The ‘Paradigm Shift’ Driving Gold Jim Rickards, Strategist The world of gold trading and investing was rocked last month when multibillionaire and the world’s largest hedge fund manager, Ray Dalio, published a column called ‘Paradigm Shifts’ on LinkedIn. You can find it here. A paradigm is a mode of thought or a prism through which one views the world. A paradigm is not a model. It’s the overview that informs the models that are built to predict or track specific phenomena. The idea that the Sun and planets revolve around the Earth (the ‘geocentric system’) was a paradigm that prevailed for over a thousand years until it was overturned by Copernicus in the 16th century. Based on that paradigm, astronomers and mathematicians worked out elaborate models of planetary motion. Of course, once the paradigm shifted, the models were discarded because they were simply wrong. Those geocentric models described a reality that never existed. Dalio says that paradigms in capital markets last about 10 years. He describes separate paradigms for finance from the Roaring Twenties, the Great Depression, the Second World War and post-war period, the boom-and-bust 1960s, and other periods. It’s an informative essay and a great historical overview. Dalio’s article hit the gold markets like a bunker-buster bomb. Gold rallied US$30 per ounce (over 2%) in the days after the article was published. Even that rally understates the full impact of what Dalio was writing. Dalio foresees this ‘new paradigm’ for debt, inflation and gold lasting a decade or more. We agree. If that’s true, the gold rally is just getting started. US dollar set to fall With the gold market boosted in the short run by the ‘Ray Dalio Effect’, where are gold prices most likely to go next? The chart below offers important guidance as to the future price of gold. This is a chart of the US dollar index (DXY). It shows what technical analysts call a consolidating trend. In the past six months, the dollar index has traded in a range between 96.30 and 95.70. However, that range has narrowed considerably and is now tightly bunched between about 97.50 and 96.75. As this range narrows daily, a pattern forms in which the US dollar is poised for a ‘breakout’. Once the breakout occurs, large rapid moves are the most likely pattern. Of course, the question is whether the greenback will break out to the upside or the downside. US dollar index – daily chart Source: Barchart.com; The Daily Shot The dollar will almost certainly break out to the downside. There are numerous reasons for this forecast. The first is that the Fed has now embarked on monetary easing after six years of tightening. (For this purpose, ‘tightening’ includes the 2013 taper, the 2014 end of quantitative easing, the 2017 start of quantitative tightening, nine rate hikes and forward guidance.) The easing began in late 2018 when the Fed announced it would be ‘patient’ with future rate hikes. This was understood to mean the Fed would not raise rates without giving the market early warning. This was quickly followed by the Fed’s decision to drop the word ‘patient’, and to signal clearly that rate hikes were off the table and rate cuts were under active consideration. Then in June and early July 2019, the Fed signalled clearly that it will cut rates (probably by 0.25%), which it then did at its FOMC meeting on 31 July. It went one step further by announcing an early end to its quantitative tightening (QT) program. QT involves reductions in the base money supply (the opposite of QE) and is a form of tightening. QT was scheduled to end in September 2019. By bringing the end of QT forward, markets will get a double dose of easing by the Fed. Beyond that, the Fed may cut rates again in September, but it is too soon to state that definitively. Weaker greenback to drive gold higher These Fed easing actions come on top of repeated calls by Donald Trump for more rate cuts and further easing by the Fed. Trump has been explicit about his wish for a cheaper dollar that will promote US exports, create export-related jobs, and import inflation in the form of higher prices on US imports because of the cheap dollar. Chairman Jay Powell and the other Fed governors will maintain the independence of the Fed and not simply cave into demands by the president. Still, the combination of actual easing by the Fed (for its own reasons) and demands for easing from the White House have made rates and the dollar a one-way bet. Interest rates are headed down and so is the US dollar. Why is this tendency towards a cheaper dollar determinative of the dollar price of gold? The answer is that gold and the dollar are both forms of money. Their prices (gold priced in US dollars and dollars calculated by weight in gold) are reciprocal. A stronger US dollar means a lower dollar price for gold. A weaker US dollar means a higher dollar price for gold. With a weaker US dollar on the cards, a higher dollar price of gold is to be expected. This applies equally to shares of gold mining stocks, although the price increase in the stocks can be even more powerful because of the leverage embedded in mining companies. Of course, weakness or strength in the dollar are not the only drivers of gold prices… Gold bull market has a long way to run Gold is also affected by basic supply and demand, inflationary expectations and geopolitical concerns. Yet, those factors have been priced in for some time. Demand for gold has remained high, particularly because of steady purchases by Russia and China of 15 to 30 tonnes per month each. Meanwhile, supply from gold mines has been constant at around 4,200 tonnes per year for the past six years. Constant supply with rising demand is a recipe for higher prices. Still, that vector has been priced into the gold market for some time. Likewise, weak inflationary expectations are a headwind for gold prices, but that has prevailed for the past nine years. The geopolitical vector has also been dangerous for years thanks to the Syrian and Ukrainian wars, the prospect of war with North Korea and now the likelihood of war with Iran. These factors are important, but they have been in the market for a long time. The only new factor, and the one driving prices today, is the prospect of a weaker US dollar. The US dollar hit an all-time low in August 2011 at almost the exact same time that gold hit an all-time high at about $1,900 per ounce. That contemporaneous occurrence of the super-weak dollar and super-high gold prices was no coincidence. That’s to be expected. The US dollar has been much stronger since those 2011 lows. Now that a weak US dollar is back in market expectations, the pressure for higher gold prices comes as no surprise. This surge in gold prices will play out in the shares of gold mining stocks in the short run. And, according to Ray Dalio’s paradigm analysis, the gold bull market has a long way to run. All the best, | | Jim Rickards, Strategist, The Daily Reckoning Australia |
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