Why the US mid-term elections might spell good news for gold

I wanted to take a quick look at gold this morning.

Gold has had a pretty dull year. In dollar terms, it's currently near its low for 2018. It's doing a little better in terms of pounds sterling and euros, but overall, the story is of an asset becalmed.

Given that this year has been reasonably eventful so far trade wars and ongoing European political spats are just a couple of highlights gold's lack of reaction seems odd.

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Are things likely to turn around? Or has the shine come off the precious metal?

What really drives gold prices

One major reason for gold's drift lower this year has been the steady march higher of the US dollar. That in turn has been driven by the divergence between US monetary policy and that of the rest of the world.

The US central bank, the Federal Reserve, seems pretty set on continuing to raise interest rates. If anything, the Fed under Jerome Powell has grown increasingly hawkish. All the other central banks are either going the other way, or catching up only very slowly.

The Bank of England appears to be paralysed by Brexit. Over at the European Central Bank, Mario Draghi is trying to make sure that monetary policy stays as loose as humanly possible, before he hands over the reins next year. And in Japan, there's little signs of progress towards 2% inflation, despite there being more jobs than there are people to fill them. So the Bank of Japan plans to keep printing for as long as it takes.

So the US dollar has got stronger, and that means all else being equal the value of anything measured in US dollars will fall.

MoneyWeek has always suggested that you should have at least 5% of your portfolio in physical gold (whether you choose to do that with an exchange-traded fund or not really depends on how concerned you are about the full-on financial catastrophe side of things).

The point is to diversify your portfolio. When things get really bad, and other assets struggle, gold tends to outperform. So in some ways you can think of it as a form of portfolio insurance. From that point of view, the day to day movements don't really matter all you really need to focus on is keeping your asset allocation roughly in line with your plan.

Equally though, it's interesting to keep an eye on gold as a barometer of what's going on in the financial system. Right now it's becalmed. So what could change that?

We can't predict the future (which is the main reason that we diversify in the first place). But if there's any "macro" factor that seems to drive gold prices, it's "real" interest rates. That is, interest rates adjusted for inflation.

Put very simply, if the Fed allows inflation to rise more rapidly than interest rates, you'd expect gold to go up, because monetary policy if effectively getting looser. If rates rise faster than inflation, you'd expect gold to fall, as "real" rates rise.

This is why I pricked up my ears the other day when I heard a key member of the Donald Trump administration, gently hinting that the Fed should be wary of raising rates too fast.

Donald Trump is not keen on higher interest rates

Central banks around most of the developed world are independent these days. The point of independence is to stop politicians from messing around with monetary policy in the hope of artificially boosting the economy when election time rolls around.

You can certainly have a debate as to whether or not this has in practice made any difference to monetary policy over the last few decades. But that's the theory anyway.

Politicians have by and large, tried to respect that independence. Again, there's been little reason for them not to. Central banks spent most of the last 20 years cutting interest rates or printing money, after all.

But the other day, Larry Kudlow Trump's main economic advisor, and someone who also advised the Ronald Reagan administration was being interviewed on Fox Business. He was asked about the risks to the economy of tighter monetary policy.

"My hope is that the Fed under its new management understands that more people working and faster economic growth do not cause inflation... My hope is that they understand that and that they will move very slowly."

Now that's an interesting line in itself. This may or may not be true (clearly, in Japan, having more people working and faster growth has struggled to cause inflation). But the idea that higher growth and more competition for labour leads to higher wages is certainly the orthodox economic view, and one that you'd expect the Fed to broadly follow.

However, it's more the heavy hints from Kudlow that the Fed should be taking things easy, that's of interest.

We're coming up to US mid-term elections later this year. If Trump wants to do well, then there are a few things he'll be keeping an eye on. The oil price is one hence the desperate attempts to prove that Saudi Arabia is going to pump more oil. And another is the path of monetary policy, and the impact this has on the stock market.

If the Fed comes under political pressure to go easy on rates, that would be no surprise. Trump is hardly backward at coming forward. At the same time however, this would be happening just as inflation is finally showing signs of taking off (it hit a six-year high in the US in May).

Assuming that Kudlow is wrong and the impressive pay rises being awarded in certain under-pressure industries, such as truck driving, suggest he might be then it's quite possible that inflation could surprise on the upside. In turn, that suggests that real interest rates could start to tick lower. Which would be good for gold.

I'm not saying you should pile in to grab it with both hands. But it might be worth checking your asset allocation. If you're a little short on gold, it might be a good idea to rectify that.