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Wednesday, 14th February 2018

For Gold, It's Goldilocks Inflation  

Inflation is good for gold? It depends. If inflation provokes a hawkish Fed to raise rates faster than inflation, not so much. But if the Fed is worried about the stock and bond markets and therefore won't raise rates fast enough to keep pace with inflation, that's good for gold. And that's where we seem to be now.

Fear of inflation has been weighing on the bond market, helping to drive interest rates higher, and that's been a negative for the stock market. February 14th, we got a 'hot' CPI number which confirmed the market's fears and the initial reaction was to sell stocks and gold, sending them lower, and the dollar caught a bid. That's the response you would expect from anticipation of a more hawkish Fed.

But then came the reversal and quickly. The dollar tanked, gold soared and the stock market mounted a comeback. However, the bond market also fell, pushing yields higher at the long end. That is going to put renewed pressure on stocks if the last few weeks tell us anything.

We now have two reasons to think interest rates are going higher. First, there is the late cycle stimulus to the economy from the Trump tax plan and budget which are forecast to drive the annual budget deficit to a $1 trillion, double the recent past. This is a boost to spending without a commensurate increase in economic output because, as we all know, the government does not produce goods and services. This is inflationary and that appears to be the bond market's interpretation; the bond market has been under pressure since the tax plan was passed last December.

Second, the issuance of new debt will double to $1 trillion in 2018 while at the same time the Federal Reserve is scheduled to be selling assets (Treasuries and mortgage bonds) at an annual rate of $600 billion by October of this year. All this added supply is going to pressure rates higher.

Higher rates and a weaker dollar are not typical companions. Neither are higher rates and higher stock prices. But a weak dollar and a steeper yield curve are historically good for gold.

All considered, we could be brewing a perfect storm for gold. Let's see if gold can punch through the 2016 high around $1370. If so, the game may be on. Gold could be the best game in town.