Gold: Risk from Diminished Rate Expectations

Diminished rate-hike expectations are great news for precious metals.  Investors perceive the metals as a store of value which pay no interest.  So, when expectations for interest rate hikes diminish, it increases the relative attractiveness of holding precious metals (PMs) as compared to holding cash.  The correlation between the day-to-day changes in Fed Funds Futures, expressed as an interest rate (100 minus price), and the day-to-day changes in gold, silver and platinum prices has become increasingly negative over the past few years (Figure 2).  This implies that the influence of U.S. interest rate markets on precious metals has increased over time. 

While investors in precious metals are undoubtedly content with their recent gains, there are reasons to be both nervous that they won’t last and optimistic that they might continue.  Before elaborating on the upside and downside risks to precious metals, it is worth pointing out that: the recent easing of rate-increase expectations has little to do with the current state of the economy.  GDP, the labor market and most other economic indicators show a stable rate of expansion, and there has been a modest uptick in inflation.  All else being equal, this should argue for expectations of more and not fewer rate hikes.  Moreover, the U.S. and most other yield curves (except for China) remain positively sloped, suggesting a low likelihood of an economic downturn in the next 12-24 months.

The diminished expectations for higher interest rates appear to be related to political concerns.  And, there are several pressing questions. Will Janet Yellen be reappointed as Fed Chair?  If not, who will replace her?  Who will be appointed to the other posts on the policy-making Federal Open Market Committee (FOMC) and how hawkish or dovish might they be?  Does the collapse of health care reform signal that tax reform and infrastructure spending also won’t make it through the gridlock in Congress?  Will the Administration’s relatively low popularity and contentious relationship with Congress leave the Fed to continue supporting economic growth through monetary policy in the absence of a boost from fiscal policy?  Will there be a government shutdown?  None of the answers to these questions are clear, and this lack of clarity is weighing on expectations that the Fed will continue to hike rates.

To the extent that concerns about the direction of U.S. monetary policy have weighed on interest rate expectations and boosted metals prices, this poses downside risks to metals.  There remains an enormous gap between Fed expectations expressed in their ‘dot plot’ – FOMC members’ rate projections – and market expectations.  FOMC members, many of whom will soon be replaced, seem to think that the Fed will have its policy rate at 3% by the end of the decade.  This implies seven more rate hikes between now and the end of 2019.  Fed Funds Futures price the Fed target rate at 1.5% at the end of a decade –that’s one more rate hike with a 50-50 chance of another. Rarely has the gap between market expectations and the dot plot been so wide. 

If unemployment continues to fall, consumer incomes and spending keep growing, housing continues to rebound and the world avoids a conflict involving North Korea, the risk is that the Fed will hike rates a great deal more than what the market is currently pricing.  The Fed probably won’t make it to 3% by the end of the decade, which seems like a bit of a pipedream, but rates could certainly make it to 2%.  If the Fed goes beyond the 1 or 2 rate hikes the market expects by the end of the decade, it could be bad news for precious metals.  Likewise, the reduction in the size of the Fed’s massive balance sheet might not be helpful to precious metals to the extent that it drives intermediate and long-term interest rates higher. However, if the Administration and Congress surprise the market and pass significant tax reform or an infrastructure spending bill while avoiding a government shutdown, it could also boost rate-hike expectations at the expense of precious metals.

On the flipside, there is a case to be made that already diminished rate expectations might fall further.  Equity market valuations are quite high and corporate earnings are no longer growing.  If the equity market corrects sharply, interest rates markets could go from anticipating an extremely slow pace of Fed tightening to anticipating no Fed tightening at all or even begin to price that the Fed could reverse course and begin easing policy.  If that happens, precious metals would soar and gold would likely lead the way higher since it is the most negatively sensitive to interest rates among them.

One final reason why precious metals prices aren’t any higher: gold and silver mining supply continue to rise, albeit slowly.  While changes in Fed Funds dominate day-to-day trading in gold and silver, changes in mining supply exert a strong year-to-year influence, and in 2017 mining supply will likely be at a record high for both metals, which isn’t good news for the price.  Moreover, mining supply might continue to grow.  Gold can be profitably mined at $818 per ounce ($630 per ounce operating costs + $188 per ounce overhead costs).  At $1,300 per ounce, that’s an average 59% margin.  Silver’s total cash costs + capital expenditure cost of production averaged $11.38 per ounce in 2016.  With silver trading near $17.50 per ounce, this gives silver miners operating margins comparable to that of gold producers.  With mining this profitable, it may spur further investment resulting in further growth in supply, which should put downward pressure on prices over the long term.

The one exception is platinum.  Platinum production costs average around $974 per ounce, around the current price of platinum.  In sharp contrast to gold and silver mining supply, which have increased by 27% and 33% over the past decade, respectively, platinum mining supply is about 8% lower than it was a decade ago.  Unfortunately for platinum, demand from automotive and electronics has been soft.  In 2007, 4,109 metric tons of platinum were used to make catalytic converters in automobiles, compared with 3,286 metric tons in 2016.  Over the same period, electronics demand for platinum shriveled from 397 metric tons to 148, and its use in glass fell from 431 metric tons to 291.  The petroleum industry has also been more frugal in the use of the metal, with demand falling by 20% over the past decade.  Growth in other areas such as retail investment, jewelry and other industrial applications has been insufficient to offset the drop in demand from the automotive, electronics, glass and petroleum industries.  As such, mining supply is not as influential in determining platinum prices as it is in the prices of gold and silver.  

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