Gold’s Dot Plot

The Fed dot plot, published after every Fed meeting, shows where each of the 16 members of the FOMC (Fed Open Market Committee) expect interest rates to be at the end of the various calendar years displayed, as well as the peak level of rates upon completion of the tightening cycle. From time to time, the price of gold begs to differ with the Fed’s – and by extension, the investment world’s – consensus on the course of the economic path forward. Note that the gold price continues to grind higher, having dipped to a low of $1051/oz at year-end 2015, and now trades approximately $300/oz higher. Should bullion begin to trade above the 12-month range currently capped at around $1360, it will signify that the Fed’s dot plot is due for an overhaul. We write this note in anticipation that an overhaul of mainstream expectations is long overdue, and likely to occur in the remainder of calendar year 2018.

In our 2017 year-end letter, “Connecting the Dots,” we mentioned several factors likely to rekindle dormant investor interest in gold and gold mining shares. These included (1) extreme valuations of US financial assets, (2) a potential worsening of the US fiscal position, (3) the possibility of rising inflation, (4) precarious financial-market structure (reflexive risks posed by wide use of risk-mitigating and passive-investment strategies), and (5) an expected further weakening of the US dollar against other currencies, and each is discussed further below. Of these, we highlighted potential financial market losses as the most likely catalyst to cause investors to rethink their exposure to risk and the merits of gold as a risk dampener:

…there can be little debate that financial-asset prices now sit at valuation extremes that have been, without exception, followed by periods of meaningful disappointment. In our view, valuation excesses signify systemic risk.

(1) During the quarter, the metal price was up 7%. However, the financial markets began to exhibit extreme volatility. Although the S&P 500 declined only 1.2%, there were trading moves of -10.2% from peak to trough, far greater than quarterly ranges in 2017, which averaged only 5.6%. We believe that if these patterns continue, risk preferences of a broad range of investors will shift from targeting maximum gains to avoiding significant losses. As of this writing, the major US averages are trading at or below their 200-day moving averages, while many foreign-stock indices are trading well below this widely accepted benchmark of market health.

(2) The fiscal position of the US has begun to exhibit significant deterioration; this in turn has resulted in a dramatic increase in the supply of new treasury issuance. In February the deficit was 12% above year-ago levels and the largest in 6 years. In our previous letter, we stated that $1 trillion fiscal deficits could become commonplace, which would lead to an annual increment to national debt outstanding of 5% per annum, assuming a continuation of very low interest rates. We also noted that an increase of only 1% on outstanding US debt would balloon those deficits by $140 billion, a legitimate concern since the average maturity on outstanding debt is only 70 months.

(3) Inflation appears to be on the rise. The consumer price index (CPI – admittedly volatile) rose .5% in January (6% annualized) and .2% in February (2.4% annualized). The March CPI will not be reported until April 11, and one could argue that the jury is still out on inflation. However, important labor statistics suggest that a steady rise in wages is taking place, and tight labor-market conditions make a continuation seem likely. The ECEC (Employer Cost of Employee Compensation) rose 2.9% in Q4 2017. This is a real-time measure of actual labor costs. This index has been increasing at close to 4% per year (the most recent quarterly increase at only a slightly lower rate, but an increase nevertheless). Labor-market conditions are extremely tight, with unemployment claims the lowest in 45 years.