All Roads Lead to Gold
These are very important and exciting times for gold. This week, HAI will attempt to communicate what this author believes is the essential short story on what’s now driving the gold price higher and what will likely continue to drive the gold price significantly higher over time.
For over a decade, many of the world’s elite investors, Federal Reserve Officials, Defense Department players, and members of global multilateral organizations have known that the U.S. was headed toward an acute fiscal crisis if U.S. policymakers didn’t “do the right thing” within a 10-year time window.
Back in 2016, legendary investor Stan Druckenmiller called the U.S. entitlement picture “the most unsustainable situation I have ever seen in my career.” In 2015, former Fed Chair Alan Greenspan said, “We need to shrink entitlements back as a percent of the pie, and we need to resolve it before we have a crisis… Unfortunately though, I don’t see how we are going to get out of this.” In 2011, Former Chairman of the Joint Chiefs of Staff Adm. Michael Mullen said, “The number one threat facing America is its rising debt burden. [This threat] is greater than that posed by terrorism, weapons of mass destruction, and global warming.” In 2016, JPMorgan CEO Jamie Dimon warned about the fiscal problem saying, “after 10 years, it will become clear that action will need to be taken…. This [unsustainable debt growth] is a tragedy that we can see coming.” In 2015, Former Dallas Fed President Richard Fisher said, “The Congressional Budget Office estimates interest expense and healthcare expenditures will soon be greater than 50% of revenues; at some point, you have to pay the piper… We [the Fed] have been suppressing the yield curve—if rates rise, it’s a ticking time bomb.”
Fast-forward to our modern moment. The U.S. has not only failed to “do the right thing” and right the fiscal ship, we’ve significantly accelerated our fiscal largess and dramatically deepened our hole in total debt and deficits. As the Wall Street Journal put it in September, “The US isn’t fighting a war, a crisis, or a recession, yet the federal government is borrowing as if it were. Not including interest, the U.S. government will spend $1.21 for every $1.00 it collects in revenue this year. Add interest and that climbs to $1.39… Something important has changed for the fiscal outlook since the pandemic… Inflation and interest rates have risen, and that creates a more dangerous dynamic going forward.”
Debt growth in the form of Covid stimulus checks caused a surge of inflation to 9.1% in 2022. In response, the Federal Reserve raised interest rates from zero to over 5%. Sure enough, just as Richard Fisher warned in 2015, we raised rates and it is indeed “a ticking time bomb.”
Interest expense on over $35 trillion of total debt is now booming at over $1 trillion annually, and it’s growing rapidly. It’s now the second largest government outlay (bigger than defense spending for the first time) and is America’s fastest growing line item.
The recent Federal Reserve inflation fighting rate hike blitzkrieg has demonstrated one thing. At north of $35 trillion in total debt, the Fed can no longer raise rates significantly to fight inflation without risking an interest-expense-driven debt spiral. The recent rate hike cycle sent the US Federal Insolvency Ratio (defined as gross interest expense divided by federal tax receipts) hockey sticking higher to a sudden and totally unsustainable new generational high approaching 35%. It has also sent U.S. “true interest expense” (interest expense + entitlements) to nearly 100% of tax receipts. That’s a level of true interest expense (at 100% or more of tax receipts) that can cause the bond market to buckle.
In HAI’s view, it is likely this risk of an interest expense-driven debt spiral and the associated risk of a broken bond market that caused what economist Mohammed El-Erian called a “historic…fundamental change in the [Fed’s] reaction function” at the most recent FOMC meeting on September 18th. At the meeting, Jay Powell and the FOMC initiated an easing cycle with a jumbo 50-basis point rate cut despite the fact the Taylor rule estimate of the neutral policy rate would have called for a 25-basis point rate hike. Again, in HAI’s view, the best “Occam’s razor” explanation for the Fed’s highly unusual jumbo rate cut is that the Fed is serving a new shadow mandate: ease the government’s financing burden.
