‘In Gold We Trust’: The triple showdown in monetary policy, geopolitics, and gold

Incrementum AG’s ‘In Gold We Trust’ (IGWT) report is now in its 11^th edition and is widely considered to be the industry-leading compendium on gold and macroeconomic research.

The authors, Ronald-Peter Stöferle and Mark J. Valek are deeply influenced by the principles of the Austrian School of von Mises and Hayek, which informs much of their commentary.

For the report this year, the authors have selected the timely and prophetic title, ‘Showdown’.

On a side note, who could forget the incredible ‘original economics rap battle’ featuring ‘Keynes’ and ‘Hayek’?

Stöferle and Valek argue that deep frictions throughout the global economy are likely to result in three independent but enmeshed showdowns – monetary, geopolitical, and in the realm of gold prices,

…in which economic, political and social developments are on the brink of a fundamental change…

Monetary showdown

Over the past 18 months, inflation has ravaged the US and other leading economies.

In April 2023, PCE stood at 4.4%, rising higher than 4.2% in the previous print and landing well above industry forecasts of 3.9%.

It is worth noting that even this optimistic forecast was twice the Fed’s target level.

In response to the great recession of 2008, Fed interest rates plummeted to near-zero, only to stay there for over seven years.

Such ultra-easy policies coupled with quantitative easing were destined to be a recipe for runaway inflation.

Of course, the bulk of these cheap injections found their way into financial market instruments resulting in massive asset bubbles and delaying the impact on established and more visible measures of inflation.

Attempts by the Fed in the middle of the 2010s to normalize rates were quickly abandoned, as the withdrawal of cheap liquidity proved painful and distorted incentives continued to fuel capital misallocations.

With the outbreak of the global pandemic, things were only about to become more challenging, forcing a 100-bps reduction in March 2020 and a return to rock-bottom rates.  

At the same time, international supply chains crumbled and global lockdowns halted economic activity in its tracks.

In a bid to preserve the purchasing power of household budgets, US authorities deployed unprecedented fiscal policy and $800bn in payroll protections.

These events did not shake the trust of monetary decision-makers and treasury officials who continued to insist that inflation would be ‘transitory’, despite the PCE shifting well above the 2% target.

The report references Mohamed El-Erian, chief economic adviser at Allianz who stated,

The characterization of inflation as transitory is probably the worst inflation call in the history of the Federal Reserve, and it results in a high probability of a policy mistake.

This fragile and over-extended economic situation was met with a new cataclysmic shock – the Russian invasion of Ukraine, which resulted in disrupted food supply chains, the relentless roll-out of sanctions, accelerated national protectionism and a precarious geopolitical situation.

Crucially, the image of the dollar as a ‘relatively’ neutral store of value was dented, perhaps permanently so.

The aggressive Fed

Caught off-guard, the Fed members and other global monetary authorities scrambled to tighten conditions and withdraw liquidity from the system.

Under Jerome Powell’s leadership, the FOMC raised rates at a pace scarcely seen before, having tightened in 10 successive meetings, which included four consecutive supersized actions of 75 bps, and two hikes of 50 bps.

An earlier piece discussed Danielle DiMartino Booth’s views on tightening and the potential impact of monetary lags.

As was widely anticipated, the era of prolonged low-interest rates and staunch refusal to recognize the oncoming barrage of inflation, led to the CPI peaking at 9.1% in June 2022 (commentary of which is available here).

The Federal Funds Rate now stands at 5.0%-5.25%, having been 0%-0.25% barely 15 months ago.

However, the Fed’s radical shift in policy came at a price with the United States enduring three of the four largest bank failures in its history, all earlier this year.

An article examining the concerns that dominated the regional banking system is available here.

Stöferle and Valek note,

All in all, more than USD 500bn has already had to be written off since the beginning of March. This is a clear warning signal that the financial system is much more fragile than generally assumed.

Despite the Fed’s aggressive tightening, inflation remains well above the 2% target and is threatening to not only remain persistent but rise higher.

Earlier today, JPMorgan CEO Jamie Dimon was quoted as saying,

Inflation is kind of stickier, I think people are coming around to that, which means rates may have to go up a little more. People should be a little prepared for that.

Signs of the oncoming recession

At the same time, recessionary forces are becoming more acute.

GDP growth remains low, the yield curve is deeply inverted while the Conference Board’s Leading Economic Index continues to warn of a recession in the next 6 months.

Significantly, negative money supply growth is now in unchartered territory, having contracted for five consecutive months for the first time since records began in 1959, dealing a blow to any soft-landing expectations.

Economists have long noted that the resilience of the labour situation has been the key ingredient in imparting confidence to the economy, allowing the Fed to continue its tightening pathway.

However, the unexpected robustness of the labour market is finally showing signs of fatigue.

For instance, manufacturing data has shown a contraction in overtime hours (on a yearly basis) since August 2022, further compounded by a sharp drop of 20% in February 2023.

The authors of the IGWT note that this has been,

…a reliable recession indicator in the past.

The graph below also shows the explosive surge in layoffs, particularly in the tech sector.

