- The sharp drop in precious metals prices over the past week has provided us with another opportunity to scale in in anticipation of the longer-term bull market.
- While lower near-term prices look likely, the fundamental outlook continues to improve which should enable gold, silver, and platinum to post higher lows over the coming weeks and months.
- The slight uptick seen in real bond yields has been entirely due to falling inflation expectations, which appears to have been driven by the equity market drop.
- 10-year breakeven inflation expectations, at just 1.6%, remain far below the long-term inflation rate, and considerably below the 5+% annualized rate of inflation seen since May.
The sharp drop in precious metals prices over the past week has provided us with another opportunity to scale in in anticipation of the longer-term bull market. While lower near-term prices look likely, the fundamental outlook continues to improve which should enable gold, silver, and platinum to post higher lows over the coming weeks and months.
XAU, XAG, XPT, and M2, Rebased From 1987
Source: Bloomberg
Fundamental Outlook Continues To Improve
Precious metals are, to varying degrees, a hedge against inflation and financial repression – the act of central banks keeping interest rates far below the rate of inflation to inflate away its debt. With government debt still surging relative to GDP, real interest rates are likely to head further into negative territory over the coming months and years, providing support to the precious metals complex.
Source: BLS
Despite the recent dip in inflation expectations, inflation potential continues to build as the ratio of government debt and money supply relative to real GDP continues to rise. 10-year breakeven inflation expectations, at just 1.6%, remain far below the long-term inflation rate, and considerably below the 5+% annualized rate of inflation seen since May.
Gold Has Been A Victim Of The Equity Market Selloff
Gold is the ultimate monetary metal whose price tends to be almost entirely determined by real interest rates in any given period. The lower the level of interest rate expectations relative to expectations of inflation, the more the opportunity cost of holding gold declines. Gold’s drop over the past few weeks has been largely driven by the slight uptick in U.S. 10-year real bond yields. While they remain in deep negative territory, it is changes in real yields that determine short-run prices, and the move back up from -1.0% has been enough to undermine gold demand.
XAU Vs. U.S. 10-Year Inflation-Linked Bond Yields (inverted)
Source: Bloomberg
That said, if we look at the recent correlation between gold and 10-year inflation-linked bond yields, we can see that gold’s drop has been outsized in relation to the relative tightening of monetary policy expectations. Furthermore, the slight uptick seen in real bond yields has been entirely due to falling inflation expectations which appears to have been driven by the equity market drop, rather than any upside pressure on nominal interest rate expectations, which remain firmly anchored.
10-Year Breakeven Inflation Expectations Vs. SPX
Source: Bloomberg
Our view is that any further equity weakness would likely be met with increased expectations of further monetary easing, putting renewed downside pressure on real yields. Alternatively, a recovery in stocks should see inflation expectations recover. Essentially, the latest uptick in real yields reflects a near-term blip in the longer-term trend of lower real bond yields.
From a longer-term perspective, as we noted in ‘Gold’s Rally May Be Getting Ahead Of Itself,’ gold prices are largely determined by the general price level and the price of commodities in general. The fact that gold prices are currently so elevated relative to the rest of the commodity complex reflects the fact that investors have been encouraged by low real yields to bid up prices in anticipation that general consumer and commodity prices will catch up. So, while the metal is ‘overvalued’ from a long-term perspective, this overvaluation is entirely justified by low real bond yields.
Silver Back To Undervalued Levels
Silver is more of an industrial metal than is gold, yet it still has a high degree of monetary demand due to its high stocks-to-use ratio. Therefore, silver prices tend to partly track gold prices and partly track the broad commodity complex. As we showed back in early July (see ‘SLV: Bull Market Material‘) silver traded at a huge discount to its fair value implied by the historical correlation with gold prices and the continuous commodity complex. After surging by over 50% in July and August to close the gap, the recent selloff has seen the metal fall back to undervalued levels once more.
Source: Bloomberg, Author’s calculations
This is not an indication of an imminent bottom and we would not be surprised to see a return to the USD20 area before sentiment turns bearish enough to suggest an upside reversal. However, the recent outsized drop is nonetheless a positive factor for medium-term performance.
Platinum Is Cheap Relative To The Commodity Complex
Platinum is the most attractive precious metal currently in our view. Having failed to take part in the breakouts to new highs seen in gold and silver in July, the metal is at or near its cheapest level on record in relative terms.
Platinum-Silver And Platinum-Gold Ratios
Source: Bloomberg
The metal is also extremely cheap relative to the continuous commodity index, which it has closely tracked over the long term owing to its high level of industrial use and sensitivity to the global economy. The fact that platinum trades at a discount to the continuous commodity index despite the positive impact of low real bond yields on the fair value of monetary metals suggests that the metal faces upside risks over the medium term.
Source: Bloomberg, Author’s calculations
