“Pain is a useful symptom. Pain is a warning to us of bodily dangers.” 
“And who created the dangers?” (Lieutenant Scheisskopf’s wife and Yossarian, Catch 22)
The above exchange feels like it could have been held about the Federal Reserve this week between tactical and strategic gold bullion bulls one side, and gold’s ‘old believers’ (christened by us as such due to the proliferation of beards amongst their adherents) on the other.
The mere suggestion that rates could rise by the end of 2023 cause the US dollar to spike and gold to drop c. $80 an ounce from c. $1,860 to $1,780 at the time of writing (c. 4.3 per cent). At such times, we would suggest it pays to try as removed from the market fluctuations as possible and to remain in control of our emotions (and I’ll kill anyone that says I’m not).
Undoubtedly the change in relative rates dynamics poses a potential short-term challenge to gold bulls, and this was reflected in a sharp bounce higher in real interest rates. This took real 10-year yields all the way back up to where they were on…. 20 April 2021, at a whopping negative 0.75 per cent.
Perhaps more interestingly (it’s a subjective word), the rise in real interest rates was more pronounced in the shorter end of the curve than the longer at every stage; the market seemingly concurs with Jay Powell that higher upwards pressure on rates from inflationary pressures are cyclical and not structural from here.
Source: St Louis Federal Reserve
Whither now? Well, understandably this move will cause many holders consternation, but gold’s recent strong performance had in any event moved it into overbought territory.
The bullion price remains roughly 2.7 per cent higher at the time of writing than when we tipped it back in March 2021 (with gold miners, as represented by the Vaneck Gold Mining ETF, approximately 15 per cent higher).
And whilst the move downwards as real rates move upwards is rational, the divergence seems more on the side of gold underperformance in recent weeks; if we are to see convergence, we would suggest it should perhaps be from rates rising more rapidly than gold falls.
Source: St Louis Federal Reserve
Moreover, when measured against the money supply we see no signs that gold is overvalued. We have previously looked at the gold bullion relative to the M2 money supply in the US, which showed a strong relationship and which suggested that bullion was undervalued. This remains the case, we note, though we only have M2 data to 1 April 2021.
Still, if the relationship were to hold true, current bullion prices would imply M2 at c. 9 per cent lower than it was in April. Given the worst three-month contraction of M2 going back to 1973 is -0.5 per cent, we consider this unlikely.
If we take the six-month average M2 monthly growth rate forward from April, we would estimate that fair value for bullion is about $2,063 (c. 15.8 per cent above current levels) on the basis of the historic trendline relationship.
Source: St Louis Federal Reserve, Kepler calculations. Date range 1 Jan 1973 to 1 Apr 2021
So gold looks undervalued relative to the money supply at present. When we look at how gold has tended to perform in period where this implied it was undervalued against overvalued, we see it has tended to presage periods of outperformance.
Source: St Louis Federal Reserve, Kepler calculations. Date range 1 Jan 1973 to 1 Apr 2021
A rising spot price might be expected to be of benefit to gold mining equities and trusts that hold significant exposure to them, such as BlackRock World Mining (BRWM). When we look at how BRWM has done subsequently in periods of gold being under/overvalued since launch, we see a similar patterns.
Source: St Louis Federal Reserve, Kepler calculations. Date range 1 Jan 1973 to 1 Apr 2021
Aside from any valuation considerations, we note the coming introduction of the Basel III regulations on 28 June 2021. Again invoking the inherent subjectivity of the word, we think this is interesting.
Under Basel III, European banks will now be able to hold gold as a risk-free Tier 1 asset from the end of the month. Obviously there is no positive carry on bullion, but when even Greek five-year debt is negative yielding, this seems like there may well be some relative attractions to holding gold as Tier 1 capital in place of some sovereign debt (or cash which also receives a negative rate of interest).
As the regulations tilt towards making ‘allocated’ (in practise, physical) gold more attractive relative to unallocated/paper gold, this could reduce liquidity in the gold bullion market but also make opportunistic shorts harder to enact. We see this as a tailwind in the long-term.
Of course, sentiment moves in swings and roundabouts, and actions have implications beyond their own shores. The current moves by the Chinese Communist Party to try and rein in excess credit growth (attempted periodically, and thus far generally followed after a few months by capitulation and a return to credit expansion) have implications beyond domestic shores.
This fading of the Chinese credit impulse to negative levels, we would suggest, has proven more important than the Fed’s announcement that they might increase rates at the end of 2023 to recent headwinds for commodity markets and trusts such as BlackRock World Mining or Golden Prospect Precious Metals (GPM). This is likely particularly true for industrial metals such as copper (though we note the potential headwind to copper production globally from the seeming election of President Castillo in Peru, the 2nd largest producer country in the world, who has made noises around potential nationalisations).
Despite the headwinds to industrial metals, we think the market reaction to the Fed’s announcement with regards precious metals has been overdone.
Callum Stokeld is an investment trust research analyst at Kepler Partners. The views above are his own and should not be taken as investment advice.