Well, if rampant money printing inflates the value of financial assets and strengthens the appeal of gold as a hedge against the kind of nightmarish, hyperinflationary reality one might expect to result from running the fiat presses at full-tilt for the better part of a decade, then the converse must also be true, right?
As Pimco’s Anthony Crescenzi put it this week, “it’s illogical to think that quantitative easing would help markets but quantitative tightening won’t hurt.”
So is it equally “illogical” to assume that QT won’t put downward pressure on gold prices? I mean, if you just think about traditional relationships and the current trajectory for inflation, one wonders about the bull case for bullion. Recall this simple assessment from Bloomberg’s Mark Cudmore:
Gold is still just an inverse real yield play. Since most major central banks — such as the Fed and the ECB — are more likely to hike rather than cut rates as their next move, despite a lack of sustained inflation, it’s unlikely the next major move in real yields is going to be lower.
The question then, would seem to be this: what won’t fall as the Fed normalizes?
And indeed that’s precisely what BofAML wants to know on Tuesday. Here’s an excerpt from a new note:
In the past, a drop in the Fed’s balance sheet has hurt gold prices.
In aggregate, the Fed has indicated a plan to suck out $1.4tn in reserves (read money supply) over the course of the next four years, bringing its balance sheet down by $30bn this year, $381bn next year, $425bn in 2019, and 337bn in 2020.
The Fed’s intended cumulative balance sheet reduction exercise of 1.4tn looks gigantic when compared to total global central bank gold reserves of 1.6tn or to the total value of global annual gold production of $145bn. While hard to prove quantitatively, it is no secret that the Fed’s balance sheet expansion following the Global Financial Crisis led to a massive boost to gold prices (Chart 13). In fact, our work generally shows a cross correlation between Fed balance sheet changes and gold prices (Table 1), particularly when we narrow our focus on the Fed’s traditional UST portfolio. Interestingly, we also find that Fed balance sheet changes may Granger cause gold price moves, a concerning result. With the Fed’s balance sheet poised to contract and financial conditions set to tighten either steadily or abruptly, we fear gold, fixed income, and equity asset prices may suffer a sudden drop.
So where does one hide? Well, probably in cash (or maybe bullets, kerosene, and canned goods), but there is a silver lining (get it?) for gold. Namely that in the event the stock-bond return correlation flips positive in a tantrum thus catalyzing all kinds of carnage for the risk parity crowd, central banks will almost surely step right back in with the printing presses, bolstering bullion. Here’s BofAML again…
A sharp drop in the value of all asset classes due to unexpectedly tighter financial conditions would render low volatility risk parity strategies on its head.
So if all major asset classes could drop in value as the supply of dollars falls, should investors just hold cash? Not necessarily.
Timing a negative market reaction to a Fed balance sheet unwind is nearly impossible, and surely the Fed would quickly react to stem a massive dollar rally and a synchronous drop in asset values. Gold markets would love that and easily rise above $1500/oz. As such, we continue to believe that a 2% to 5% gold allocation should provide strong diversification benefits in a diversified conservative 70% fixed income/30% equity portfolio. Don’t fight the Fed. There is a strong case to beef up cash allocations and to remain broadly diversified as the Fed balance sheet unwinds.
And yes, that’s an absurd dynamic, but such is the world in which are forced to live (and trade)…