2. Points To Be Covered Today:
• Will Upcoming Inflation Take Gold With It?
• Importance of Inflation In Gold Market
• Will Trump-Biden Twin Deficit Support Gold?
• US Current Account ,Fiscal Deficit & Gold Prices
• Gold Fundamental Overview
• Gold Price & Chart
3. Will Upcoming Inflation Take Gold With It?
• Inflation is coming. Gold may benefit from it, especially if inflation turns out to be more long-lasting
than central bankers and markets believe.
• Brace yourselves, inflation is coming! Importantly, not only grumblers such as myself are talking
about rising prices right now, but even the Fed officials themselves admitted that inflation will jump
this year.
• Indeed, in the latest dot plot, the Federal Open Market Committee (FOMC) expects that the PCE
annual percent change will soar from 1.3 percent in December 2020 to 2.4 percent at the end of this
year. Importantly, their projections increased significantly in the last three months when they
amounted to 1.8 percent.
• And remember, we are talking here about the official inflation figures. The real inflationary pressure,
which also affects asset prices, is much stronger.
• Furthermore, the pandemic changed the composition of consumption, as people are buying more
goods and less services.
• And guess what, the prices of goods are rising more than the prices of services, so many people’s
actual consumption baskets have become more expensive than official ones, implying that true
inflation is higher than the officially reported one, as the IMF has recently admitted.
5. 5 & 10 Year Inflation Expectation - I
• As you can see, both medium-term and long-term inflation expectations have
significantly increased in the last few months. It means that investors don’t only
expect a temporary rise in inflation – on the contrary, they forecast a more
persistent increases in prices. Indeed, Mr. Market believes that inflation will be,
on average, 2.5 percent in the next 5 years and almost 2.3 percent in the next 10
years, significantly above the Fed’s target of 2 percent.
• Of course, it might be the case that Mr. Market is wrong, and Mr. Powell is right.
But what is disturbing is the Fed’s confidence – or, rather overconfidence – that it
can contain inflation if it turns out to be something more than only a temporary
phenomenon. Such a conceit led to stagflation in the 1970s. Gold shined at that
time.
• Then, as today, the central bank focused more on the maximum employment
than inflation, believing that it can always control the latter by raising the federal
funds rate if necessary. But, as Robert J. Barro, from Harvard University, points
out, “the problem is that hiking short-term rates will have little impact on inflation
once high long-term expected inflation has taken root.”
6. 5 & 10 Year Inflation Expectation - II
• The recent Fed’s actions, including the new monetary framework, according to which the
U.S. central bank tries to overshoot its target for some time, may easily waste the
reputational capital that was created by Paul Volcker and de-anchor inflation expectations.
• In other words, a negative shock can be accommodated by the central bank without long-
lasting effects, as people understand that it’s a unique one-off event, after which
everything will return to normalcy. But the Fed is far from normalizing its monetary policy.
• On the contrary, it has recently signaled that it wouldn’t raise interest rates preemptively
to prevent inflation, as it could hamper the economic recovery. The risk here is that if
people start to view exceptional as the new normal, their inflation expectations could shift,
and become unanchored.
• To sum up, it might be the case that markets are overstating short-term inflation risks. But
it’s also possible that politicians and central bankers understate the longer-term
inflationary dangers, as Kenneth Rogoff, also from Harvard University, argues.
• After all, unlike in the aftermath of the Great Recession, when only the monetary
base skyrocketed, the pace of growth of the broad money supply also soared this time –
and it’s still increasing, as the chart below shows.
8. M2 Money Supply Annual Growth Rate - I
• In other words, while all the created liquidity after the global financial
crisis of 2007-2009 flowed mainly into the financial markets, during
the pandemic, it flowed into the real economy to a much larger
extent, which can create more inflationary pressure.
• What’s more, the easy monetary policy is now accompanied by a
very loose fiscal policy and the unprecedentedly large fiscal deficits,
which could push the economy deeper into the debt trap. This could
undermine the central-bank independence and prevent a timely
normalization of interest rates, not to mention the weakening of
globalization’s downside impact on inflation, caused partially by
demographic factors and reshuffling in supply chains.
• Last but not least, the rising commodity prices and international
transport costs, accompanied by the weakening U.S. dollar, may be
harbingers of an approaching inflation monster.
