A Gold Bull Run Is Coming And No, It Will Not Be Due To Coronavirus

Until recently, it has been a protracted bear market for gold, the price of which had peaked at a little under $1,900 per ounce (oz) in August 2011, staying sub-$1,300 until May 2019. The irony of this bear market is that this happened under conditions of an unprecedented loose monetary and fiscal policy.

The US Federal Reserve (Fed) was pretty much on ZIRP (zero interest rate policy) and QE (quantitative easing) for most of the period mentioned.

Fiscal deficits also averaged around $1 trillion annually during that period as we witnessed the US national debt increase from $14.8 trillion to $22.8 trillion.

There is really no rational explanation for the above relative performance of the US dollar and gold other than saying that the Dollar Index also strengthened for most of the above period on account of ‘technical reasons’ and this ‘strong dollar’ resulted in the brutal bear market for gold and other commodities.

But that is, at least, not a root cause and digging deeper for an explanation will lead us to ‘human actions’ that cause commodity price cycles.

All it implies is that the bills for the monetary sins of the last decade(s) are coming due and the world will soon see the latter effects of inflation (which is what ZIRP and QE really are). We are just about entering payback zone.

Since gold prices bottomed out around 10 months back, there are nascent signs that the metal has entered what will be an extraordinary bull market over the course of the next decade.

With a return of 25 per cent-plus in the last 12 months (measured in US dollar, much higher in rupee terms) despite a strengthening US dollar, this so called ‘barbaric relic’ has been one of the best performing asset classes. But this is just a warm-up though.

The Maginot Line

As the Second World War aficionados will recall, the Maginot Line was a 1,000-mile-long series of concrete fortifications, with backup underground railways and state-of-the-art living conditions for the troops and weapons installations built by the French between 1929 and 1936 to prevent an anticipated German invasion.

Considered impregnable, which indeed it was, it did not serve its intended purpose as the Germans outflanked the French around the edge of the Maginot Line with their swift and intense military strategy popularly referred to as Blitzkrieg.

Seven years of planning and engineering was outmanoeuvred by four days of Blitzkrieg.

Technically speaking, the Maginot Line was never breached by the Germans. But as I will explain, the Gold blitzkrieg is going to slice open the equivalent of the Maginot Line.

The bulwark against rising gold prices over the last decade has been two related bubbles — the strong dollar and the treasury bond market (the long-dated ones, ie, the 10-year and 30-year bonds).

All bubbles eventually find a pin and these bubbles may well have found a gigantic pin in the Coronavirus (Covid-19).

As I have written earlier, the US economy has been floating on gigantic asset bubbles of equity, housing and bonds and we really did not need so large a pin.

That said, I would not be surprised if the world continues to believe, for the foreseeable future, in the myth that the virus causing the market mayhem emanated in Wuhan rather than at Eccles building, which houses the offices of the US Fed.

A good metaphor to understand the above would be to consider an obese, medically-sick individual who indulges in all kinds of unhealthy practices — eats junk food, does no exercise, smokes two packs a day, etc.

Now he catches a common flu and dies as a consequence. Do we blame the flu or his baseline immune-compromised condition? The flu might well have been the trigger, but if not this flu, it would have been something else a few weeks down the line.

I am not downplaying the seriousness of Covid-19, but had the world not been in this absolute fiscal/monetary mess we are in, this would have passed off with a few minor hiccups.

Even if it were not the Covid virus today, we would have had a markets meltdown similar to 2008 a few months down the line on some other account. The US and the world economy were tottering on the edges of a precipice with massive bubbles across asset classes waiting for a pin. Covid-19 is a massive pin. A pin nevertheless.

Much like the Germans outflanking the Maginot Line, rising gold prices over the last 10 months have occurred despite a strengthening dollar.

This condition of gold and the Dollar Index having a positive correlation is a particularly odd one from the perspective of recent history. But it makes logical sense if one understands the monetary history of the last century, or more generically, the economics of the Austrian School.

The Fountainhead Of Bubbles

The treasury bubble might well be the last domino that has continued to strengthen in the face of rising gold prices. As I will explain, when this bubble bursts, the consequences aren’t going to be pretty for any of the ‘good’ asset classes — equities, bonds or housing.

We might well be entering the mother of all bear markets for these asset classes as we speak. If we consider the recent 20 per cent correction in stocks (that officially classifies equities as being in a bear market) as brutal, all I can say is that we haven’t seen nothing yet!

Despite overwhelming evidence to the contrary, the world continues to believe in the propaganda that, but for Covid-19, we would still be proceeding uninterrupted on the road to life, liberty and pursuit of happiness.

That the valuation standards used to justify these overtly inflated asset prices are underpinned by one egregiously mispriced cornerstone — ie, long-term treasury yields — seems to be entirely lost in the marketplace.

If I considered those yields to be ridiculous last year, it has only become absurd now. Both the 10-year and the 30-year treasuries were quoted for a brief period at close to zero yields.

Who in their right minds is lending money to a bankrupt government for 10 and 30 years at less than 1 per cent when even the officially reported rates of inflation are greater than 2 per cent, with promises of even more to come?

The bond pits have really come to epitomise the ‘Theatre of the Absurd’, so much so that it can really be stated that sand castles have better foundations than the one that underpins asset valuations worldwide today.

To put things in perspective, the treasury market has never witnessed a meaningful bear market in the last 40 years.

More importantly, at that time the US economy was in a fundamentally sound position with a positive savings rate where it could withstand Paul Volcker hiking interest rates to 22 per cent during the previous bond bear market of the 1970s.