An unintended consequence of the U.S. debt binge is that monetary policy now appears to be fundamentally compromised. In HAI’s view, this newly emerging reality of compromised monetary policy is a major driver for the rise in the gold price. HAI has long viewed gold as financial insurance against monetary policy malpractice. Hence, it’s no surprise here to see the price of golden financial insurance rise as the monetary policy inflation brake is broken.
In addition, the U.S. debt problem has now swelled to the point where the rest of the world can clearly see it and anticipate the likely U.S. policy playbook to inflate the debt away. As Hirschmann Capital has pointed out, “Since 1800, 51 out of 52 countries with gross government debt greater than 130% of GDP have defaulted, either through restructuring, devaluation, high inflation, or outright default.” HAI readers take note, the U.S. hit 130% debt/GDP in 2020. The rest of the world can now see the inflationary writing on the wall, and can anticipate the likely accelerated depreciation of the real value of U.S. Treasurys. As a result, global central banks have become net sellers of U.S. Treasurys and net buyers of gold at record levels, as gold is the new preferred reserve asset.
As the Bank for International Settlements put it in their first ever Gold Investing Book for Asset Mangers released earlier this year, “In recent years, gold has regained its importance as a financial asset… The role of gold as a reserve asset for central banks has been a significant driver of demand for the precious metal.” To serve as the top global reserve asset, U.S. Treasurys must be viewed to be as good as gold with a yield kicker on top. With the U.S. now so heavily indebted and an extended period of inflation anticipated, Treasurys are rapidly losing that distinction of “as good as gold,” even with a yield. This added demand for gold as the new preferred global reserve asset is also powering the price of gold higher. It should continue to do so on a secular basis as global reserve ratios will take time to adequately adjust to the new reality.
The ongoing transition from Treasurys to gold as the preferred global reserve asset has also been greatly accelerated by the U.S. weaponization of the dollar. This was most clearly demonstrated to the world when the U.S. froze Russian dollar FX reserves after Russia invaded the Ukraine. The weaponized dollar means that it is necessary from a national security standpoint for foreigners to reduce Treasury reserves and increase holdings of a neutral reserve asset—and that means gold.
Simply put, the U.S. debt problem started the transition from Treasurys to gold as the favored global reserve asset, but the weaponization of the dollar forced a meaningful acceleration of the trend. The debt problem and a weaponized dollar now represent an unprecedented dual threat to the prevailing petrodollar system of the last 50 years, and in response to that threat we have a global paradigm shift now underway toward gold and away from Treasurys as the preferred global reserve asset. We now appear to be witnessing the endgame of the petrodollar system, and a fundamental regime change from global “dollar recycling” to global “gold recycling.”
HAI believes that the 50-year petrodollar system is beginning to unwind at an accelerating pace. Major commodity producers are no longer automatically recycling their dollar-denominated commodity revenues back into US Treasurys.
As Jeff Currie, the highly respected and very well connected former Goldman Sachs Head of Commodity Research recently put it in a Bloomberg interview in May, “For the first time ever, that dollar recycling is not occurring. And what is replacing it? I like to call it gold recycling. It explains a lot, why gold prices are as strong as they are. And what is the evidence of that is that the emerging markets—the BRIC countries—all met with Saudi Arabia and other key participants [in] November of last year and discussed how they’re going to trade with one another using local currencies. And then whatever it nets out in settling they would settle in gold.” Currie continued, “I think you’re unlikely to see that dollar recycling playing out probably ever again.”
In a separate interview with MacroVoices in June, Currie elaborated further on his “gold recycling” thesis. Currie said, “The question you have to ask yourself now is, why aren’t they recycling the dollars into US Treasurys? One answer is fear around purchasing dollar-based assets…meaning asset freezes. In my own conversation with many of these emerging markets that are not recycling dollars, they tell me it has to do with the yields at 4.5% on the 10Y Treasury are simply not high enough relative to their inflation expectations.”
Currie continued, “They’re not recycling the dollars. They’re purchasing physical goods in local currencies, but ultimately the settlement is net in gold. That’s creating that excess increase in demand…and that’s a lot of gold buying… The way I like to label what we have seen is gold recycling replacing dollar recycling… This is a new paradigm.”
