Higher rates in March lead to US dollar strength, gold weakness

Improving outlook, higher rates lead to US dollar strength, gold Weakness

Gold edged lower in March consolidating around the US$1,700 per ounce level, dragged down by the rise in long-term Treasury rates after Federal Reserve (Fed) Chairman Jerome Powell promised to keep monetary policies steady. Higher interest rates and an improving outlook for the U.S. economy also caused the US dollar to reach near-term highs. These trends, along with outflows in bullion exchange traded products, all weighed on gold.

Gold stocks, however, performed well with the the NYSE Arca Gold Miners Index gaining 5.18%.  We did notice a positive divergence of the large-cap gold mining stocks from junior miners which suggests that the gold price weakness may have run its course.

Jewelry demand returns in China and India

Gold should find support from improving Asian demand. China and India are by far the largest consumers of gold. Asian jewelry demand is price sensitive, which means demand typically increases on price weakness. Gold demand in both India and China are showing signs of recovery after been decimated in 2020. According to the World Gold Council and Reuters, Indian gold imports jumped 45% and 72% in December and January, respectively. Meanwhile, Metals Focus shows Chinese jewelry sales returning to normal in yuan terms in the fourth quarter of 2020, while tonnages appear to be trending towards normal in the first quarter of 2021.

Keeping tabs on deficit spending and the looming lunch bill

The Congressional Budget Office's (CBO) report shows that the 2020 federal deficit reached US$3.13 trillion, or a record 14.9% of GDP.  Each trillion in debt is equivalent to US$7,785 for every household in America. The total deficit is currently at US$28 trillion. The CBO forecasts that the US's deficit will hit US$2.26 trillion or 10.3% of GDP in 2021.  This doesn’t include the US$1.9 trillion spending bill passed in March. President Joe Biden is now asking for trillions more for infrastructure, green initiatives and social welfare. Meanwhile, the Fed keeps buying government debt and limits debt service costs with low rates. In a sane world this would be labelled currency debasement, yet the dollar has been trending higher since January. The market sees all of this deficit spending going towards economic growth with no side effects.

According to a recent Wall Street Journal op-ed piece, the purchasing power of American families reached record highs in 2020. Total employee compensation was down by US$215 billion, yet government personal transfers rose by US$893 billion. This was before the US$900 billion December stimulus took effect which suggests that the government’s response to the pandemic went far beyond those who were truly harmed.

We believe that sometime in the coming years burgeoning debt and the expansion of the money supply would have several consequences:

• If long-term rates lurch higher from here, debt service could become a big problem.
• Problems may arise if the Fed ever stops funding the government. Likewise, if foreigners stop buying Treasuries.
• Once the profligate spending stops, will the economy be able to withstand the increased regulations and higher taxes the administration has planned?
• An inflationary spiral would create problems unseen for decades.

Gold and gold stocks may hedge against these risks.

Acceptance of bitcoin no longer in question

The gold vs. bitcoin question is coming up more often now than ever before.  The bitcoin market has historically been retail oriented, both in terms of its use in transactions and as an investment. However, over the past year bitcoin has made significant inroads on the institutional front. Its expanding list of adherents includes corporates, high-net worth individuals, endowments and fund companies. It trades on the CME futures exchange and as a Nasdaq-listed trust worth US$38 billion (as of end-March). Several prominent custodial banks have reportedly announced plans to service bitcoin. It appears it can no longer be dismissed as a fad or tech curiosity. The chart below shows that, while bitcoin is more volatile than gold or gold stocks, the volatility profile is stabilising, indicative of a maturing speculative asset class.

Bitcoin volatility appears to be stabilising

Source: Bloomberg, VanEck. Data as of March 31, 2021. Volatility is a statistical measure of the dispersion of returns for a given security or market index and is measured here using standard deviation of returns on 252-day rolling time period. Standard Deviation is a statistical measurement of dispersion about an average, which depicts how widely the returns varied over a certain period of time. Past performance is no guarantee of future results.

There are, however, major logistical issues facing bitcoin, including the low speed and cost of transactions, how regulatory bodies will treat it, whether some governments will allow it, how it is taxed, how it is collateralised and insured and how to prevent hacks and illicit activity. Bitcoin is a new asset class with high volatility and is part of a stimulus-fueled mania. According to a Cambridge Center for Alternative Finance report, bitcoin has a carbon footprint equivalent to that of New Zealand. Assuming all of this can be ironed out over time, where does bitcoin land in the investment universe and does it affect gold?

The gold vs. bitcoin debate continues

Bitcoin’s greatest potential is as a decentralised global payment system and substitute for cash. Many investors believe bitcoin is a store of value, and it could certainly become a hedge against currency debasement.

The reason investors focus on gold vs. bitcoin, and not other cryptocurrencies, is becuase of the characteristics they have in common. Both have limited supply, sit outside of the mainstream financial system, carry no counterparty liabilities, are uncorrelated assets and have been used as currencies. The anti-establishment ethos of bitcoin users is akin to the lack of trust many gold investors have in the financial system.

Yet, there are also stark differences. Bitcoin is not a tangible asset. Like paper currency, it only has value so long as the public believes it has value. Without public trust, it is worthless. Gold, on the pther hand, is real. It is used in electronics, medicine and aerospace. It is displayed on millions of people around the world every day. It has utility beyond its use as a store of value and is intertwined with human culture and history.

Current landscape supports gold and bitcoin working together

Interest rates have been falling for 40 years. We are entering a post-pandemic era where rates have nowhere to go but up. The potential for excessive inflation is palpable. Investment strategies that worked for the last 40 years are not likely to work in the foreseeable future. This investment landscape of risk and uncertainty is amenable to both gold and bitcoin. While bitcoin may steal some gold investors at the margin, it is also likely to attract new investors to the safe-haven realm where gold and silver are established. Perhaps gold will find new use as a stabiliser in volatile crypto funds. In any case, it is not a gold vs. bitcoin world. It is a gold and bitcoin world, where both can coexist.