Gold Rides Higher on Recession Fears

Key Takeaways

• The gold market continues to be bullish as the probability of a recession rises, regional banking stress resurfaces and the U.S. Federal Reserve (the Fed) seems determined to reach its 2% inflation target.
• Historically, every Fed rate hike cycle has concluded with a financial crisis. The current cycle features a U.S. regional bank crisis. Regional bank stock prices and inverted yield curves are correlated, and today's yield curve points to further banking stress ahead.
• If past recession cycles are reliable indicators, gold appears to be positioned to perform well (one year before and during a recession) on an absolute basis, especially relative to other asset classes.
• The looming U.S. debt ceiling showdown is creating financial uncertainty, which is bullish for gold prices. However, this particular risk scenario — the threat of a U.S. debt default due to partisan politics — has not come up before, and we place it in the category of known unknowns.

Month of April 2023

Source: Bloomberg and Sprott Asset Management LP. Data as of April 28, 2023.
*Mo % Chg and YTD % Chg for this Index are calculated as the difference between the month end's yield and the previous period end's yield, instead of the percentage change. BPS stands for basis points. **ETF holdings are measured by Bloomberg Indices; the ETFGTOTL is the Bloomberg Total Known ETF Holdings of Gold Index; the ETSITOTL is the Bloomberg Total Known ETF Holdings of Silver Index.

April in Review

Gold bullion increased $20.72 per ounce (or 1.05%) in April, ending the month at $1,990. Gold peaked at $2,040 in mid-April on spiking recession fears, then drifted for the rest of the month on short-term overbought conditions and reduced momentum in positive near-term catalysts. However, April overall was a solid month for gold as it consolidated recent gains and recorded an all-time monthly closing high.

Gold may now be in the proverbial ‘sweet spot’, given that a recession has not yet started, but markets are starting to price in the probability of a recession.

The broader equity market saw unusual activity in April. Market breadth was exceptionally narrow, with a half dozen mega-capitalization technology stocks accounting for most of the monthly gains. Significant flows into systematic strategies (e.g., volatility control, risk parity and CTA funds) led to volatility compression, resulting in an asset-purchasing feedback loop seemingly at odds with perceived market fundamentals. April data suggest that inflation is becoming further entrenched and stagflation is more likely. Recession predictions are increasing and ongoing stress in the banking system indicates loan and credit conditions are tightening, likely leading to slower economic growth.

Gold Bullion: Bullish Technicals in Place

Central bank gold purchase data for Q1 2023 are not yet available, but anecdotal evidence points to ongoing gold accumulation by central banks directly or via bank-related entities (to mask their buying). From a charting perspective, we expect near-term support for gold bullion at the $1,960 per ounce level and along the rising trendline shown in Figure 1. The major resistance level to watch is $2,070-$2,075, which were the highs from 2020 and 2022.

Silver (see Figure 2) has also broken out of a three-year corrective wave, with many bullish reversal-type patterns in place, such as the reverse head and shoulders pattern. We will have a more detailed silver note in our next commentary, but CFTC⁷ data indicate that traders have returned to the long side and covered their shorts.

Figure 1. Gold Looks Ready to Test Resistance (2021-2023)

Source: Bloomberg. Gold bullion spot price. Data as of 5/01/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.

Figure 2. Silver Signals a Bullish Reversal (2018-2023)

Source: Bloomberg. Silver bullion spot price. Data as of 5/08/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.

Recession, Banking Crisis, Inflation and the Debt Ceiling

More macroeconomic risk conditions and events are emerging, boosting gold's role as a safe haven asset.

Recession Probability Rises to a New High

Recession speculation picked up again in April as lending conditions tightened further and the yield curve re-steepened after several months of being inverted. With the Fed firmly targeting 2% inflation, the market has been pricing in concerns about growth in various cyclical assets and commodities.

Predicting recessions accurately is complex. The reliability of predictive models varies and depends on whether the economic inputs used fully represent underlying economic conditions. No "best" recession indicator exists — each has strengths and weaknesses.

Several recession probability indices are available from Bloomberg, and we created a composite average of four indices that seemed sensible (see Figure 3). Inputs include yield curves, unemployment rates, consumer confidence, industrial production and leading economic indicators. Again, with the usual caveats, our composite indicator shows a higher probability of recession today than in 2008 and 2020 (the last two recessions) but does not indicate the potential timing or intensity of a recession.

