Is Deflation Bullish for Gold?

It’s official, the two largest economic zones have moved into deflation and the trend isn’t indicating that things are going to change anytime soon:





The euro area deflationary trend has been fairly steady, whereas, the US has seen a sharp spike in the deflationary pull during the past few months.

There has been a wide misconception that inflation is bullish for gold and deflation is bearish for gold. While fundamentally this concept is truer than not, it does not apply at all to the current global macroeconomic environment. Central bank stimulus programs and unconventional monetary policy measures have turned much of the economic theories we read in textbooks on their head.

Given that the ECB and Federal Reserve are committed to creating a modest and healthy level of inflation (roughly 2%) the current conditions are clearly unacceptable. If anyone thinks the Fed will raise rates in deflationary environment they need to get their head examined. Quite frankly, I believe there is a better chance of the Fed restarting QE (quantitative easing i.e. balance sheet expansion) during 2015 than there is of the Fed raising the Fed Funds Rate. Meanwhile, the ECB has embarked on a full blown QE program which is almost certainly the first tranche of many more to come.

Given the current backdrop the fundamental thesis for owning gold may have never been stronger. The deflationary challenges are structural in nature, global central banks will continue to ‘fight the deflationary fire’ with extraordinary policy measures (balance sheet expansion), financial markets are frothy and 2005-2007 style risk taking is back in vogue (leveraged loans with loose covenants, high-yield debt, subprime lending, Chinese equities, etc.). Markets have a short memory, central bankers only know how to do one thing (increase the money supply), and gold hasn’t been this out of favor with investors since the early 2000s.

From my estimation the recent outperformance of gold mining shares relative to the metal itself is an indication that astute investors have begun to appreciate the potential energy which is building in the precious metals space. Mining shares are well positioned to give investors leveraged exposure to the next leg higher in the long term secular bull market in precious metals.