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Precious metals prices have recovered strongly of late. This is hardly surprising given that commodities generally are seeing their strongest rally since 2011. Everywhere you look, raw material prices have surged, both industrial and non-industrial. Dollar weakness amplifies the picture somewhat, with the benchmark DXY index slipping below 90 this week, a roughly 10% decline over the past year.
Surprisingly in this context, precious metals prices have done poorly relative to other commodity groups. There are three explanations for this, which also help explain the recent reversal and apparent breakout in gold and silver.
First, real rates began rising in the second half of last year and continued to do so until quite recently, when they declined sharply due to a combination of falling Treasury yields but primarily rising inflation breakevens. Second, until only very recently, actual, realised inflation rates had remained low, notwithstanding gathering evidence of pipeline pressures. But now US CPI y/y has surged to over 4%, the highest since before the global financial crisis of 2008.
Those factors are significant. However, it is the third reason that remains a headwind for precious metals: stocks and other risk asset classes have been trading firmly. The VIX has generally remained under 20 in recent months, following a prolonged, elevated period during the Covid scare. As long as investors are willing to take incremental risk in anticipation of an incremental further return, precious metals tend to underperform.
Risk aversion is therefore the key. Real rates are now much lower than they were, whether measured by breakevens or actual, realised CPI. Consequently, should risk aversion begin to rise, it would likely unlock significant precious metals upside. Key technical levels, trendlines and momentum measures have all swung positive over the past week.
Indeed, the previous highs for both gold and silver are easily within reach. If those are breached, then longer-term charts come into play and show a highly bullish picture. But it is the fundamental context which, throughout this entire period of consolidation, is the most bullish factor of all.
All prices are ratios. Normally, the numerator is a base currency and the denominator the good, service or asset being bought, sold or traded. When it comes to precious metals, however, different ratios can apply, as they are established stores of value – alternative monies.
When taking a broad look at relevant ratios, a highly bullish picture emerges. During the past few years, the supply of both base and broad money has exploded. Yes, velocity has declined in tandem, but most recently, velocity has recovered sharply. Compared with the available above-ground stocks of gold and silver, which grow only slowly, the ratios of money supply to gold and silver supply are far higher today than ever before.
Alongside the exploding supply of money has been an explosion in debt. Much of this yields essentially zero or less than either realised inflation or forward breakevens. As gold and silver are widely expected to at least hold their real value in an inflationary environment, this implies that, unusually, there is a positive opportunity cost in switching out of negative-real-yielding debt into gold or silver (Chart 2).
Yes, central banks may eventually begin to raise rates alongside rising inflation. But few expect real yields to rise substantially, as that would rapidly choke off the post-Covid recovery. Debt burdens are extremely high relative to GDP historically – especially excluding wartime periods – and so rising debt-servicing costs would have a much stronger negative impact on growth prospects than was the case back when debt burdens were at more normal levels.
Simply extrapolating these trends and allowing for gold/MS and gold/debt ratios to mean-revert over time, as seems reasonable, the implied gold price soars into five digits. While not a forecast per se, that does provide an order of magnitude for what is fundamentally and historically justified.
Silver might have even greater upside potential from here. Stocks are tight, the market is thin, and silver’s growing medical, photovoltaic and other tech and ‘green’ uses imply strong real demand going forward. Although the gold/silver ratio has declined far from the historically elevated levels of a year ago, it remains well above longer-term historical averages.
The 60 level for the ratio held for many years. Consequently, were gold to rise strongly from here, as discussed above, silver could end up in the triple digits.
While that might sound somewhat aggressive, keep in mind that the fundamental global economic environment of today greatly resembles that of the stagflationary 1970s. Exogenous shocks have led to both fiscal and monetary stimulus. Real rates are now as low as they were during the 1970s, when the US Fed and other central banks accommodated the oil shocks. Today it is the Covid shock, but remember that it arrived in a context of still highly indebted governments and highly leveraged corporations.
Stagflation is a highly challenging economic environment. Businesses with pricing power can still grow real profits. But most profit growth is simply nominal, more or less keeping up with inflation, and in many industries, profit margins get squeezed as firms seek to maintain some portion of market share. P/Es naturally compress in that case, and it is worth observing that the P/Es for the US benchmark indices declined into the single digits by the early 1980s.