Today, given the levels of public, private and corporate debt, it cannot even withstand a 2 per cent interest rate — or, as we shall soon see, even zero per cent would be too high. But interest rates, especially at the long end of the curve, have a life of their own and they cannot be too bothered about the whims and fancies of the US Fed for an extended period of time.

When this cycle reverses in the next few months, the US economy is going to witness the worst of both worlds — an economy mired in a deep recession coupled with rising interest rates, ie stagflation.

The Mirage Of Fed-Induced Recovery

The Fed’s solutions to the problems of the 2008 crisis have been inflation — ie, ZIRP and QE. These programmes have been touted as a success on the basis of two factors, ie, recovery of gross domestic product (GDP) growth rates and a boom in the stock markets. But are these really reflective of the changes in the underlying economy?

Not a chance, as I will explain.

The changes to stock prices since the bottom of 2008 have primarily been a case of increasing valuations at multiple levels. The basic ratio of Total Market Capitalisation to US GDP has grown almost 2.5 times since 2008 from a little over 60 per cent to more than 160 per cent today.

But perhaps a more important and much less understood factor is the change in the GDP itself.

What has really grown over the last decade are the ‘fluffy industries’ — hospitality, tourism and government-related employment.

The really productive sectors of the economy such as manufacturing — are at levels lower than the pre-crisis levels of 2007. The S&P 500 in comparison has more than quadrupled.

What these really imply is that the growth in the GDP itself, even as anaemic as it has been, is a mirage that could vanish in a jiffy during a recession.

The Road Ahead

The bubbles induced by central banking have been pricked and there is no going back to even the mirage of a Fed-induced recovery this time. We all just have to live with the consequences for a long time to come — Buddhists call it Karma; Christians call it the Golden Rule.

The unfortunate part of it is that most of the people who are going to suffer had really nothing to do with the causative factors. At worst, they were ignorant; perhaps a dereliction of duty to oneself in some sense.

But then as the libertarian protagonist Cicero would put it, “Do not blame Caesar, blame the people of Rome who have so enthusiastically acclaimed and adored him and rejoiced in their loss of freedom and danced in his path and gave him triumphal processions.

Blame the people who hail him when he speaks in the Forum of the ‘new, wonderful good society’ which shall now be Rome, interpreted to mean ‘more money, more ease, more security, more living fatly at the expense of the industrious”.

The similarities between what lead to the decline of the Roman civilisation and Western civilisation today are uncanny. That, of course, is a topic for a different day.

The equity bubble has burst (DJIA, S&P, Nasdaq — all have recorded more than a 20 per cent correction) and, despite a return to monetary stimulus in the form of ZIRP/QR and fiscal stimulus in the form of payroll tax cuts/other measures, markets are not going to bubble valuations again.

With time, the recession that is almost a given now, is going to drag the earnings down dramatically and we might well see a further significant fall in these indices in the months and years ahead.

How much further can equities fall over the next decade?

In nominal terms, it can easily decline another 50 per cent and still be considered overvalued if one accounts for the earnings that are going to be dramatically downgraded and interest rates that are going to increase substantially in the years ahead. But the fall in real terms is going to be much worse.

Measured in terms of ounces of gold, DJIA could well decline from the current level of a (forward) price-earnings multiple of 15 (DJIA – 24000, Gold – $1600/oz) to low single digits.

The next shoe to drop is probably going to be that of US housing. Median house prices are up nearly 40 per cent as compared to the 2008 peak levels, and this at a time when there has been almost no substantive change in median incomes.

Again, there is no way to engineer a recovery as the Fed managed during the 2008 crisis. This decline could well easily start within a few months when the signs of a recession become obvious to the general public. I guess the duration and extent of declines in housing is going to largely mirror the equities markets.

But the equivalent of the Maginot Line has to be the dollar/treasury bubble. When that bursts, the consequences are going to be far more dramatic than what we saw even during the peak of the 2008 crisis.

The fact that the governments/central banks become entirely powerless to handle the crisis and stand exposed for their monetary machinations over the decades would indeed make it a poignant scenario for somebody viewing it even from their wide-screens, let alone their windows.

But I am also equally sure that governments the world over would manage to shift the attention of the general population from their own fiscal recklessness to some external factor such as currency speculators, futures markets, mercenary capitalists — the list of the usual suspects is a long one and it never fails to deliver.

Running into tens of trillions of dollars, the size of the bond bubble dwarfs the equities and housing bubbles combined.

So, it stands to reason that the losses are going to be far greater in bonds than on the other two asset classes. Besides, the predictable Fed response of a stimulus is going to impact bonds far more negatively than equities or housing.

On the timelines, the bond bubble might live for another year or two utmost. It’s hard to come to definitive timelines on these events.

From a fundamental perspective, these should have burst when the US Fed embarked on QE for the first time in 2008. That these measures of ZIRP and QE were a one-way street and there was no conceivable way in which the US Fed could have meaningfully rolled back these programmes ought to have been obvious to anyone who understood Austrian Economics.

The impact on gold prices is going to be dramatic when the bond bubble collapses. Price swings of several hundred dollars in a day will be commonplace and we will even witness a four-digit price increase in a day before this bull market ends over the next decade.

So, we are still in the very early stages of a bull market in gold and one where fortunes can be made with the correct investment thesis.

So, is there light at the end of the tunnel? I would see that almost as a philosophical question rather than an economic one. The best hope remains a transition to the gold standard but it is going to be one epic struggle between governments and markets.

The history of these struggles is not particularly inspiring, but somewhere we have to hope that we can elect a Cicero or a Ron Paul to lead us out of this quagmire that we have dug ourselves into.