Importantly, the data backs Currie’s dollar recycling to gold recycling thesis. According to the Wall Street Journal in December of 2023, “An estimated 20% of global oil this year was bought and sold in currencies other than the USD… Twelve major commodities contracts settled in nondollar currencies were announced in 2023 compared with seven in 2022 and just two in 2015 through 2021.” So the trend toward multi-currency commodities trading has been established—and it is accelerating.
Multi-currency commodity pricing with net gold settlement would result in global net commodity surpluses effectively bidding for gold. But crucially, oil markets alone are some 12-15x bigger than the global gold market in annual physical production terms.
That means that, given a relatively fixed supply of gold, only a substantial rise in the gold price can make the gold market “big enough” to successfully fulfill its new role as preferred global reserve asset.
So if Jeff Currie is correct—and HAI believes he is—the dynamics of net gold settlement of multi-currency commodity trading would result in rising gold prices, a rising gold-to-Treasury ratio, and a rising gold-to-oil ratio over time. The fact is, that’s exactly what we’re seeing. Surging gold prices along with dramatic outperformance of gold versus both Treasurys and oil is very strong “smoking gun” evidence confirming the Currie gold recycling thesis.
The reason is that, from a big picture perspective, the gold-to-oil ratio is a temperature gauge on the health of the petrodollar system. All else equal, under the petrodollar system, a low and steady gold-to-oil ratio indicates that the petrodollar system is healthy, and there is demand and even a preference for Treasurys over gold as a reserve asset. A low gold-to-oil ratio implies that the market views Treasurys as being safe and as good as gold for oil as a reserve. When gold and Treasurys are deemed equally safe, Treasurys are preferred because, unlike gold, they offer a yield.
A high and rising gold-to-oil ratio implies the opposite. It’s a Treasury pressure gauge suggesting that the petrodollar system is breaking down. A high and rising gold-to-oil ratio, as we have been seeing since 2008, implies that the market no longer views Treasurys as being as good as gold for oil. It implies more competition from gold as a reserve asset in which to store oil profits. The 5.5 times increase in the gold-to-oil ratio since 2008 strongly suggests that, as Currie claimed, global oil profits are increasingly being saved as reserves in gold over Treasurys. In other words, the rising gold-to-oil ratio alongside a rising gold-to-Treasurys ratio suggests that global oil profits are indeed “recycling” back into gold and that the gold recycling is directly fueling rising gold prices vs. both oil and Treasurys. The rising gold-to-Treasurys ratio along with a high and rising gold-to-oil ratio is a sign of stress for the petrodollar system. We are undeniably seeing that now.
Keep in mind that, so far, roughly $80 billion worth of foreign reserves has been taken out of US dollars and reinvested into gold. Those purchases were the primary driver for the gold price to surge from $1500 to $2500.
But there is a further $8 trillion US dollars still sitting on central bank balance sheets around the world. A considerable amount of those dollar reserves still needs to squeeze into the relatively small gold market to appropriately adjust reserve ratios for the new “gold recycling” system. So if Jeff Currie is correct, this recent move higher in the gold price is likely just the beginning of a much more substantial move higher in the gold price over time.
We are witnessing a paradigm shift in real time. It’s a paradigm shift that looks very likely to translate to much higher gold prices over time. When the Wizard of OZ was released in 1939, the advice was to “follow the yellow brick road.” That still appears to be an excellent suggestion today. Further, it seems like the new wisdom is: all roads lead to gold.
Weekly performance: The S&P 500 was up 1.11%. Gold was up 0.32%, silver was down 1.97%. Platinum was off 0.73%, and palladium jumped 7.14%. The HUI gold miners index was up 0.94%. The IFRA iShares US Infrastructure ETF was nearly flat, up 0.11%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 1.59%, while natural gas lost 7.78%. The CRB Commodity Index was off 0.23%. Copper lost 1.76%. The Dow Jones US Specialty Real Estate Investment Trust Index lost 0.21%. The Vanguard Utilities ETF was down 2.38%. The dollar index was up 0.39% to close the week at 102.68. The yield on the 10-yr U.S. Treasury was up 14 bps to close at 4.10%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
