by the Asset Allocation Committee | PDF

One challenge for investors seeking to benefit from rising gold prices has been that trading and holding the yellow metal is often more expensive than trading or holding stocks or other financial assets.  Buying physical gold can involve fat commissions and large costs for storage and insurance.  Buying gold futures requires a margin account that may not be available for some investors.  Many investors therefore buy gold miner stocks instead, assuming that rising gold prices will buoy miner profits and cause their stocks to appreciate in line with gold.  Our analysis suggests that was a reasonable strategy until about 2003, when the Securities and Exchange Commission first allowed exchange-traded products (ETPs) that invest in gold.  Up until 2003, the NYSE Arca Gold Miner Price Index (GDM) was highly correlated with gold prices.  Since then, however, the relationship has swung wildly across periods.  Now, there appears to be no lasting, consistent relationship between the GDM and gold prices.  In the post-2003 era, it appears private investors seeking gold exposure should just buy gold or gold ETPs.

But what is the correlation between gold and gold ETPs?  Until recently, spot gold prices have tended to move in tandem with the amount of the yellow metal held by ETPs, suggesting financial investors have become the market’s key drivers.  As investors buy gold ETPs, the funds purchase physical gold and buoy prices.  Our analysis suggests investor demand for physical gold and gold ETPs is often driven by concern about the value of the dollar and can increase when investors worry about issues like the rising federal budget deficit or inflation.

More recently, however, we have noted a breakdown in the relationship between spot gold prices and ETP gold holdings.  As shown in the chart below, gold prices and ETP holdings had moved largely in tandem for more than a decade and a half, but they began to move in opposite directions toward the end of 2021.  Since then, gold prices have soared and recently reached a new all-time record of $2,212 per ounce, but ETP gold holdings have been declining.  How can gold prices be rising in the face of an apparent drop-off in investor demand for gold?

We think the answer is increased gold-buying by central banks.  The chart below shows that the world’s central banks now hold nearly 36,000 metric tons of gold, a new record high.  Importantly, central banks don’t necessarily act like private investors.  For central banks, gold is part of their foreign reserves, which can be seen as a sort of “rainy day fund” for their country.  Since the gold held in these reserves is for their own country’s economic security, central banks are likely to be relatively price insensitive when they go out into the gold market.  Another distinguishing aspect of central bank gold-buying is that the institutions are much more oriented toward the security of holding physical gold rather than ETPs.  Putting it all together, it appears that major central banks have been actively buying up physical gold despite today’s record-high prices, while gold-holding ETPs have apparently been selling to them.

We suspect much of today’s central bank gold-buying is being driven by institutions outside the US geopolitical and economic bloc or the central banks of other countries at odds with the US.  After seeing US and Western moves to seize foreign currency reserves belonging to Afghanistan and Russia in recent years, we think many governments that aren’t on good terms with the US or might fall afoul of US policies have directed their central banks to shift their reserves more toward physical gold and other assets that the US or other Western governments wouldn’t be able to seize in times of souring relations.  Given today’s ongoing spiral of tensions between the US bloc and the China/Russia bloc, which seems set to continue for years, we think central bank gold purchases will remain strong and give a continued boost to gold prices, at least in the near term.

Note: there will not be an accompanying podcast for this report.

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by the Asset Allocation Committee | PDF

While the Federal Reserve’s dual mandate focuses on achieving maximum employment and stable prices, managing long-term interest rates has also played a significant role since the enactment of the Federal Reserve Act in 1977.[1] Recent actions have raised questions about the Fed potentially anchoring the 10-year Treasury yield to remain within a range of 4.0% to 5.0%, primarily using the nontraditional tool of “forward guidance.”

Over the last few months, policymakers have leaned heavily on forward guidance to achieve their policy aims. The strategic communication of future policy intentions allows Fed policymakers to influence market expectations and adjust financial conditions significantly. This, in turn, grants them greater flexibility in adjusting monetary policy and enables them to react more nimbly to economic changes without solely relying on interest rates or balance sheet adjustments.

This tool became particularly noticeable in October 2023, when yields on 10-year Treasury bonds surged above 5% for the first time in over 16 years. Several factors contributed to this surge. For instance, heightened government issuance of US Treasury obligations coupled with a surprisingly resilient economy prompted investors to reassess whether the low interest rates adequately compensated for the risks associated with holding long-term debt. Moreover, the Fed’s September Summary of Economic Projections hinted at an additional rate hike before year-end, fueling concerns that forthcoming short-term rate increases might outpace long-term yields even further.

In response, Fed Chair Jerome Powell signaled a potential pause in rate hikes at the October 31- November 1 meeting of the Federal Open Market Committee. The central bank doubled down on this sentiment in the subsequent meeting by revising its 2024 year-end rate forecast, cutting its median target from 5.1% to 4.6%. Fueled by hopes of a dovish pivot from the Fed and a potential economic soft landing, investors heavily purchased long-term US Treasury bonds. This surge in demand contributed to a substantial drop in long-term yields, with the average 10-year yield plummeting nearly 80 basis points, dropping from 4.80% to 4.02% in just two months.[2] This significant decline in yields helped loosen financial conditions and relieved fears of a protracted increase in long-term interest rates.

However, the Fed’s dovish stance proved less aggressive than the market initially thought. As interest rates dropped below 4% on the 10-year Treasury, policymakers quickly signaled their opposition to an immediate cut. San Francisco Federal Reserve Bank President Mary Daly and Dallas FRB President Lorie Logan even suggested that further hikes remained a possibility. Fed Governor Waller, who opened the door to a spring rate cute, later emphasized the need for patience, indicating the committee wanted to see inflation continue its descent toward target levels. Chair Powell cemented this shift in stance at the January FOMC meeting, confirming that a March cut was not on the table. This hawkish pivot triggered a modest reversal in expectations over policy, causing the 10-year Treasury yield to rise by 15 basis points to 4.21%.