For now, all eyes will be on tomorrow’s nonfarm payroll data and the employment situation report with Investing.com forecasting an increase of 180K, down from last month’s reading of 253K.

In addition, the authors note that throughout modern financial history, a crash regularly follows the withdrawal of an artificial flood of stimulus, as is occurring today.

The coming recession will not only crush undisciplined businesses that have been kept afloat by the flow of cheap money but will also pit the necessity to keep rates high to combat stubborn inflation against the overriding impulse to lower rates to weather ‘price collapses’ and insolvencies.  

Unlike some commentators who anticipate disinflationary effects to be a welcome by-product of the recession, Stöferle and Valek, note that,

When systemic problems arise, central banks ultimately have only one remedy, and that is to provide additional liquidity.

This in turn could pave the way for even higher inflation.

Thus, we have grounds for our first major showdown.

Given that PCE is still twice the target rate, will the Federal Reserve’s response to inflation necessarily be inflationary? Will the institution manage to walk a tightrope amid a weakening labour market, jaded consumer sentiment and a deeply inverted yield curve?

To add to the complexity, the dollar’s image has been hurt by events of the past year, with Andy Schectman, President of Miles Franklin Precious Metals noting,

And if they all (other countries) start to dump dollars, and I think it would happen quickly, you would have a tsunami of inflation hitting the shores of the West.

Geopolitical showdown

The world is rapidly moving apart.

To begin with, the global pandemic exposed the fragility of global supply chains and differentiated priorities around healthcare.

In 2023, the BRICS surpassed the G7’s collective GDP, accounting for an estimated 31.5% of global GDP versus 30.7%.

Fuelled by this confidence, protectionism, bilateral currency agreements, and regional security are the order of the day.

In the post-war era, the dollar has been the glue of the international order.

However, the flurry of sanctions and the weaponization of the dollar following Russia’s invasion of Ukraine has had a damaging impact on the greenback’s reputation.

A piece on Invezz entitled “The shift in the RMB’s reserve currency math: A deep dive”, notes,

Concerns about the ability of the US to disrupt financial flows via the SWIFT network are not new but have suddenly been forced into becoming the most urgent question in global monetary debates. The Atlantic Council’s GeoEconomics Center has catalogued a total of 1,009 Russian entities that have been sanctioned by the United States, with another 964 such actions from the UK, EU, Canada, Japan, Switzerland, and Australia, as of April 17, 2023.

To sidestep the dollar’s control over the SWIFT network, several countries have now begun engaging in non-dollar bilateral agreements, while the BRICS are expected to accept more members and discuss the establishment of a new monetary ecosystem and payment mechanism during the August 2023 meeting.

As a result of these growing tensions on the economic, currency and commodities fronts, the authors anticipate international relations to become increasingly confrontational, with room for a showdown between the ‘saturated establishment’ (comprising the USA and Western allies) and the ‘hungry upstarts’ (comprising China, Russia, and their partners).

The above-mentioned article also noted,

In a significant move, the Chinese government was able to broker an agreement between Saudi Arabia and Iran to resume diplomatic ties, putting a stop to the regional conflict… This was nearly unthinkable not long ago and has helped China establish a strong image in the region.

Further,

…the Chinese government is likely closing in on formulating an FTA with the Gulf Co-operating Council (GCC) countries which include the UAE, Bahrain, Saudi Arabia, Oman, Qatar, and Kuwait.

This could place considerable pressure on American influence in the resource-rich region.

In addition, the Chinese Ministry of Foreign Affairs launched a very public and scathing attack on US dollar policies in February 2023.

European populations have not been immune to the wrath of sanctions either, with major question marks on the bloc’s long-term energy security.

At the same time, resource protectionism is on the up with countries such as Chile in the process of nationalizing prized lithium mines (more details are available here).  

Given these circumstances, the authors anticipate that the stage is set for a geopolitical collision, especially as the commodities super cycle is gaining momentum (of which commentary is available here).  

The showdown in the gold price

The central topic of the IGWT is the likelihood of a ‘showdown’ in gold prices.

Demand for gold and gold products is expected to continue to rise particularly due to its historic role as an inflation hedge.

As discussed above, the geopolitical scenario is also likely to become more tense, which is another bullish factor for gold.

The authors anticipate that central bank demand, particularly in the non-Western world will be an important driver, as countries look to shift away from dollar-dependent transactions into bilateral agreements or multi-lateral efforts.

The OMFIF Global Public Investor Survey 2022 noted that reserve managers were keen to increase their gold holdings moderately or significantly in the next 12 to 24 months.

Notably, the National Bank of Poland purchased 15 tons of gold in April 2023.

With gold reaching all-time highs in various currencies, the authors expect that this indicates a coming breakout in gold prices, even in the USD.

A reversal in restrictive monetary policy would prove highly beneficial to the yellow metal, as financial assets that offer returns are in direct competition with gold.

Stöferle and Valek anticipate that,

…at new all-time highs, FOMO will kick in and new players will then enter the field in a flash.

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