GLDI - Gold's Bearish Reversal May Be Just Beginning

Summary

• Gold prices have finally succumbed to the fundamental downside pressures that I outlined last month.
• While the recent price drop has eased some of the metal's short-term overvaluation, its fair value has inched further down as US inflation-linked bond yields have resumed their rise.
• The fair value for gold prices now sits below USD1,500 based on the correlation between real gold prices and US 10-year inflation-linked bond yields.
• These short-term headwinds are also being joined by a deteriorating outlook for liquidity conditions. M2 money supply is now running at -1.3% and is set to fall even further.

My bearish call on gold prices last month came just before the market peaked as the fundamental pressures I outlined then were too much for speculative demand to contend with ( see ' Sell Gold And Buy TIPS ' ). While the recent price drop has eased some of the metal's short-term overvaluation, its fair value has inched further down as US inflation-linked bond yields have resumed their rise. I remain bearish on the metal, particularly relative to inflation-linked bonds.

Anyone investing in precious metals should be well aware of the extreme inverse correlation between gold and US 10-year inflation-linked bond yields - bonds that pay interest that tracks the rate of inflation. Rises in interest rate expectations relative to inflation expectations undermine the opportunity cost of holding gold as a store of value. As shown below, rising real yields have caused gold prices to fall without exception over the past two decades.

Even after the 6% decline in gold prices, the metal remains extremely overvalued relative to its fair value implied by real bond yields. The chart below shows real price of gold relative to its fair value implied by 10-year inflation-linked bond yields. It makes sense to use inflation-adjusted historical gold prices as inflation gradually raises the fair value of the metal over time. Based on this correlation, the fair value for gold prices sits below USD1,500. This figure should not be taken as concrete as depending on how far back you take the data, the fair value changes significantly. The key point is that gold is still close to the most overvalued it has been in decades.

It should be noted that even if the fair value of gold is currently USD1,500, this does not mean that gold prices will necessarily fall any time soon, for a number of reasons. Firstly, gold remained overvalued for several years from 2010-2012, but continued to rise. Secondly, positive inflation will steadily raise gold's fair value. Thirdly, real bond yields themselves face mounting downside pressure as the real economy buckles under the weight of rising debt burdens.

Even so, the degree of overvaluation relative to current real bond yields suggests now is a bad time to be long gold, and this is also supported by the metal's technical picture. Having failed to hold onto gains above USD2,000 on two prior occasions over the past three years, the recent failure to reach that hurdle has put the focus clearly to the downside, with a triple-top pattern potentially in the making.

These short-term headwinds are also being joined by a deteriorating outlook for liquidity conditions. M2 money supply is now running at -1.3% and as the Fed's balance sheet continues to shrink, an even deeper contraction should be expected. This is not a positive backdrop for gold prices over the coming years. While I ultimately believe that continued increases in government spending will necessitate a reversal of current liquidity conditions, such an inflationary policy response would likely require a crash in asset prices. In such an event, gold would not be spared.

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