Yes, they subsequently rose again, and strongly, once the Volcker Fed addressed the stagflationary conditions. But no investor then would have wanted to just ride that out. Indeed, it was during this time that both gold and silver soared as safe-haven demand rose.
For those who see a significant probability to history at least rhyming this time round, if not repeating exactly, being long gold and silver is an obvious choice. Silver may have more potential, but of course the corresponding volatilities represent that. The six-month ATM vol spread for gold vs silver is trading roughly around its recent averages (Chart 3 and 4).
Focus is on the unprecedented actions of global central banks and governments. Also, we are experiencing some of the most negative real rates in 40 years. Yet despite all that, volatility in gold and silver are both well within recent ranges. For gold, volatility has only recently started moving away from one-year lows.
We are approaching some of the most favourable conditions for precious metals since last century. Considering that, the upside vol and skew look incredibly cheap. We believe this is a time to separate your thinking from the recent lower realized volatility and consider the possibility of very large breakout moves in both, driven by the rapidly changing fundamental dynamics.
In silver, we suggest:
6 Month $38 XAG Call Prem .81 USD Pips Vol 42.75 Delta 20
In gold, we suggest:
6 Month 2100 XAU Call Prem 28.10 USD Pips Vol 17.85 Delta 22
Most understand that if individuals expect higher inflation, prices will follow suit. This self-fulfilling prophecy comes from firms, households and banks all making forward-looking decisions based on where they believe prices will be. A new NBER working paper analyses the results from a new US firm-based survey of inflation expectations. It finds that:
Inflation expectations are arguably the most important input into central bankers’ current and future inflation forecasts. However, being unobservable makes them notoriously hard to measure. There are two approaches to addressing this. The first is a model-based measure, the second a survey-based measure. Models rely on estimation and typically include financial variables and inflation series. Surveys directly elicit expectations from respondents.
While several inflation expectation measures exist, the NBER paper’s authors point out an absence of systematic survey data on the macroeconomic expectations of US firms. Those that exist tend to focus on expectations about firm-specific outcomes (e.g., firm-level uncertainty or costs). Those that extract firm-level expectations about aggregate conditions are either very small/non-representative (Livingstone Survey) or qualitative (Duke CFO Survey).
The authors introduce a new US-based survey, the SoFIE, to measure the inflation expectations of firms. The survey started in 2018, runs quarterly, and builds upon a pre-existing privately run survey of CEOs. Each wave contains an average of 300-600 firms, most (40%) of which are small companies with 1-19 employees. Around 35% of firms participate only once, and the average participation is 3.3 waves.
In the survey, respondents answer two quantitative questions about inflation and monetary policy. One consistently measures their quantitative expectations about US inflation over the next 12 months. The second rotates across different formulations investigating long-run inflation expectations, perceived recent inflation, uncertainty about future inflation risk, and knowledge of the Fed’s inflation target. The survey is unique for these latter formulations and for measuring expectations of aggregate inflation. The authors build a case for including this survey because firms, as opposed to households and professionals, are central to aggregate inflation beliefs.
The authors compare the one-year ahead inflation expectations from the SoFIE survey against the Michigan Survey of Consumers, the Survey of Professional Forecasters and the Cleveland Fed (Chart 1). This comparison shows firms’ inflation expectations deviate significantly from households’ and professional forecasters’, suggesting the latter two are no substitute for a representative survey of firms’ beliefs.
For example, during the pandemic, professional forecasters significantly reduced their inflation expectations. Households, in contrast, immediately raised their inflation expectations from 2.9% in 2020 Q1 to 4.0% in 2020 Q2, and these have remained high through 2021 Q1. Meanwhile, firms initially displayed little change in their inflation expectations but ultimately raised them to 2.8% by 2021 Q1 and 3.2% by 2021 Q2.
Interestingly, the deviation of firms’ expectations from professional forecasters’ increases when the willingness of managers to provide forecasts in the survey decreases. This finding suggests that in periods of greater uncertainty, or when firms are paying less attention to inflation dynamics, professional forecasts are less representative of firms’ expectations.
