Inflation Expectations and TIPS

Gold ticks up as range bound trading continues

The gold priced edged up 0.2% to US$1,759/oz, and has remained range bound between US$1,750/oz-US$1,800/oz for over a month as investors continued to await some clear direction to emerge from either new data or the Fed.

A look at base metals' prices and TSXV-listed base metals stocks

This week we look at the recent performance of base metals' prices and TSXV-listed base metals stocks, with many of the stocks seeing company specific factors having a bigger share price impact than moves in the underlying metals prices.

Producers and juniors rise as stock market picks up

The producers and juniors gained, with the GDX up 3.2%, GDXJ up 4.8% and the Canadian juniors were mostly rose, as investors moved back into risk assets especially towards the end of the week and equity markets picked up.

Inflation expectations and TIPS

Gold rose 0.2% this week to US$1,753/oz, with gold continuing to trade in a range between US$1,750/oz-US$1,800/oz for about a month as the market continues to await a clear direction from either new data or the Fed. The big questions remain; 1) will inflation continue to be persistently high, 2) will growth remain strong even as the post-global health crisis boom seems to be easing, and 3) what action will the Fed take in reaction to both of these? For gold, inflation will probably remain the key driver for the time being, at it is generally considered an inflation hedge and tends to maintain its value over time, in contrast to fiat currency, and it is also a liquid safe haven asset during a crisis.

Gold will therefore tend to do best in times of high inflation, weaker growth and high risk. The current situation has at least two of these, with both inflation and risk still high. With the recovery from the global health crisis having been almost entirely stoked by massive monetary and government stimulus, it is difficult to tell how long the expansion would last without these (we expect not long). The situation with the current inflation is also unclear, as to whether it falls into the category of Passing Inflation, Procyclical Inflation and Stagflation, or some combination of these three.

Passing Inflation: The first scenario of 'passing inflation' would mean that the inflation we are seeing is just short-term, caused by disruptions to supply chains by the global-health crisis. This led to pent up demand, which has been unleashed as constraints have eased, leading to a temporary surge in inflation. In this scenario, inflation year on year looks artificially high because the dip in prices in mid-2020 made for a low base of comparison for 2021. The US Fed seems to be embracing this idea, believing that inflation should fall considerably in the coming months.

Procylical Inflation: Procyclical inflation could be considered 'good' inflation, being driven by a genuine pickup in economic demand, and prices rising because of this strong expansion. While there may be an element of this in the current inflation, the distortions of the global health crisis and massive economic stimulus have made it difficult to determine how much of the demand is organic, and how much simply propped up by monetary expansion and handouts.

Stagflation: Stagflation is a period of high inflation and low growth. The most wellknown example is the 1970s, where an oil shock and monetary expansion sent prices surges, but growth remained low. There are some concerns that we could be entering a similar period, where even though prices are rising because of the massive monetary stimulus, that strong growth may not be sustained past the initial post-global health crisis growth rebound.

While we expect that the outcome is likely to be some combination of all three of these, we probably weight the potential stagflation outcome more highly than the market. While it is not possible to split out the market's expectations for these different scenarios, we can see what the market is targeting for inflation over extended periods. We can get this estimate by comparing the spread between the yield on US Treasury Inflation Protected Securities (TIPS) versus US government bonds. Specifically, we consider the yield on the 'benchmark' 10-year US government bond, versus the yield on the 10-year TIPS.

How TIPS function compared to regular bonds

The underlying principal value of most bonds does not change over their life. An investor buys a $100 bond and at the end of the period gets back $100 and gets paid any interest payments owed over the life of the bond. Therefore the principal in a regular bond is not really protected against a major rise in inflation. TIPS are different than regular bonds in that their principal value does change over time, based on inflation. If an investor buys a $100 bond, and inflation goes up 5%, the TIPS bond principal also goes up 5% to $105, thus protecting against inflation. Because of this protection, as inflation rises, investors will have a higher demand for this bond compared to a bond not indexed to inflation, pushing its price up, and therefore its yield down (mathematically, as bond prices rise, bond yields fall).

This property of TIPS can be used to gauge the amount of inflation that the market is baking into bond prices. If we take the difference between the yield on TIPS and the yield on a government bond of the same duration, in our case, ten years, we would expect that the market will push up the price on the TIPS versus the stan'dard bond, so that the yield spread between the two would approximate the markets expectation for inflation. We show this in Figure 4, with the US 10-year government bond yield over the 10-year TIPS yield going back to 2003.

We can see that the spread between the two has actually held steady at an average of about 2.0% over most of the period. This appears to mainly be driven by the Fed's mandate to ensure that inflation does not move significantly above 2.0% for extended periods, although it can breach this level within a reasonable band for a short period. We see a similar situation with the US 5-year government bond yield versus the 5- year TIPS (Figure 5). There have really only been two major deviations from this. The first was during the 2008-2009 financial crisis, where the 10-year yields converged, effectively implying that the market was expecting inflation to go to zero. During the crisis the 5-year TIPS yield actually went above the 5-year government bond, indicating market expectations of deflation. The second deviation from trend has been over the past year, with the highest spread of the period, with the market appearing to expect inflation to be driven right to the limit of the Fed's mandate.

