Wednesday, 11 October 2023

By Brian Chu Editor, Fat Tail Commodities

[5 min read]

Dear Reader,

On Saturday evening, news broke on Hamas militants firing over 5,000 projectiles into Israel causing hundreds of deaths. The Israeli government responded by announcing they’re preparing for a full-scale invasion of Gaza.

This is indeed a tragic event. Will things escalate in the coming days?

We can only pray that things will subside, rather than turn into a full-blown war.

As expected, gold jumped in response to this conflict breaking out. Gold producers rallied strongly from this too, rising almost 5% yesterday.

It’s quite a change from what we’ve experienced in the past couple of weeks.

Only last Friday we saw gold in US dollar terms fall to just over US$1,800 (~AU$2,850) an ounce as the US Dollar Index [DXY] continued its bullish trend. However, gold has managed to bounce back above US$1,850 (~AU$2,900) yesterday and while the US Dollar Index retreated to 106.

Gold stocks have suffered a bearish trend for several weeks, as you can see in the figure below:

Yesterday’s bounce has brought the index back to the 200-day moving average, allowing the index to stay in the game rather than head into a bear market.

Bounce or rally in gold? Understand what drives the price of gold

Now you may ask whether this conflict will bring an end to the bearish trend for gold and gold producers.

I’ll answer this question in two ways.

The first is that I don’t wish for the conflict to escalate into something bigger. Should that happen, it could cause gold to rally further as it’d cause a flight to safety.

But it would be distasteful to wish for this to happen for the sake of seeing your precious metals portfolio gain. It certainly wouldn’t be profits that you’d enjoy.

My second response is to discuss the factors that lead to a sustainable rally for gold. Knowing these and keeping track of what’s to come could hopefully deliver you better results.

Recall that gold is both an inflation hedge and a safe haven when things turn bad, especially in an economic crisis.

That said, my observation from studying financial history is that investors tend to take refuge in the US dollar first when they see signs of trouble with the economy and the markets.

The first reason for this is because everything is priced in fiat currency terms in this system. So fleeing to the dollar is more an instinctive and psychological move.

The second is that fiat currencies pay interest while gold doesn’t. The relative attractiveness of gold vs fiat currencies comes down to which is better in retaining purchasing power.

This is where inflation comes into play.

While many believe the price of gold is manipulated and should be worth over US$10,000 an ounce today, this view is too simplistic.

I agree that there is some manipulation going on. But it’s logical…I’ll reveal how it works.

The price of gold is closely correlated with the US long-term real yield (return of long-dated US government bonds less the inflation rate). The US Federal Reserve and the markets trade gold to correspond to the US long-term real yield, which measures the extent in which the US dollar can deliver returns exceeding inflation. They move in opposite directions.

Currently, it’s at 2.6% which is a level not seen since 2009. Let’s have a look at how gold and the long-term real yield have moved since 2005:

Just two years ago, the long-term real yield was still negative. That’s why gold was trading at its all-time record. As the real yield rose sharply in the past year gold fell, because the US Federal Reserve aggressively raised the Federal Funds Rate to fight inflation.

The last time the Federal Reserve was able to control inflation and revived the long-term real yield was in 2013. That caused gold to plunge from US$1,700 to as low as US$1,045 in late-2015.

This time, gold only dropped from around US$2,000 to US$1,600. This is despite the real yield rising more than it did in 2013–15.

That’s a good sign. Gold is clearly more resilient this time to central bank monetary policy.

So let me go back to answering the original question of whether this conflict could cause gold to rally.

It all hinges on whether this conflict causes significant economic slowdown worldwide. Should that happen and the markets look fragile, it may force central banks to back down on their stance on keeping rates high. That would cause gold to rally.

Notice that there are many conditions to meet. All the dots must join.

At this stage, it’s up in the air. I’m not of the view that the magnitude of the conflict now is enough to change economic conditions.

This could change if the conflict escalates, causing large scale economic disruption on the commodities markets.

I notice that the price of crude oil has edged back up. The price of gas has also increased overnight as Chevron Corporation [NYSE:CVX] closed down the Tamar offshore gas field on fears of potential attacks of its facilities.

Therefore, it’s important to monitor the situation and see what happens.

Opportunity to take profits and set yourself up for bigger rewards

And what about gold producers? How will they perform from the latest events?

Let’s have a look at the key drivers of the profitability of gold producers with the gold-oil ratio and my very own Gold Stocks Valuation Index in the figures below:

The gold-oil ratio is currently at 22.8, almost 10% higher than last week. We need to see it head back above 25 to be more confident that the falling trend has ended.

Meanwhile, the GSVI is at 51.2%. At such levels, gold producers are fairly valued relative to their fundamentals. Gold stocks have had a tough three years as prices fell and investor sentiment disappeared. They went through a brutal sell-off last year, but have staged a strong recovery from last October to April this year.

The bounce yesterday for the ASX Gold Index shows me that the market currently is correctly pricing these producers to account for the current conditions. So I believe that it may be a good time to take some profits on a few gold producers that have bucked the bearish trend in the last few months.

That said, there’re companies that are undervalued and make a great long-term buy.

As the world continues to descend into more turmoil and chaos, gold could offer you not only a safe haven, but also provide opportunities to benefit in the years to come.

If you want to find out what these companies are or if you want to start building a precious metals portfolio now, why not consider signing up to The Australian Gold Report? You’ll also get to learn about two small-cap gold stocks that could benefit in the coming gold bull market.

God Bless,

Brian Chu,
Editor, Fat Tail Commodities