The Coming Gold Breakout
By Jim Rickards
Gold is one of the best performing asset classes of 2017, but it has faced headwinds over the past few weeks based on market expectations that the Fed will raise rates in December. This expectation has caused a set of market movements, including a stronger dollar and weaker gold prices.
But as I’ve argued before, my view is that the economy is fundamentally weak and the Fed will not raise rates in December. I base that on nine months of disinflation data (using the Fed’s preferred measure, not alternate measures that market analysts flock to) and on a weakening employment picture including job losses in September for the first time in seven years.
Once the market wakes up to the real state of play, probably in late November or early December, the current trends will suddenly reverse. You’ll see the dollar down and gold prices up.
That makes the next few weeks an excellent entry point for gold and gold mining stocks. You have a chance to take advantage of weakness and position ahead of the rally to come when the Fed tips its hand.
Gold seems poised to resume its march to $1,350 and then $1,400.
The physical fundamentals are stronger than ever for gold. Russia and China continue to be huge buyers. China bans export of its 450 tons per year of physical production.
Gold refiners are working around the clock and cannot meet demand. Gold refiners are also having difficulty finding gold to refine as mining output, official bullion sales and scrap inflows all remain weak.
Private bullion continues to migrate from bank vaults at UBS and Credit Suisse into nonbank vaults at Brinks and Loomis, thus reducing the floating supply available for bank unallocated gold sales.
In other words, the physical supply situation is tight as a drum.
The problem, of course, is unlimited selling in “paper” gold markets such as the Comex gold futures and similar instruments.
A flash crash in June was precipitated by the instantaneous sale of gold futures contracts equal in underlying amount to 60 tons of physical gold. The largest bullion banks in the world could not source 60 tons of physical gold if they had months to do it.
There’s just not that much gold available. But in the paper gold market, there’s no limit on size, so anything goes.
There’s no sense complaining about this situation. It is what it is, and it won’t be broken up anytime soon. The main source of comfort is knowing that fundamentals always win in the long run even if there are temporary reversals. What you need to do is be patient, stay the course and buy strategically when the drawdowns emerge.
The main source of comfort is knowing that fundamentals always win in the long run even if there are temporary reversals. What you need to do is be patient, stay the course and buy strategically when the drawdowns emerge.
Where do we go from here?
China may be leading the world back to some form of gold standard by allowing oil exporters to convert the yuan they receive from China into gold on the Shanghai Gold Exchange.
Deteriorating relations between the U.S. and Russia will only accelerate Russia’s efforts to diversify its reserves away from dollar assets (which can be frozen by the U.S. on a moment’s notice) to gold assets, which are immune to asset freezes and seizures.
The countdown to war with North Korea is underway. A U.S. attack on the North Korean nuclear and missile weapons programs is likely by mid-2018. The stock market may not have noticed, but the gold market has. This partly explains why gold has done as well as it has in the face of all the talk about a December rate hike.
And that leads us to with our friends at the Fed. Despite the recent weak inflation data, the market is still pricing in about an 86% chance of a December rate hike. Rate hikes make the dollar stronger and are a head wind for the dollar price of gold.
But as I said, the Fed will not hike rates again in December. Once the market wakes up to the reality of a prolonged “pause” by the Fed, they will conclude correctly that the Fed is once again attempting to ease by “forward guidance.” This relative ease will keep the dollar on its downward trend and be a boost to the dollar price of gold.
The determining factor is disinflation.
The Fed’s main inflation metric has been moving in the wrong direction since January. The readings on the core PCE deflator year over year (the Fed’s preferred metric) were:
January 1.9% February 1.9% March 1.6% April 1.6% May 1.5% June 1.5% July 1.4% August 1.3%
Notice the trend?
The Fed’s target rate for this metric is 2%. It will take a sustained increase over several months for the Fed to conclude that inflation is back on track to meet the Fed’s goal. There’s no chance of this happening before the Fed’s December meeting.
A weak dollar is the Fed’s only chance for more inflation. The way to get a weak dollar is to delay rate hikes indefinitely, and that’s what the Fed will do.
And a weak dollar means a higher dollar price for gold.
Current levels look like the last stop before $1,350 per ounce gold. After that, a price surge is likely as buyers jump on the bandwagon, and then it’s up, up and away.
There’s an old saying that “a picture is worth a thousand words.” This chart is a good example of why that’s true:
Gold analyst Eddie Van Der Walt produced this 10-year chart for the dollar price of gold showing that gold prices have been converging into a narrow tunnel between two price trends — one trending higher and one lower — for the past six years.
edit: and here is the chart we follow for comparison
Live prices here Soren K.
This pattern has been especially pronounced since 2015. You can see gold has traded up and down in a range between $1,050 and $1,380 per ounce. The upper trend line and the lower trend line converge into a funnel.
Since gold will not remain in that funnel much longer (because it converges to a fixed price) gold will likely “break out” to the upside or downside, typically with a huge move that disrupts the pattern.
At the extreme, this could imply a gold price on its way to $1,800 or $800 per ounce. Which will it be?
The evidence overwhelmingly supports the thesis that gold will break out to the upside. Central banks are determined to get more inflation and will flip to easing policies if that’s what it takes.
Geopolitical risks are piling up from North Korea, to Syria, to the South China Sea and beyond.
Markets will soon have to come to grips with the realization that the Trump tax cuts as originally envisioned will not materialize. A substantial market correction may be in the cards.
Acute shortages of physical gold have set the stage for a delivery failure or a short squeeze.
Any one of these developments is enough to send gold soaring in response to a panic or as part of a flight to quality.
The only force that could take gold lower is deflation, and that is the one thing central banks will never allow. The above chart is one of the most powerful bullish indicators I’ve ever seen.
Get ready for an explosion to the upside in the dollar price of gold. Make sure you have your physical gold and gold mining shares before the breakout begins.
Jim Rickards for The Daily Reckoning
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