Gold’s Recent Correction Is a Big Buying Opportunity

October 26, 2016

Since the Federal Reserve raised its target interest rate last December, every dovish or hawkish comment from Janet Yellen and other voting members of the Fed has sent stock, bond, and commodity markets into flux.

Most notably, the gold price rallied 30% and silver 40% since the December 2015 rate hike, as likelihood of the Fed’s four planned interest rate increases dwindled.

The Fed has been on hold this year due to a myriad of reasons, including subpar economic growth, sluggish job and wage growth, low inflation, and the unexpected exit of the UK from the European Union.

But another year-end rate hike could be on the horizon, evidenced by the relatively strong jobs reports we’ve seen since July. In fact, the Federal Funds futures market is currently predicting a 70% chance of a rate hike in December.

As those odds have increased over the past month, gold and silver have experienced declines of 10% and 15%, respectively.

If you’re considering precious metals for your portfolio, it’s a good time to buy.

The Rate Game

Typically, the Fed will adjust monetary policy based on prevailing economic conditions and forecasts. Its dual mandate is price stability and full employment.

When the Fed thinks the economy is beginning to overheat, it raises the Fed funds rate. If it feels the economy is underperforming, it lowers it.

But the nominal interest rate doesn’t tell the whole story.

To accurately assess the performance of your investments, you have to take inflation into account. For example, if a 10-year government bond returns 5% and inflation is 3%, your investment has a real interest rate of 2%.

How Real Interest Rates Affect Gold

Low to negative real rates—created by the Fed’s unprecedented approach to monetary policy after the 2008 financial crisis—have created a headache for investors seeking positive returns from stable, fixed-income securities.

And this dilemma does not look to be changing anytime soon. Just last Friday, Janet Yellen said the Fed may let inflation run hot for a while to let the US economy “catch up” from years of slow growth. 

The barely positive (or even negative) real interest rate on many fixed-income securities is going to prompt many to look for a “safe haven” investment. And that can significantly impact the performance of gold.

Take a look at gold’s inverse relationship to the real rate of interest:

Even though the Fed may increase rates slightly in December, higher inflation may offset the effect on real rates next year.

Central Banks Are Driving Interest Rates Lower

As global debt continues to soar, attempts to stimulate economic growth have moved global interest rates lower—and even negative in many countries.

Although the Federal Reserve ended quantitative easing in 2014, several other key central banks have picked up the slack.

The Bank of Japan and the European Central Bank have expanded their assets by $2.1 trillion since December 31, 2015. Additionally, both Switzerland and Brazil’s central banks have each increased holdings by more than 15%.

The 10 largest central banks now own assets totaling $21.4 trillion, a 10% increase from the end of 2015. This represents 29% of the world’s GDP—double what it was in September 2008 when Lehman Brothers collapsed.

Increasing debt from non-US central banks will most likely keep a lid on interest rates well into 2017, probably beyond.

While central bank balance sheets and overall global debt have ballooned in recent years, the stock and bond markets have continued to make all-time highs.

No one knows the sustainability or duration of these bull markets. However, judging by gold’s move in 2016, it appears investors are becoming ever more skeptical.

Gold’s Recent Correction Can Benefit Investors

With many predictions for lower gold prices not panning out earlier this year, and the relentless increase for most of 2016, a lot of investors are on the outside looking in.  

Attempting to pick a market or cycle bottom is an exercise in futility.

Gold’s recent decline from $1,370 to $1,250 (a 9% correction) and silver’s 15% correction to the low $17s provide a good opportunity to dollar-cost average into a new position or increase exposure.

As the Federal Reserve tiptoes toward a token rate increase in December and major central banks continue to expand their balance sheets, the market forces behind gold’s rally in 2016 look to be largely intact for 2017.


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