There are many problems with the calculation methodology of the Consumer Price Index (CPI) and with the whole concept of coming up with a single number to represent the purchasing power of money. Interestingly, however, if we calculate the inflation-adjusted (‘real’) gold price by dividing the nominal US$ gold price by the US CPI, which is what we have done on the following monthly chart, we see that the result has peaked at around the same level multiple times over the past 50 years and that the current value is around this level. Does this imply that gold’s upside is capped?

It adds to the reasons that we should be cautious about gold’s short-term prospects. These reasons include the size of the speculator net-long position in gold futures, the August-September cyclical turning-point window for the gold mining sector, the likelihood of a reduced pace of US federal government spending during the months following the November-2024 election, the fact that gold’s true fundamentals are not definitively bullish, the high level of the gold/GNX ratio (gold is expensive relative to commodities in general), the extent to which the financial markets have discounted Fed rate cuts (four 0.25% Fed rate cuts are priced-in for 2024, creating the potential for a negative surprise from the Fed), and the high combined value of gold and the S&P500 Index relative to the US money supply. However, we expect that within the next 12 months the gold/CPI ratio will move well into new high territory, mainly because:

1) The US economy finally will enter the recession that has been anticipated for almost two years and that has been delayed by aggressive government spending, leading to efforts by both the Federal Reserve and the federal government to stimulate economic activity.

2) Despite the rise in government bond yields over the past few years, it is clear that neither of the major US political parties nor their presidential candidates have any concern about the level of federal government indebtedness. Putting it another way, currently there is no political will to reduce government spending. On the contrary, both presidential candidates are going down the well-worn path of trying to buy the votes of influential groups while ‘turning a blind eye’ to the government’s debts and deficits.

3) Using our own method of adjusting for the effects of inflation*, which generally will not be accurate in the short-term but should be approximately correct over periods of several years or more, the current ‘real’ gold price is a long way below its 1980 and 2011 highs (our method indicates inflation-adjusted highs of around US$5000/oz in 1980 and US$3400/oz in 2011). Refer to the following monthly chart for more detail.

So, while the proximity of the gold/CPI ratio to its long-term resistance adds to the short-term risk, this resistance probably won’t act as a ceiling for much longer.

*The theory that we apply can be summarised as follows: The percentage reduction in a currency’s purchasing power should, over the long-term, be roughly equal to the percentage increase in its supply minus the percentage increase in the combination of population and productivity.

By our reckoning, during the first half of 2022 the US economy entered the bust phase of the economic boom-bust cycle caused by monetary inflation (rapid monetary inflation causes a boom that inevitably is followed by a bust as the receding monetary tide exposes the boom-time malinvestments). The bust phase almost always culminates in a recession, although it doesn’t have to.

So far, the performances of commodity prices in both US$ terms and gold terms are consistent with an economy in the bust phase, in that last week the GSCI Spot Commodity Index (GNX) tested its cycle low in US$ terms and made a new 3-year low in gold terms. The following daily chart shows GNX in gold terms, that is, it shows the commodity/gold ratio. Booms and busts are defined by the commodity/gold ratio, with booms being multi-year periods during which the commodity/gold ratio trends upward and busts being multi-year periods during which the commodity/gold ratio trends downward.

Note that it is not unusual for the stock market, as represented by the S&P500 Index (SPX), to trend upward for a considerable time after the start of an economic bust. For example, an economic bust started in October of 2018 but the SPX didn’t peak until February of 2020. Therefore, the fact that the SPX made a new all-time high as recently as last month is not inconsistent with the US being in the bust phase of the economic cycle.

What is inconsistent with the bust phase are credit spreads, which prior to the turmoil of the past 1.5 weeks were at their boom-time lows. However, the relatively low average level of US credit spreads does not mesh with the relatively large number of corporate bankruptcies, so it’s likely that credit spreads are sending a misleading signal.

