the pressures that contributed to rising deficits during the baseline period would accelerate and push up debt even more sharply. Three decades from now, for instance, debt held by the public is projected to be about twice as high, relative to GDP, as it is this year-which would be higher than the United States has ever recorded.

It should also be noted that the CBO is currently underestimating the level of interest rates in its forecast:

CBO projects that the interest rate on 10-year Treasury notes will be 1.9 percent in the fourth quarter of 2016, rise to 3.4 percent in the fourth quarter of 2020, and average 3.6 percent over the 2021-2026 period.

The 10-year Treasury yield is already at 2.4%, or only 1% below where the CBO is projecting it to be by Q4 2020. I think it’s safe to say that with Trump’s policies and the Fed raising rates, the 10-year yield is going to increase more than 100 basis points over the next four years. Which will have a profound effect on the interest that the U.S. is paying on the debt load.

The net interest payments highlighted below are based off of the CBO’s expectations for the 10-year yield over the next decade. Bottom line, net interest that is shelled out by the U.S. government will be much higher than what is currently anticipated by the Congressional Budget Office. Which means that the deficit (and total debt) projections are also too conservative. It’s extremely likely that the $1-trillion deficit mark that is expected to be reached by 2024 will need to be moved forward a few years.

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As the CBO warns:

Because of rising interest rates and, to a lesser extent, growing federal debt, the government’s interest payments on that debt are projected to rise sharply over the next 10 years-nearly tripling in nominal terms and almost doubling relative to GDP….Federal spending on interest payments would increase substantially as a result of increases in interest rates, such as those projected to occur over the next few years….Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected challenges.

A few things to take away from that statement. One, if rates increase substantially above the CBO’s projections, future statements out of the CBO will sound even more dire. Two, this could derail some of Trump’s economic policies. Although I will say that, even if it doesn’t, it’s going to be fun watching all of the carnage in the bond market and balance sheet of the U.S. play out. M2 will be moving at a blistering pace, and gold should benefit enormously as a result.

The Fed painted itself into a corner a few years ago, and gold investors have been counting down when it would be time for the Fed to finally make a move. They have already begun the rate normalization process, which is why the gold sector bottomed when the Fed funds rate was increased for the first time in December 2015. M2 was already signaling future inflation, the rise in interest rates is just confirming that.

The Gold Edge

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.