Publications

- October 1, 2019: Vol. 6, Number 9

The ‘debt-to-gold’ ratio: Yellow metal prices soar as deficit spending reaches the breaking point

by Trey Reik

After spending three years in a $250 trading range (between $1,121 and $1,375), spot gold has erupted since late May and is up about 18 percent year-to-date. At the same time, gold mining equities, as measured by Sprott Gold Miners ETF (SGDM) are up about 40 percent YTD.

The operative questions surrounding gold are: What factors ignited gold’s breakout from a three-year consolidation? And, are these fundamentals likely to persist in future periods?

Gold is clearly responding to a global pivot by central bankers back toward concerted monetary easing, and the intractable nature of excessive global debt levels suggests we are in the very early innings of the developing easing cycle. In short, for gold this is the real deal and we suspect things are just getting started.

For some, the investment thesis for gold rests largely on the unsustainable nature of global debt levels. While investor consensus recognizes that debt levels are a daunting structural dilemma, the inability to predict either timing or method of inevitable resolution has long relegated debt concerns to the back burner of investor priorities. But global asset markets may finally have reached the point at which excessive debt levels are overwhelming longstanding relationships in normally functioning capital markets such as interest rates, time preferences and capital formation. The cumulative distortions of a long period of debt-
fueled growth are finally coming to bear.

The prior century of financial history suggests healthy capital formation in the U.S. economy hinges on reducing the debt-to-GDP ratio to roughly half its current level. Of course, this would require either extinguishment of roughly $30 trillion in debt without impacting GDP or doubling GDP without incurring an incremental dollar of debt, both exceedingly remote possibilities. Remaining options are debt default or debasement, and we are certain global financial stewards will do everything in their power to choose the latter over the former.

One can only smile at Fed chairman Jerome Powell’s seemingly earnest assertion that the Fed’s July 31 rate cut was a “mid-cycle adjustment” and “not the beginning of a long series of rate cuts.” Be assured, just as with early 2019 arguments for a “pause in the Fed’s tightening cycle,” current prognostications for a “one and done insurance cut” belie shallow understanding of what is truly troubling the Fed. It is patently clear that despite respectable output growth, full employment and record financial asset valuations, the Fed now believes it has strayed too far from the zero bound to guarantee against incipient debt deflation. Expect fed funds to retreat toward the 1 percent level and beyond in very short order.

Excessive debt levels absolutely mandate ever-declining interest rates.

Boiling things down, gold’s prospects are inextricably linked to consensus recognition that global interest rates not only cannot rise but must continue to decline to keep the ever-
burgeoning debt pyramid from toppling. Along these lines, gold’s accelerating performance since October 2018 can be attributed to broadening recognition that global rate structures are once again crashing through the zero bound.

For gold, this is the real deal and things might just be getting started.

 

Trey Reik is senior portfolio manager for Sprott Asset Management. Read the complete version of this article on the Sprott website this link: https://bit.ly/2krOAcw

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