Yields Are Spiking, Buy Sprott Physical Gold Trust Anyway

I've covered the Sprott Physical Gold Trust (NYSEARCA:PHYS) for Seeking Alpha a few times over the last year with varying rates of success. My most recent piece was a focused largely on the BRICS nations preparing for a shift in the global monetary system. Gold (XAUUSD:CUR) has not performed all that well since that article. With the underlying asset in decline, shares of PHYS have also fallen by roughly 9% since my July article.

Despite the recent weakness, my confidence in the long-term prospects for Gold, and by extension, the Sprott Physical Gold Trust shares has not wavered. Frankly, Gold has arguably held up remarkably well given the increase in US debt yields over the last 14 months.

At $1,820, Gold is essentially flat since July 2020 and down about 13% since the April high of $2,080. In that time, we've seen the US 10 year move from 0.60% up to 4.75%. Again, all things considered, Gold has held up well in my eyes.

Inflation Or Deflation?

Often looked at as an inflation hedge, perhaps it is unsurprising seeing Gold now struggling as the rate of change for inflation has slowed down significantly since summer 2022. However, the reader's interpretation of this section may be dependent on how one defines inflation. If one looks at price increases as the definition, the inflation story may be nearing an end. Furthermore, we've seen the yield on bonds versus the year-over-year rate of consumer price inflation go from deeply negative to positive in recent months:

However, what's notable in the chart above is the rate of change in CPI more recently. At 3.67% in August, the year-over-year change in CPI increased for the second month in a row after declining for 12 consecutive months between July 2022 and June 2023. In recent weeks, the metal markets seem to finally be reacting to the idea that the Federal Reserve will keep interest rates higher for longer. Perhaps giving credence to that notion is the return of bullish oil:

What potentially pushes year-over-year CPI back up is the rapidly increasing price of oil. When oil increases, the cost to produce and ship goods also increases. Possibly compounding the problem is that oil is already moving higher and the replenishment of the US strategic petroleum reserve hasn't even really started. Coupled with production cuts overseas, the price of oil could be going much higher unless there is a deep recession first - which is entirely possible.

But in that scenario, rates likely come back down and the monetary spigots come back on. Which brings us to the non-CPI view of inflation. Personally, I like this quote from Milton Friedman very much:

Now, the first step to our understanding the cause of inflation is to recognize that it is always and everywhere a monetary phenomenon. It's always and everywhere a result of too much money, of a more rapid increase in the quantity of money than in output.

There is certainly no question that the supply of money has drastically increased in recent years:

In the last 5 years, US M2 Money Supply has increased by 47% and Gold's USD-denominated gold price has risen roughly inline with that money supply growth. However, M2 is now contracting as yields on US debt continue to rise. This is a recipe for further weakness in the yellow metal provided we get deflation rather than stagflation. I believe we're getting the latter.

Stagflation

Stagflation is when there is slowing economic growth and high price inflation simultaneously. I would argue stagflation is already upon us. For example, we haven't seen quarter over quarter growth in real US GDP since Q3 2022. And if we take out the outlier quarters of COVID lockdowns, 2023 has been anemic compared to what we observed in 2019.

So if we're indeed in a stagflation environment, I see the 1970's as a strong analog for what we're experiencing today. And if we get a repeat of what saw in the 1970's, higher yields on the 10 year are not going to stop gold from rising as well:

Sources: FRED, MacroTrends.net - annual closing prices

During the 1970's when the 10 year more than doubled from 5.89% to 12.43% by the end of 1980, Gold still rose with yields in seven of the ten years from the table above.

Investor Takeaways

Checking sentiment, we have Rick Santelli prepping the CNBC audience for 14% rates on the 10-year by the end of the decade. We have a daily gold RSI that is currently under 19, which is lower than at any point in the last 7 years:

And Technical setup aside, we have a fundamental macro setup that I believe will benefit gold in the medium to longer term. I think oil is going to stay higher, which will likely keep consumer price inflation sticky. Economic growth is slowing. While the debate among some analysts is inflation or deflation, I don't think we can rule out stagflation. In that environment, Gold rises with yields. And then there's the debt situation:

The interest payments on federal government debt is going parabolic. Debt to GDP is 120%. As I see it, the federal government either has to cut spending, raise taxes, or the economy has to grow at a faster rate than the debt expansion. I'm struggling to see any of those three things happening. Economic growth is slowing. The deficit is actually getting worse. And raising taxes before the 2024 election is highly unlikely.

More than a hedge against inflation, I think gold is a hedge against the entire monetary/fiscal system. There is very little doubt in my mind that this system is under considerable stress already and I think when push comes to shove, we're going to see the fed return to accommodative. But again, that outcome isn't even necessary if we're in stagflation. Gold will likely win there as well.

Gold's selloff since May has been frustrating. My technical view is gold bulls are simply enduring an aggressive correction before the metal takes the next leg higher. That doesn't mean we can't go lower, but I think even sub-$1,800 gold will be short-lived. Fundamentally, my view is the macro setup will ultimately push gold much higher from current levels in the next 12-24 months. I'm a big advocate for holding physical metal. But for gold exposure in a traditional investment account, I like PHYS shares as a safe alternative.