The misleading signal could be the result of junk-rated corporations delaying their re-financings for as long as possible in the hope that if they wait long enough, they will be able to re-finance at lower interest rates during the next Fed rate-cutting cycle. The problem that many of these companies will encounter is that a Fed rate-cutting cycle probably will begin near the start of a recession and a multi-quarter period during which interest rates fall on high-quality debt while rising rapidly on low-quality debt.

In a blog post earlier this year we wrote that the conflict between the signal from the commodity/gold ratio and the signal from credit spreads would have to be resolved either by credit spreads widening substantially in response to evidence of economic weakness or by the prices of industrial commodities rising substantially in response to evidence that a new boom had been ignited. Our view then and now is that the former is by far the more likely outcome. In fact, there’s a good chance that last week’s rise in the credit-spreads indicator shown on the following daily chart marked an important turning point.

[This blog post is an excerpt from a recent commentary at www.speculative-investor.com]

In a blog post in February-2017, we discussed an age-old relationship between interest rates and prices. The following chart-based comparison of the T-Bond yield and the commodity/gold ratio is a pictorial representation of this relationship. At least, it was until about two years ago when a major divergence began to develop between two quantities that previously had been positively correlated. Does this mean that the age-old relationship no longer applies?

The answer is that the age-old relationship hasn’t changed. It can’t change, because it is firmly rooted in economic reality. What’s changed is that the following chart has stopped being a good way to depict the relationship.

The fundamental basis for the underlying relationship is what Keynesians call “Gibson’s Paradox”. We won’t revisit Gibson’s Paradox in this discussion except to point out that it was the name given to the observation that interest rates during the gold standard were highly correlated to wholesale prices but had little correlation to the rate of “inflation”. For a more thorough explanation, please refer to the above-linked blog post.

This excerpt from our blog post explains how the above chart relates to Gibson’s Paradox:

“The commodity/gold ratio is the price of a broad-based basket of commodities in gold terms. In essence, it is a wholesale price index using gold as the monetary measuring stick. Although gold is no longer money in the true meaning of the term (it is no longer the general medium of exchange), it is still primarily held for what can broadly be called ‘monetary purposes’ and in many respects it trades as if it were still money. According to the age-old relationship discussed above and labeled “Gibson’s Paradox” by a confused JM Keynes, the commodity/gold ratio should generally move in the same direction as risk-free interest rates.

The risk-free US interest rate that is least affected by the direct manipulation of the Fed is the yield on the 30-year T-Bond, so what we should see is a positive correlation between the commodity/gold ratio and the T-Bond yield. Or, looking at it from a different angle, what we should see is a positive correlation between the gold/commodity ratio and the T-Bond price. That’s exactly what we do see.”

Well, that was exactly what we WERE seeing until about two years ago, when the T-Bond yield began to trend upward in parallel with a downward trend in the commodity/gold ratio.

As stated near the start of this discussion, the age-old relationship between interest rates and prices (“Gibson’s Paradox”) hasn’t changed. Furthermore, the nature of gold hasn’t changed over the past two years, so the commodity/gold ratio still should be positively correlated with the risk-free interest rate, which, in turn, is determined by economy-wide time preference. What has changed is that the T-Bond yield has stopped being a good indicator of the risk-free long-term interest rate.

Looking from a different angle, the fact that the commodity/gold ratio has trended downward tells us that societal time preference (the determinant of the risk-free interest rate) has been falling, that is, that people are becoming more inclined to save and less inclined to spend. This is a global phenomenon, not a US phenomenon, but evidence in support of this can be found in the following chart of US retail sales. The chart shows that nominal (that is, not inflation-adjusted) US retail sales were only about 3.5% higher in May-2024 than they were two years’ earlier. Over the same period the US CPI rose by 7.5%, so in real terms the dollar value of US retail sales has fallen over the past two years.

The commodity/gold ratio tells us that the risk-free interest rate has fallen since the second quarter of 2022; however, the T-Bond yield is now much higher. This can’t be explained by rising inflation expectations, because the market prices of Treasury Inflation-Protected Securities (TIPS) tell us that inflation expectations have fallen since the second quarter of 2022.

