Currency traders talk about the US dollar smile theory. It states the US dollar does well in a global crisis or when the US economy is outperforming its major rivals.
Neither of those scenarios is playing out. There seems to be little to turn the US dollar’s frown upside down as long as COVID-19 threatens states like California and Texas, two of the world’s largest sub-national economies.
Negative ‘real’ rates
But gold is also gaining from the fact that the world’s major economies are beset by negative ‘real’ – or inflation-adjusted – interest rates.
Negative interest rates are a result of the quasi-nationalisation of global bond markets by central banks, which have flexed their balance sheets to buy bonds to keep interest rates low.
But traders are betting that the massive amounts of stimulus – the Federal Reserve’s balance sheet grew from $US4.1 trillion in February to $US7.1 trillion earlier this month – will eventually result in higher inflation as economic growth gains traction. Gold has long served as an inflation hedge.
Those concerns are reflected in market-based measures of inflation expectations known as break-evens.
While there are the short-term inflationary impacts from a rebound in growth and pick-up in oil and metals prices, the risk of higher prices over the medium term looms as supply chains are rejigged away from low-cost countries like China.
The US 10-year break-even – a gauge of where inflation may be in 10 years – is trading at 1.5 per cent, up from 0.55 per cent in March and back to levels before COVID-19 struck the world’s largest economy. It is significantly higher than the 0.58 per cent yield on a 10-year US Treasury bond.
So earning zero per cent yield – but potential capital upside – on gold looks appealing relative to a roughly negative 1 per cent ‘real’ yield.
While the record-breaking run of US tech stocks has monopolised the headlines, there has been a return of capital – rather than return on capital – mindset among investors unconvinced about the prospects for a quick recovery.
How else to explain not only the rally in gold but the surge in the value of negative yielding debt from a low of $US7.7 trillion in March to $US14.7 trillion at last count.
As long as uncertainty reigns in a low-yield environment gold will find support.
That traders are pricing December 2021 gold futures just shy of $US2000 an ounce suggests the global economy and markets may be in for a bumpy ride.