Firms’ mean forecasts are generally lower than households’, but higher than professionals’ (Chart 1). This is also true for the standard deviation (or level of disagreement) among firms. The level of disagreement is around 1.4pp on the mean during the sample – higher than for professionals (1.1pp) but lower than households (3.3pp). Also, all firms are equally likely to disagree, regardless of size and sector.
For inflation expectations to be anchored, (i) average beliefs should be close to the central bank’s inflation target; (ii) beliefs should not be too dispersed across agents; (iii) agents should be confident in their forecasts; (iv) agents should display small forecast revisions, especially at longer horizons; and (v) there should be little co-movement between revisions in long-run and short-run inflation expectations.
On the first point, firms’ inflation expectations deviated significantly from the Fed’s 2% target at the beginning and end of the limited three-year sample (Chart 1). For long-run (five-year ahead) forecasts, firms’ expectations were similar to households’, whose long-run forecasts were consistently just under 3% over this period. So, by this metric, firms seem to have poorly anchored inflation expectations.
For the second point, the cross-sectional dispersion of forecasts must be low. For example, the dispersion of long-run forecasts among FOMC members is zero: they all agree that inflation will be 2% in the long run. For professional forecasters, the dispersion is around 0.2-0.3pp, and for households it is 2.5pp. The dispersion in firms’ forecasts ranges from 1-2ppt, again suggesting expectations are unanchored. Greater dispersion is also related to lower confidence regarding beliefs around future inflation, required for the third point.
The fourth point requires revisions in individuals’ inflation forecasts to be small, since agents expect the central bank to be able to keep inflation stable over long enough horizons. Plotting the distributions of revisions of one-year-ahead (beige) and five-year-ahead (black outline) forecasts, we can see that firms display very large revisions (Chart 2). On average, firms revise long-term inflation expectations by 1.4%, compared with 0.2% for professional forecasters.
Lastly, a commonly used approach to assess whether expectations are anchored is to examine the co-movement of changes in short-run and long-run inflation expectations. The idea is that transitory economic shocks can affect short-run expectations but not long-run ones when the latter are anchored. On this front, the authors find a strong positive relationship between managers’ long-run and short-run inflation expectations, indicating the prediction is wrong.
If expectations are unanchored, firms are either unaware of central bank inflation targeting or do not consider the central bank credible and so use the latest inflation print for forecasting instead. On this front, the authors find that long-run expectations are related to (incorrect) beliefs about the inflation target, while short-run expectations are better explained by perceptions of recent inflation.
Specifically, the average firm believed the Fed was trying to achieve an inflation rate of 2.9% in the long run. This aligns with the mean five-year ahead inflation forecast in the sample. However, 65% of firms answered that they did not know. This share has actually fallen during the pandemic as inflation concerns garner significant media attention.
When asked about beliefs regarding inflation over the previous 12 months, very few firms could provide the right answer (Chart 3). The inaccuracy was more noticeable than for the inflation target. Nevertheless, the authors find that 12-month ahead forecasts are more closely tied to what respondents believed inflation was over the last 12 months.
The results suggest that in the now-long history of low and stable inflation, firms are paying less attention to central bank communications and are likely to be unaware of the current inflation rate. This is surprising given 38% of firms responding to an Atlanta Fed survey indicated that aggregate inflation influenced their pricing decisions. Also, recent studies in Italy and New Zealand find that firms’ inflation expectations influence employment and investment decisions.
The inherently forward-looking nature of most firms’ decisions, such as price setting, employment, and capital expenditures, implies a key role for firms’ expectations in future inflation. This research reveals that managers are ill-informed about central bank inflation targets and unaware of current inflation. Perhaps most concerning is that short-term inflation expectations, which are most likely to feed into business decisions, are unanchored and positively influenced by perceptions of recent inflation. If the Fed is unable to communicate clearly that higher inflation prints are temporary, business owners could adjust their expectations upwards leading to more permanent increases in inflation.
Candia B., Et Al., (2021), The Inflation Expectations of US Firms: Evidence from a new survey, NBER, Working Paper (28836), https://www.nber.org/papers/w28836
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