The only way to explain the rise in government bond yields in the face of a falling risk-free interest rate and flat-to-lower inflation expectations is declining confidence in government and/or increasing fear that the rate of growth in the supply of government debt is going to become a major problem in the not-too-distant future. That is, trends in the T-Bond yield no longer reflect trends in the risk-free interest rate due to an expanding risk premium in the T-Bond yield associated with an increasingly profligate government. This, by the way, is one of the reasons why anyone who predicts that Treasury yields are going back to anywhere near their 2020 lows will be wrong.

We now have a market analysis challenge because there is no longer an indicator of the risk-free interest rate that is independent of the gold price. At least, we can’t identify one at the moment. We can use the commodity/gold ratio to provide information regarding the interest rate that underlies all other interest rates, but we don’t have a separate indicator of the risk-free interest rate that can be used to assess whether gold is too expensive or too cheap relative to commodities.

[This blog post is an excerpt from a recent commentary at www.speculative-investor.com]

With regard to the topics that we write about regularly, over the past year we have been most wrong about the stock market and the US economy. It’s true that the average stock has not fared particularly well, but we have been consistently surprised by the strength of the S&P500 Index and other large-cap-focussed indices for about 18 months now. Also, we thought that the US economy would be in recession by the end of last year and would be very weak during the first three quarters of this year, but while the US economy certainly slowed during the first half of this year it clearly has not yet entered recession territory. These mistakes are linked, in that major bearish trends in the stock market tend to encompass recessions. Today we’ll discuss, in broad-brush terms, a likely consequence of both the stock market and the US economy performing much better than we expected up until now.

In our opinion it’s not the case that the US economy has avoided a recession, but rather that the current cycle has been elongated.

We use the commodity/gold ratio (the Spot Commodity Index (GNX) divided by the US$ gold price) to define booms and busts, with booms being multi-year periods during which the ratio trends upward and busts being multi-year periods during which the ratio trends downward. The vertical lines drawn on the following GNX/gold chart mark the trend changes (shifts from boom to bust or vice versa) that have occurred since 2000.

It’s not essential that the bust phase of the cycle contains a recession, but it’s rare for a bust to end until a recession has occurred. Usually, the sequence is:

1) The commodity/gold ratio begins trending downward, marking the start of the economic bust period.

2) The economic weakness eventually becomes sufficiently pervasive and severe to qualify as a recession.

3) Near the end of the recession the commodity/gold ratio reverses upward, thus signalling the start of a boom.

Note that it is not unusual for the stock market to continue trending upward after the bust begins, but the stock market always peaks prior to a recession getting underway. For example, an economic bust began in October-2018 but the SPX continued to make new highs until early-2020.

In the current cycle the commodity/gold ratio has been trending downward since the first half of 2022, meaning that the US economy has been in the bust phase of the cycle for a little more than two years without entering recession. While this is much longer than average, it is comparable to what happened during 2005-2009. During 2005-2009, a bust began (the commodity/gold ratio commenced a multi-year downward trend) in Q4-2005, but a recession did not begin and the stock market did not peak until Q4-2007.

Evidence that the US economy is slowing is becoming clearer almost by the week, but a recession probably won’t start any sooner than September of this year and could be postponed, with help from the government and the Fed, until late this year or even early next year. This means that the coming recession probably won’t end any sooner than the second half of 2025 and could even extend into 2026, which has implications for all the financial markets. It’s the implication for the gold market that we are concerned with today.

The US$ gold price tends to peak on a multi-year basis after it has fully discounted the economic, fiscal and monetary consequences of a recession. This usually happens in the latter stages of a recession but before the recession has ended. Therefore, whereas a year ago we were thinking along the lines of the cyclical gold bull market climaxing in the second half of 2024, the current economic cycle’s elongation and the postponing of a recession probably mean that gold’s cyclical bull market will continue until at least the second half of next year.