Figure 3. Rising Probability of Recession (2008-2023)

Source: Bloomberg. Composite recession probability index. Data as of 5/01/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.

Gold Historically Has a Great Track Record Before and During Recessions

If past recession cycles are a reliable guide to the future, then gold is now in the proverbial “sweet spot” in which the recession has not officially started, but the market is beginning to price in some probability of recession. In Figure 4, we highlight the performance of various asset classes during the past six recessions and for the year leading up to those recessions. Past cycles indicate that gold has the best risk-reward profile of any asset class heading into and during a recession.

For potential gold investors waiting for a downturn before buying (witness the low levels of gold currently held in exchange-traded funds), history suggests it would be better to buy now ahead of the expected recession. If you are long equities and commodities, timing becomes more critical as the recession approaches.

We believe the current economic situation can be described as ‘cost-push inflation’ or ‘stagflation-lite.’

The causes of recessions are complex and multifaceted. Figure 4 briefly summarizes the main factors involved in prior recessions. We believe the current economic situation may be described as "cost-push inflation" or "stagflation-lite."

“Cost-push inflation” occurs when the economy experiences a supply-side shock, such as an increase in the cost of production inputs that causes the overall price level to rise. Firms pass the higher costs on to consumers, leading to higher inflation. At the same time, the supply-side shock can lead to lower economic growth and higher unemployment, as firms may cut back on production and hiring in response to higher costs.

“Stagflation-lite” is a term used to describe an economic situation with low economic growth, high inflation and low unemployment (similar to full-blown stagflation but with lower levels of unemployment). In this situation, the economy is not experiencing a full-blown recession, but growth is sluggish and inflation is high enough to cause concern.

As history has shown, both cost-push inflation and stagflation-lite are challenging economic situations for policymakers to address, as they involve a combination of high inflation, low growth and potentially high unemployment.

Figure 4. Recessions: Asset Performance and Trigger Events

Source: National Bureau of Economic Research, Bloomberg. Included for illustrative purposes only. Past performance is no guarantee of future results.

The Fed Usually Breaks Something at the End of a Rate Hike Cycle

Typically, something breaks near the end of a Fed rate hike cycle or shortly after that. Most often, the result is a financial stress event. Figure 5 reproduces a popular and effective visual used by a well-known and highly regarded market strategist who plots the Fed Funds rate and marks the crisis events resulting from higher interest rates. The message is clear: A financial crisis has occurred at the end of every rate hike over the past five decades. The only questions are: How severe and how long will the next financial crisis be?

Figure 5.  U.S. Rate Hikes and Financial Crises (1975-2023)

Source: Bloomberg. Federal funds target rate, upper bound. Data as of 5/5/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.

Fed Policy is Testing Regional Banks

By the end of April, a third regional bank, First Republic, failed (and was seized and sold to JP Morgan). This failure was a reminder that the forces that brought on the failure of Silicon Valley Bank (SVB), Signature Bank, and Credit Suisse are still with us, and their effects will linger (see our March 2023 Gold Commentary). It is a common refrain that the regional bank crisis is "nothing like 2008," but we would caution that such comments bring back memories of another common refrain from years ago: "the subprime crisis is contained."

The 2008 global financial crisis was centered on the largest global banks because their balance sheets were stuffed with toxic assets backed by the imploding U.S. housing market. In today's crisis, small- and medium-sized banks are struggling with the rapid increase in interest rates. Some of the recent trillions of stimulus dollars ended up in checking and savings accounts that paid near-zero interest rates, giving these banks near-zero lending costs (and soaring profits). However, as the Fed hiked rates aggressively, this carry trade ended. Depositors could receive much higher yields on ultra-safe government money market instruments and so they began withdrawing deposits. Year-to-date in 2023, an estimated $600 billion has moved to U.S. money market funds. To help stem the effects of deposit flight, the Fed created the BTFP⁸ facility, but the cost to the banks is now nearly 5% (the Fed Funds effective rate), which is crushing banks’ margins.

Since the collapse of SVB, gold has been inversely correlated with regional banks and has acted as an effective hedge.

What Broke SVB?

