Gold is back! With the strongest quarterly performance in 30 years, the precious metal in Q1 2016 emerged from the bear market that had been in force since 2013. A decisive factor in this comeback is growing uncertainty over the recovery of the post-Lehman economy. After years of administering high doses of monetary painkillers, will the Fed succeed in discontinuing the practice? Or is the entire therapy about to be fundamentally challenged?

Generating growth and inflation remains the imperative of monetary policy. The systematic credit expansion required for this just doesn't want to get going. Even the ECB, which initially acted with restraint after the financial crisis, is nowadays stuck in a perennial loop of monetary improvisation and stimulus. General uncertainty has now increased even further after the surprise outcome of the Brexit referendum.

After years of pursuing low interest rate policies, central banks have maneuvered themselves into a lose-lose situation: Both continuing and ending the low interest rate regime harbors considerable risks. In an attempt to finally achieve the desired boost to growth, a monetary Rubicon has been crossed in several currency areas with the imposition of negative interest rates. Gold is increasingly attractive in this environment. It used to be said that gold doesn't pay interest, now it can be said that it doesn't cost interest.

As a last resort, even the radical measure of helicopter money is considered these days. As the flood of liquidity has hitherto primarily triggered asset price inflation, newly created money is now supposed to be injected into the economy by circumventing the banking system in order to boost aggregate demand. It seems realistic to expect that such a windfall would indeed ignite the much-coveted price inflation. Whether it will be possible to put the genie back into the bottle once it has escaped is a different question.

An exit from the Fed's monetary emergency programs has been announced for years in the US. This, together with the perception that the economy was recovering, led to a strengthening US dollar in recent years. Commodities and gold weakened as a result. So far, the actual extent of the normalization of monetary policy consists of the discontinuation of QE 3 and a single rate hike by 25 bps.

Eoin Treacy's view

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Brexit has been a big event and just about everyone it still talking about it, but how it has affected the precious metals markets is a little more nuanced than one might expect on first blush. With the German sovereign bond market now trading at negative yields out to maturities in excess of 10 years more than half of all sovereign bonds in the world have a negative yield. That’s an awful lot of money tied up in an investment that is entirely dependent on momentum to generate a profit. 

Put simply if anyone who has bought in the last month holds to the maturity of the bond they are guaranteed to lose money. The only way to make a profit will be to sell to someone else willing to take a bigger risk before the bonds mature. It is the epitome of the bigger fool theory. The simple answer to why precious metals, particularly gold and silver, have been rallying is because they cannot simply be printed into existence. Unlike bonds or fiat currency the supply of gold and silver is limited. 

The kneejerk reaction to the success of the Leave campaign was to buy bonds which depressed yields further and lent an additional impetus to the demand argument for precious metals. When all is said and done how are central banks likely to respond to the threat of recession in the UK and the negative effects the UK’s absence is going to have on the Eurozone? Printing money, reducing interest rates further and artificially manipulating bond yields even lower has been their answer over the last few years and there is no reason to doubt that will be their response on this occasion. 

The biggest argument for not owning gold which has been propounded by fundamental equity analysts for years is because it does not have a yield so it cannot be valued using a dividend discount model. That’s true, but it does not mean gold is worthless. It becomes attractive as a hedge against calamity when interest rates are negative. By not paying a yield in a negative yield world it actually comes out with a positive carry. 

So why are gold miners outperforming the gold price now when they couldn’t do that in the last bull market? The last time around, when gold began to rally from 2001, gold miners had not invested in new production for decades. Prices and margins were just too low to risk that kind of expenditure. When prices began to rally they had a choice. They could return the free cash-flow to shareholders or invest in new mines which would ensure their long-term survival. Almost universally the gold mining industry took the latter option. They not only invested the money they had but the sector borrowed billions to increase mine life and build new ones. With negative cash-flows the majority of gold shares could not perform, even with gold prices turning in 10 consecutive years of positive returns. The advent of ETFs also sapped demand for gold mines especially when they were unable to outperform the gold price. 

When prices began to come back down gold miners were overleveraged and their balance sheets turned ugly in a hurry. What happened next took a lot of gold miners by surprise, gold prices almost halved and while gold mining shares could not perform when gold prices were going up they could certainly underperform when gold prices were falling. On a relative basis gold shares went lower relative to the gold price than at any time since at least the 1990s.

That all began to change early this year when, following a major rationalisation where administrative staff were fired, expansion plans were cancelled and expenses were cut to the bone, gold shares began to once more offer a high beta play on gold prices. 

The NYSE Arca Gold Bugs Index has already staged an impressive rally this year and a break in the progression of higher reaction lows, currently near 220, would be required to question medium-term scope for continued upside.