9. Importance of Inflation In Gold Market
• Well, the jump in inflation in 2021 should be positive for the
yellow metal, which could gain as an inflation hedge.
• The downward pressure on the real interest rates should also
be supportive for gold prices, although the rally in the bond
yields may counteract this effect.
• But if Powell is right and inflation turns out to be only temporary,
then gold may be hard hit, and we could see a goldilocks
economy again (i.e., fast economic growth with low inflation).
• However, if markets are right, or if the long-term inflationary
risks materialize, which even investors may understate, gold
should shine.
10. Will Trump-Biden Twin Deficit Support
Gold?
• Twin deficits could negatively affect the U.S. economy, thereby
supporting the yellow metal.
• Twins. Many parents will tell you that they double the blessing.
But economists would disagree, claiming that twins – i.e., twin
deficits – could be negative for the economy.
• The recent deterioration in the U.S. current account and fiscal
balance has sparked renewed debate over the twin deficit and
its impact on the exchange rate – and the price of gold.
11. Will Trump-Biden Twin Deficit Support
Gold? - I
• A twin deficit occurs when large fiscal deficits coexist with big trade deficits. The former
happens when the government spends more money than it raises with taxes, while the latter is the
result of imports exceeding exports.
• A historical example of the U.S. twin deficit occurred in the 1980s, when a significant expansion in
the federal budget deficit accompanied a sharp deterioration in the nation’s current account
balance.
• According to the Institute for International Economics’ report, “from 1980 to 1986, the federal
budget deficit increased from 2.7 percent of GDP to 5 percent of GDP ($220 billion) and the current
account deficit increased from 0 to 3.5 percent of GDP ($153 billion).”
• Another example might be the 2000s. According to the New York Fed’s research paper, from 2001
to 2005, the U.S. current account and fiscal balances plunged by 3 and 4 percent of GDP,
respectively. So, there is some correlation between these two.
• And some economists even believe that there is a causal relationship, i.e., that increases in budget
deficits cause an increase in current account deficits.
• The link is believed to work as follows: higher deficits increase consumption, so imports expand and
the trade deficit widens.
• However, both deficits actually have a common root: the increase in the money supply. When the
Fed creates money ex nihilo to monetize the federal debt, it enables America to both borrow and
consume more goods from abroad.
13. US Current Account & Fiscal Deficit - I
• But what happened to the U.S. trade deficit is nothing compared
to the fiscal deficit! As you can see in the chart above, it
ballooned from $984 billion in fiscal year of 2019 to $3.1 trillion
in 2020!
• So, if we simply add these two deficits together, we will see
that that the U.S. twin deficits have reached a record level.
• As the chart below shows, it has expended from $850 billion in
2014 to $3.8 trillion in 2020!
15. US Twin Deficits & Gold Prices - I
• The question is how the twin deficits could affect the price of gold. Well, from
looking at the chart above, it’s hard to tell.
• Gold rallied in the 1970s, when the twin deficit was miniscule, while it entered a
bear phase when the twin deficit started to increase. However, the yellow metal
skyrocketed both in the 2000s and in the 2020s, when the twin deficit ballooned.
• The key issue is what distinguishes the 1980s from the 2000s (and 2020)? I’ll tell
you. In the former period, expansionary fiscal policy coincided with tight monetary
policy. In consequence, the real interest rates increased, which encouraged
capital inflows and strengthened the U.S. dollar. So, gold was melting.
• Luckily for the yellow metal, this time, the easy fiscal policy is accompanied by
the accommodative monetary policy.
• The Fed has already slashed the federal funds rate and it’s
conducting quantitative easing to suppress the bond yields.
• Actually, some analysts believe that the U.S. central bank will implement the yield
curve control to prevent any significant increases in the interest rates.
17. US Twin Deficit As Dollar Index - I
• And this depreciation of the U.S. dollar should ultimately support
gold prices, especially if we see reflation and the next commodity
boom.
• It’s true that since its peak in August 2020, gold has been positively
correlated with the greenback, but the inverse relationship can be
restored one day.
• Investors shouldn’t forget that the dollar is not the only driver of gold
prices – other factors also play a role. I
• n the second half of the past year, both the real yields and the risk
appetite increased, which outweighed the impact of the weakening
dollar.
• Luckily, the Fed is ready to prevent any significant upward pressure
on the Treasury yields coming from the twin deficits. That’s good for
gold.