Banks make money by borrowing at the short end of the yield curve (which was near 0% but is now near 5%) and lending for longer periods. However, the funding base for banks is now broken, with an inverted yield curve (short-term rates higher than long-term rates). Compounding the problem is that a few years ago, many of these banks invested their excess deposits in government bonds at low interest rates. While these were risk-free, they created a sizeable maturity mismatch if deposits were withdrawn and, if rates rose, they resulted in unrealized losses unless held to maturity. This situation essentially broke SVB; deposit flight forced SVB to sell its government bond holdings, which were then marked to market, blowing out the bank's capital ratios.

Regional banks carry other interest rate-sensitive items on their balance sheets, such as mortgages, industrial and commercial loans, and (the likely next big concern) commercial real estate loans, which are heavily concentrated in regional banks. Small businesses in the U.S. account for roughly 40%-45% of economic activity but typically lack access to capital markets, so they depend on bank loans. Going forward, obtaining credit will be more difficult and loan terms will be more onerous, so we can expect lower growth from the small business sector, a critical part of the economy.

Additional pressure is likely from the stress on regional banks caused by the inverted yield curve. In Figure 6, we plot the KBW Regional Banking Index (stock prices)⁹ against the differential between the 3-month and 10-year yield curves (3-month minus 10-year), forwarded by 30 weeks. The 3-month-10-year yield curve differential went negative during November 2022, and gold started its current rising trendline. Since the collapse of SVB, gold has been inversely correlated with regional banks and has acted as an effective hedge. We would also note that the 3-month-10-year yield curve differential is at its most steeply inverted level since 1980-1981. It is also within its one-percentile reading going back to January 1970, which we believe means there is a good chance the current crisis will extend beyond regional banks to affect other areas of the economy.

Figure 6. Inverted Yield Curve Correlates with Bank Stress (2018-2023)

Source: Bloomberg. Yield differential (3-month minus 10-year U.S. yields) on the right axis plotted against KBW Regional Bank Stock Index (top chart, left axis) and gold bullion spot price inverted (bottom chart, left axis). Data as of 5/06/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.

Will Central Banks Lock in Higher Inflation Rates?

At the Federal Open Market Committee meeting on May 2-3, the Fed signaled that the current rate hike cycle may be finished. Other central banks are also signaling that their rate hike cycles are near completion or the pace will drop significantly. However, in nearly all developed economies, measures of core inflation are above either policy rates (e.g., the Fed funds rate) or above the inflation target (typically 2%). Furthermore, unemployment rates remain very low, and wage inflation appears entrenched.

We consider gold an excellent hedge in many risk scenarios, regardless of how harsh some of those risks may be.

The trajectory of government spending and the rapid expected increase in debt and deficits, however, is more disconcerting. Record debt and deficits may weaken central banks' resolve and incentives to lower inflation because the temptation to let inflation erode the public debt (debt monetization) will be immense.

In time, we expect the Fed to move towards this path: accept inflation in the 3%-4% range and hope it stays relatively stable, but promise to target 2% inflation. The other choice would be to create an "L-shaped" recession and crush the economy to bring inflation back to 2% or scrap the 2% inflation target and bump it higher, which would destroy Fed credibility and any hope of price stability. For now, the first option—accepting inflation in the 3-4% range while paying lip service to a 2% target—appears to be the path of least resistance with the fewest unintended consequences.

The Debt Ceiling Showdown: A "Known Unknown"

With the U.S. debt ceiling showdown looming ever closer, the world is bracing for what may be the world's first voluntary debt default by an advanced economy. Partisan politicking in the U.S. appears ready to risk a global financial crisis. We label this a “known unknown”.

There has never been a debt default in U.S. history aside from a technical glitch in May 1979 that delayed payments on maturing Treasury bills. Today's world is far more leveraged and financialized. If investors came to believe the U.S. would truly default on its debt, it could trigger massive waves of margin calls.  U.S. Treasuries and US T-bills—the world's largest and most liquid securities, acts as collateral that underpins the global financial system. While there is never a good time for a debt default, the timing for such an event today would be disastrous as the U.S. is near a recession and experiencing stress in its banking system.

Globally, we are entering a more challenging period featuring subpar economic growth, increasing risks to systematic financial stability, stubbornly high inflation and rising geopolitical risks. Against this backdrop, we believe gold should perform well, even if the U.S. debt ceiling disaster is averted. In the event of a U.S. debt default, it is difficult to predict how high gold will react. We consider gold an excellent hedge in many risk scenarios, regardless of how harsh some of those risk may be.