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Market Outlook

Gold’s Reactions to New Economic Enthusiasm

By Elliott H. Gue, on Nov. 25, 2016

As Capitalist Times Premium subscribers know, we follow precious medals closely, including gold. Gold prices initially surged on the news of Trump’s triumph, but the yellow metal sold off in subsequent trading sessions to about $1,200 per ounce. A few competing forces will influence gold prices in the near term.

Although gold has a long history as a store of wealth, rising rates usually encourage investors to park their money in interest-bearing deposits instead.

Assuming that the Trump administration succeeds in pushing through tax cuts and spending on defense and infrastructure, the resulting fiscal stimulus could accelerate economic growth and give the Federal Reserve the necessary leeway to raise interest rates.

The futures market has priced in a close to 100 percent probability that the US central bank will hike interest rates to between 0.5 and 0.75 percent at its Dec. 14 meeting.

Futures prices indicate a 15 percent probability that the Fed won’t increase interest rates again by the time of its December 2017 meeting, a 35 percent chance of an additional 25-basis point hike next year and a 32 percent chance of two rate increases.

These expectations look reasonable. The Federal Reserve appears inclined to run a “high-pressure economy” and accept inflation rates above its 2 percent target in the near term. Higher inflation, coupled with wage growth and a tighter labor market, could help to cure some of the lingering hangover from the 2007-08 financial crisis and the Great Recession.

Accelerating wage growth could also lure workers back into the labor force, reversing some of the weakness in the participation rate. A lighter touch on regulation could spur business confidence, prompting corporations to boost their capital expenditures. In theory, these trends would strengthen economic growth and drive gains in labor productivity.

The Federal Reserve should welcome fiscal stimulus. Since the Great Recession, the Fed and other major central banks have slashed interest rates to an unprecedented degree and implemented quantitative easing in an effort to lower borrowing costs, stimulate economic growth and boost inflation.

Although these extraordinary monetary policies have kept the economy from slipping into a recession, GDP growth remains lackluster and inflation has been stubbornly low.

Higher interest rates would help financial institutions, but past efforts to begin normalizing US monetary policy have triggered selloffs in the equity market.

When the Fed hiked interest rates by 25 basis points a year ago and announced plans for three to four additional increases in 2016, the S&P 500 endured a severe selloff in January that lasted into early February 2016. The selloff abated when the Fed adopted a dovish tone.

An uptick in economic growth and inflation from fiscal expansion would take pressure off the Federal Reserve to be the sole engine of economic growth.

These efforts could result in two potential outcomes.

In the optimistic scenario, fiscal stimulus and reduced regulation accelerate economic growth and boost inflation, enabling the central bank to normalize monetary policy. Banks’ net interest margins would improve, which, coupled with lighter regulation, could prompt financial institutions to loosen their purse strings and improve credit availability.

Alternatively, with the US economy near full employment, the fiscal stimulus could stoke inflation without spurring economic growth. At the same time, elevated government debt and inflation would increase US interest rates, offsetting the tailwind associated with fiscal stimulus.

Our current outlook skews toward the optimistic scenario that we laid out. The market appears to have started to price in this potential as well, though incoming economic data and additional details about the Trump administration’s plans could change our view.

Either scenario could be good for gold prices. Although rising interest rates tend to weigh on gold prices, higher inflation and stronger economic growth would be a positive for our bet on the yellow metal. Consider that gold prices soared more than 85 percent when the Fed tightened monetary policy between June 2004 and June 2006.

The US central bank likely won’t move as aggressively this time around and may be less concerned about inflation that exceeds its target–a benign environment for gold prices.

The pessimistic scenario that we laid out would be even more bullish for gold. Weak economic growth because of inflationary pressure and a spike in interest rates because of concerns about US debt levels could prompt investors to pile into gold hold as a hedge.

The key investment concern becomes to properly position yourself to handle these two possible outcomes and take advantage of gold’s next move. Capitalist Times Premium readers already have seen additions to the Wealth Builders Portfolio that do so. If you aren’t a subscriber, become one today to read additional analysis and gain access to both of our model portfolios.

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