The Gold Miner Rally Is On Borrowed Time

London (Sept 11)  Summary •Gold prices are largely a function of real interest rates.

•The idea that the Federal Reserve is on hold is the main driver of this appreciation in gold prices and mining stocks.

•There will likely be one interest rate increase this year and at least two in 2017 as the economy improves. Markets are not discounting this.

•Negative rates in Japan and Europe are bearish for gold as it creates a tailwind for the U.S. dollar which trades inversely with gold.

•I expect gold prices to fall back to the $1,000 an oz level or below. Inflation adjusted gold prices are very elevated still.

Gold prices are largely a function of expected real interest rates. This is the difference between interest rates and inflation. Rising real rates are negative for gold, while declining real rates are gold price positive. As one can see in the charts below the 10 year inflation indexed treasury bond depicts real interest rates. When real rates are rising gold has fallen and when real rates decline, gold prices appreciate. There is an inverse correlation. I believe the upward adjustment in interest rates will be quicker and more substantial than any upward movement in inflation pushing gold prices lower in the near term.

The driver behind the gold price rally and decline in real rates since the Federal Reserve lifted off the zero lower Federal Fund Rate bound is the idea that the Fed is on hold. During the end of 2015 markets and the FOMC were anticipating three or four rate hikes over the course of 2016. Market turmoil and economic data deterioration caused the Fed to pull back from raising rates. Gold responded appropriately and prices rose on that fact, as treasury yields tumbled. I think it is overdone though. Markets have become excessive and overly dovish pricing out rate hikes through 2017. According to CME Group and the Fed Funds futures market there is only a 43% probability of one rate hike by June 2017 and a 46% probability of a December increase. This would require major deterioration in the U.S. economic data or a recession. I find this unlikely. My baseline scenario is near term moderate improvement in the U.S. economy, which will allow the normalization of monetary policy. I expect one rate hike this year, potentially in September and two or three over the course of 2017.