While the FOMC undoubtedly includes diverse viewpoints, the members’ recent pronouncements project a unified message. This cohesion amplifies the impact of forward guidance by minimizing misinterpretations. While individual views may differ, all members have publicly conveyed that current interest rates are likely near their peak, with rate cuts a possibility but not in the near-term. As a result, markets have revised their expectations, aligning with the median FOMC projection. Consequently, the moderation of policy rate expectations led to the stabilization of 10-year Treasury yields.

The Federal Reserve’s current approach, while not technically constituting yield curve control, may be a subtle form of it, which raises concerns about potential future interventions aimed at aligning with government priorities. The Fed’s use of “jawboning” to manage interest rate expectations raises questions about its potential shift toward a more active role in influencing market behavior. This could be particularly relevant considering the substantial US government debt and the alleged attempt of some officials to downplay the possibility of higher long-term rates in the future.

It’s important to note that forward guidance, while a tool for influencing expectations, is distinct from the yield curve control practiced during WWII, as it does not involve the expansion of the Fed’s balance sheet. If maintained over time and if seen as being implemented on the behest of the Treasury, this gray area could erode public confidence in the Fed’s independence. Such an impression could potentially hinder its ability to control inflation and negatively impact the value of the dollar. That said, we believe that if 10-year Treasury yields reach a range between 4.5% and 5.0%, it could present a buying opportunity for some investors.

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[1] The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

[2] The Treasury’s decision to reallocate its bond issuance toward the short end of the yield curve also played a role in the drop.

by the Asset Allocation Committee | PDF

In an important adjustment to our Asset Allocation strategies last October, we introduced an exchange-traded fund focused on uranium producers into our mid-cap equity exposure.  At the time, we noted in our Asset Allocation Quarterly that the move aimed to take advantage of government policies around the world that are encouraging an increase in the use of nuclear power to generate electricity, even as uranium supply is crimped.  However, we have not yet provided the in-depth explanation of our view that we usually do.  This report aims to start addressing that by giving a broad outlook for uranium demand and supply in the coming decades.  We expect to provide additional analysis of the uranium market in other reports in the coming weeks and months.

The chart below, from the World Nuclear Association, shows expected global demand and supply for the uranium used in electricity generation — by far the main source of demand for uranium.  As shown in the chart, electricity-generating demand for uranium is expected to rise from 65,651 metric tons in 2023 to about 110,000 metric tons by 2040, for a compound annual growth rate of 3.1%.  The expected rise in demand largely reflects new reactors currently under construction, planned, or proposed (net of reactor retirements).  China accounts for only 55 of the world’s current fleet of 436 operating reactors and 17% of today’s total global uranium demand, but its expected build-out of more than 220 new plants by 2040 represents about 44% of the new reactors to be added during the period and at least that share of the additional global uranium demand.  India is in a distant second place in terms of expected new reactors and uranium demand.  New and improved generating technologies could also support expanded generating demand.

As shown in the chart above, most of the current and future generating uranium is expected to come from existing mines, followed by restarted mines, mines under development, planned mines, and prospective mines.  Note that total mined uranium and secondary supplies are expected to fall far short of demand in the coming decades.  Many economists and industry authorities therefore expect a sharp rise in uranium prices, which would incentivize the opening of new mines.  Indeed, spot uranium prices have already surged some 66% just from our entry point into the ETF on October 19 through February.  Since electric utilities need to secure long-term fuel supplies, most uranium is currently sold under long-term contracts, so the producers in our ETF haven’t necessarily gotten the full benefit of today’s spot prices.  However, since the looming rise in demand is expected to make uranium increasingly valuable, we believe producers will soon see new opportunities to expand production at profitable prices.

As our regular readers know, we at Confluence believe a key trend going forward is that the world will keep fracturing into relatively separate geopolitical and economic blocs, and that the China/Russia bloc is likely to crimp supplies to the US bloc as tensions mount.  Fortunately, as shown in the chart below, uranium deposits are well distributed — even common — around the world.  Still, most of the world’s production today comes from the China/Russia bloc, with Kazakhstan being the main producer (at 46% of the total), followed by Uzbekistan and Russia.

Why does Kazakhstan account for such a preponderant share of today’s global uranium output?  To understand that, it’s important to first review recent global price trends.  From the run-up to the Global Financial Crisis of 2008-2009 until 2016, global spot uranium prices fell by more than 50% in the face of increased supply from dismantled nuclear weapons and falling demand due to newfound generating efficiencies and safety concerns after the Fukushima accident in Japan.  Low prices made it unprofitable to mine much uranium in regions where the cost of production was high.  As shown in the chart below, the China/Russia bloc, and Kazakhstan in particular, has a near monopoly on the world’s supply of ultra-low-cost uranium.  Kazakhstan’s production cost currently averages less than $40/kg.  That’s equivalent to about $18.18/lb and well below the average market price of about $50.00/lb through much of 2023 and the current price of almost $100.00/lb.

As shown in the last chart, most of the uranium available in the US bloc (largely consisting of deposits in Australia and Canada) costs $80 to $260 per kg to produce.  That’s equivalent to about $36.36 to $118.18 per pound, rendering it uneconomical to produce until recently.  Going forward, we believe that the expected increase in global demand, the growing shortfall in total mine production, and the risk of supply restrictions out of the China/Russia bloc will boost uranium prices further and lead to new, profitable production opportunities for uranium producers even in higher-cost regions of the world.  We therefore believe our new exposure to uranium producers could provide additional risk-adjusted returns within Confluence’s asset-allocation portfolios.

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