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The rate of appreciation has slowed over the last few hours on account of recovery from lows seen in the US dollar (the Dollar Index has moved back into the 89.90s after setting fresh multi-year lows in the 89.40s), but spot gold prices (XAU/USD) continue to trade on the front foot. The spot price for gold is now in the $1940s, up more than $40 on the day or around 2.3%, the precious metal having opened the first trading day of 2021 below $1900.

Rising inflation expectations, record low real yields drive gold upside

Note that gold two key drivers of spot gold prices…

1) Inflation Expectations – Gold is seen as the ultimate hedge against a fall in the purchasing power of fiat currencies (inflation), given the physical properties that have made gold the ultimate store of value and medium of exchange for thousands of years (scarcity, indestructibility, ease of use as a medium of exchange). Gold is seen as “real money” by many. Gold has proven throughout history that is maintains its value no matter what happens with the real economy. For example, if the US dollar collapses, gold will retain its value. Therefore, as inflation expectations rise, the demand for gold also rises, hence why its price goes up.

2) Real yields – One reason not to hold gold is that you don’t get paid anything by owning it, unlike with stocks and bonds. As the yield on stocks and bonds goes up, the incentive to hold gold is diminished. In a world where a large portion of developed-market debt now has a negative real yield, the incentive to hold gold has therefore been greatly enhanced.

In light of the above, two developments are worth pointing out today, both of which have been bullish for gold. Firstly, inflation expectations in the US are at their highest levels in more than two years (10-year breakeven inflation expectations rose as high as 2%, implying investors anticipate CPI to average 2% over the coming 10 years). Moreover, the US 10-year TIPS yield (the real yield on the US 10-year bond) hit an all-time low of -1.113%. Rising inflation expectations are one factor driving real yields lower (remember, the real yield is the nominal yield minus inflation expectations), but a safe haven bid into bonds amid risk-off on Wall Street has also helped (and has likely helped spot gold inadvertently too!).

What next for gold?

With inflation expectations at more than two-year highs, with the US dollar at multi-year lows and with real interest rates at all-time lows, it does seem strange spot gold prices are still nearly 6.5% below the highs that were set back in early August. Perhaps the rally then was somewhat detached from the fundamentals, hence why it is taking some time for spot gold to return to these levels. Still, it seems as though risks remain tilted towards further XAU/USD upside in the short-term.

Say spot gold does “catch up” with the fundamentals (as in, it hits fresh all-time highs to reflect all-time low real yields, multi-year high inflation expectations and the multi-year low US dollar). What next?

What happens with inflation expectations and real yields are likely to remain the key drivers of gold. As mass vaccinations get underway and the global economic recovery gets booming in H2 2021, will inflation expectations continue to rise? Most analysts think that would be likely. As the global growth picture and global trade conditions improve, will the US dollar continue to fall? Consensus expectations also see this as likely. Rising inflation expectations thus ought to at least be one-factor underpinning gold in 2021.

Moving from inflation expectations to actual inflation outcomes. What if inflation continues to underwhelm beyond 2021, as the Fed predicts that it will? Well, then the monetary stimulus train rolls on, and so does the bubble of everything (which includes precious metals).

What if the opposite happens and inflation surprises everyone and quickly shoots above the Fed’s 2% target? After all, 2020 did see unprecedented levels of monetary and fiscal stimulus. In that case, the Fed will be stuck in a bind. Will the Fed have the guts to hike interest rates to combat rising inflation (like global central banks did back in the 80s) and force the debt/deficit addicted US government to severely restrict spending or else risk default on its debt? Note, hiking rates would also risk a wave of bankruptcies that would put the financial system at risk (people and businesses unable to repay their debt when interest rates rise, as happened in the lead up to the 2008/9 recession).

If the Fed did have the guts to do this, then this would be bearish for gold. But most do not think they will. A much easier route to take, politically anyway, is for the Fed to let inflation run hot thus inflating away all the debt. The only problem is that this would also lead to further significant declines in the value of the US dollar, robbing ordinary people of even more spending power. But it is much easier politically to rob people of their spending power than it is to significantly cut government spending. This admittedly much more apocalyptic scenario is of course the ultimate bullish argument for gold.

What about real yields? Here the question of what the Fed will do becomes much more relevant. Better global growth conditions ought to result in higher nominal US interest rates. Real yields won’t rise as much, given that some of the rise in nominal yields will be offset by a rise in inflation expectations. But what if real yields do start to rise? Will the Fed allow economic conditions and the borrowing cost of the US government to rise substantially? Most think not. If the Fed really wants to keep monetary conditions accommodative, it might well need to amp up the rate at which it is buying debt. Further expansion of the money supply would provide further upside to inflation expectations and more reason to buy gold.