How good is TIPS at tracking the actual inflation rate? We look at the TIPS yield versus 10-year bond yield spread versus actual inflation to see if there is a relationship between the two in Figure 6. In general, the TIPS-bond yield spread doesn't have great predictive ability, suggesting that current spread may not be as indicative of actual inflation levels. Importantly, actual inflation can diverge from the expectations quite significantly, and shot well above the Fed's mandate for an extended period five times since 2003.

We believe that with inflation still high, but some signs that global economic growth is easing, that the potential for some level of stagflation may be underestimated by the market. While the Fed has discussed starting to taper stimulus as early as November 2021, we believe that it will be very gradual, and with a huge amount of liquidity already unleashed in the system, that inflation could continue to surprise to the upside. Meanwhile, the surge in economic demand off the low base of 2020 could be easing. We would expect such a situation to support the gold price.

Base metal prices starting to ease off

Base metals prices can give us some indication of inflation as they can be leading indicators, as they enter the global production chain in the earlier stages, and there can be an extensive lag between this and the time consumers purchase final goods, which is the driver of the CPI index. Overall we are starting to see an easing off of base metal prices, possibly indicating that the post-global health crisis economic surge is coming to an end. Only two of the major base metals have shown no signs of slowing down yet, tin and aluminum, with both going on to set new twelve-month highs over the past month, up 98.2% and 65.5%, respectively (Figure 7).

However, lead prices have broadly plateaued since around July 2021, and are now up 22.1% for the year, while iron ore prices have collapsed, and are now near flat for the year, up just 0.6%, although this is mainly because of some industry specific factors related to production in China. Copper, often referred to as 'Dr. Copper' for its strong ability to predict the direction of economic cycles, therefore granting it a 'Ph.D', while up 39.0% over the past twelve months, has clearly trended down for nearly half a year from its May 2021 peak (Figure 8). While zinc continues to edge up, and has gained 29.9% this year, its rate of growth has been slowing, and nickel, up 25.2%, has returned to around July 2021 levels twice now after two moves above it.

Some of the precious metals have likely also been affected by a return of the broader global industrial sector to more moderate growth. Both platinum and palladium, are both heavily driven by the auto sector given their use in autocatalysts to reduce emissions. They therefore may have been hit by an easing of the spike in broader global demand, including the auto sector. Platinum is still up 13.7% for the year, although it is down -20.3% off its peak in February 2021, as the auto sector accounts for just 32.1% of its total demand (Figure 9). Palladium is down -17.9%, the worst performer of the precious metals, as the auto sector comprises 85.9% of its demand.

Silver, which has both an industrial and monetary component of its demand, has declined -5.2% over the past year, and is down -22.9% off a peak in January 2021. In contrast to the big swings in most of these metals this year, gold has had a relatively flat performance, declining -6.9%, and was down only -11.2% at its trough. Gold tends to be driven mainly by monetary factors, and had its big surge through to around mid-2020, and by October 2020, where Figure 9 begins, it had already seen the biggest part of its contraction from an easing of peak-global health crisis fears.

Moves in TSXV-listed base metals stocks mostly on company specific drivers For many of the largest TSXV-listed base metals juniors, the underlying metals prices have moved share prices less this year than strong company specific drivers. The outstanding performer by far has been zinc and copper explorer, Foran Mining, which is up 1,078% over the past year, with most of gains from following strong drill results at its McIlvena project in May 2021 (Figures 10, 11). The next strongest performer has been Filo Mining, up 382%, with a big pick up in May 2021 on exceptional results of 1.80% CuEq over 858m at its Filo de Sol project. Tin producer Alphamin has seen steady gains along with the tin price, as it is already a producer, with its share price driven up 278% by the strong rise continued rise in the tin price. Chilean copper explorer Los Andes is up 73% on the continued advancement towards its PFS for its Vizcachitas project.

Canada Nickel has risen 44%, down from a peak of 146%, after the company released its PEA for its Crawford project, and the nickel price failed to hold new highs over the past few months. The other nickel play FPX Nickel, which operated a drilling program at the Decar Nickel District from July to September 2021, has declined - 22.4%. Osisko Metals declined -3.8% as it continued drilling and other exploration at its PEA-stage zinc Pine Project, and MacArthur Minerals was down -16.0%, with the fall in the iron ore price offsetting continued progress towards its FS for its Lake Giles iron ore project.

Producers nearly all rise as equity markets pickup

The producing gold miners were nearly all up this week even with gold just edging up, as equity markets rose especially towards the end of the week (Figure 12). Newmont provided an update on the Boddington Mine in Australia, including a new Autonomous Haulage Syst'm and a reduction in production guidance. Barrick reported that it was ramping up its Gounkoto mine, the third underground operation at the Loulo-Gounkoto's complex, and Iamgold appointed Dr. Ann K. Masse, who is currently Global Head of Health, Safety, Environment and Security with Rio Tinto, to its Board of Directors (Figure 14).

Canadian juniors rise on gains in stock markets

The Canadian juniors were mostly up along with broader gains in the stock market, (Figure 13). For the Canadian juniors operating mainly domestically, Great Bear reported drilling results from the LP Fault and Pure Gold reported a non-brokered C$3.47mn financing from Anglogold Ashanti (Figure 15). For the Canadian juniors operating mainly internationally, Lumina closed a C$24.0mn equity financing, Integra expanded the scope of its Delamar Pre-Feasibility Study, expecting a 50% or more increase in gold and silver production, and Mako Mining reported that the maturity on its US$15.15mn unsecured term loan, with $12.87mn of principal outstanding, had been extended by Wexford (Figure 16).