Gold warning bell rings as interest rates rise

Rising interest rates, especially in the US, do not mean it’s game over for gold, but it certainly means that a tailwind, which drove the price of the precious metal to all-time highs over the last two years has veered into a headwind.

War in Ukraine and the threat of a spillover into the rest of Europe will ensure a continued healthy appetite for gold in that part of the world thanks to its role as a portable store of wealth and safe haven.

Older investors remember stories from the Cold War years of the 1950s and 60s about people living close to the Russian border sewing gold coins into the linings of their winter coats in case a quick getaway was necessary.

It’s easy to imagine the same thing happening today in the Ukraine, Poland and even Germany as Russia vents its resentment about decades of decline on the western world.

But in a global context, and gold is one of only two truly universal currencies (the US dollar is the other), what’s happening in Europe will not be enough to save gold from a significant price correction as central banks launch an overdue round of interest rate rises designed to crush the worst outbreak of inflation in 50 years.

Inflation rattles asset values

Ironically, gold can be a useful hedge against inflation, but that genie is well and truly out of her bottle with the more powerful force today being the fight against inflation which is a sea-change event that hasn’t been seen for 10-years with the increased cost of money (higher interest rates) certain to rattle all asset values.

For investors with an appetite for gold, the time has arrived when they need to treat the metal with increased caution, buying it as an insurance policy against a political train wreck (they do happen) or by focusing on four types of gold mining companies, which are:

• Those generating strong profits from existing operations which will sustain a flow of dividends even at a substantially lower gold price. Companies such as Evolution Mining (ASX: EVN), Newcrest (ASX: NCM), Gold Road (ASX: GOR), and Northern Star (ASX: NST) are on that list.
• Companies which have made a significant discovery that has the potential to be a low-cost future source of gold. Companies such as De Grey Mining (ASX: DEG), Bellevue Gold (ASX: BGL) and Genesis Minerals (ASX: GMD) are on that list.
• Other companies that own a high-grade but undeveloped orebody with the potential to attract a high-priced takeover bid, including Predictive Discovery (ASX: PDI) and Sarama Resources (ASX: SRR), and
• Explorers with red-hot potential and an active drilling program, which will ensure a flow of assay results to maintain speculative interest.

Gold market in next phase

The process of sifting gold stocks into those capable of riding out the next phase of the gold market started two years ago, when the world was battling the worst effects of the COVID-19 pandemic and governments cranked up their paper-money printing presses.

That flood of cheap cash designed to keep economies ticking over created a perfect climate for gold which, in its bullion form, does not generate a return, so when interest rates fell to zero (and sub-zero in some cases) gold boomed.

The simple test of gold versus interest rates is to look back to when gold hit its all-time high of US$2,067 an ounce on 6 August 2020

On that day, the US Government’s 10-year bond, the bellwether of bonds, was trading at an all-time low of 0.5%, the Swiss 10-year bond was stuck at minus-1%, and the German 10-year bond was at minus-0.5%.

Those ultra-low, emergency government bond rates, drove investors into other assets such as gold with its capital protection quality, and high-risk alternatives such as Bitcoin also which started its spectacular rally in August 2020, rushing from US$10,000 per unit to US$63,000 by April last year.

Today, the worm is turning, and it could turn quite sharply as fear of inflation forces central banks to raise interest rates as a means of squeezing excess liquidity (which they created) out of the global monetary system.

Just as the low point in US interest rates corresponded neatly with the high point for gold, so it can now be seen in reverse and would be even clearer if not for the distraction of Russia’s war in Ukraine.

Since the start of the year the US 10-year bond rate has doubled from 1.45% to 2.98%. Gold, after a jump above US$2,000/oz at the start of Russia’s invasion has slipped back to US$1,869/oz and could go a lot lower – almost certainly taking silver, its sister metal, with it.

Propping up a high gold price short-term

RBC Capital Markets, a Canadian bank, took a sobering look at gold last week, arriving at the conclusion that in the short-term there are factors at work, which will support the gold price, including the metal’s safe haven status and store of value.

The bank said the factors, which have supported gold will be around for a little longer, helping the price stay high for “some time”.

“However, the longer-term macro relationships still point to lower gold eventually if and when the headwinds reassert themselves,” RBC said.

A high price scenario from RBC sees gold trading at US$2,036/oz in the September quarter and still sitting at US$1,986/oz at the end of the year, a forecast which assumes tailwinds continue to blow for gold.

But the flipside of that optimistic outlook, if the headwinds overpower the tailwinds, is a gold price possibly falling to US$1,563/oz in the September quarter and then down to US$1,518/oz in the December quarter.

On balance, RBC believes gold will continue to benefit from the knock-on effects of the Russian war in Ukraine but the long term the price trend is down.

UBS, another investment bank, sees a similar outlook for silver with its recent fall from US$25/oz to US$22/oz a pointer to the future price direction.

“Soaring US interest rates have pulled the silver price back in recent days,” UBS said.

“Our latest supply and demand considerations still point to a market deficit this year. However, this deficit could melt away if economic growth moderates and US interest rates continue to climb”.