Monetary tightening has created difficulties for the US and foreign governments in managing debt. As these issues persist, gold's role as a hedge against monetary instability and geopolitical unrest becomes increasingly important.
Gold prices have surged over 10% in the last three weeks, primarily due to two factors:
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- Israel-Gaza conflict — the war in the Middle East has investors reaching for gold’s promise to provide a reliable hedge against geopolitical instability.
- Treasury troubles — the US debt problem and subsequent outsized interest payments are raising questions about the security of the US monetary system.
Middle East conflict puts energy markets on edge
The current conflict in Israel has the potential to be multidimensional, multinational, and lengthy, especially considering Iran’s involvement.
As we saw at the beginning of the Russia/Ukraine conflict, energy markets are particularly vulnerable to war. Over the last 50 years, conflicts in the Middle East have often triggered energy crises and/or recessions in the United States (including the 1973 Arab Oil Embargo, the Iranian Revolution of 1979, the 1990 Iraqi invasion of Kuwait, and the Arab Spring of 2010-2011).
If the current conflict escalates and spills into energy markets, it may compound the inflationary pressures already haunting Western economies. In recent months, US CPI has been creeping back up toward 4%.
Treasurys and the US debt trap
We might expect investors to turn to Treasuries right now. They offer similar “safe haven” characteristics as gold, plus investors can earn relatively attractive interest rates.
However, surging bond yields indicate that the supply of government debt is significantly outweighing demand (yields and bond prices are inversely correlated).
Why a strong dollar can hurt
Right now, the dollar is very strong against foreign currencies due to the Fed’s monetary tightening. That may sound positive, but a strong dollar is not necessarily good news (even for Americans).
A rising dollar puts immense financial strain on foreign nations.
Firstly, oil is traded in dollars. When the dollar rises against other currencies, oil becomes more expensive for anyone using a different currency.
Additionally, foreign governments have large amounts of dollar-denominated debt, which means they have to pay back their debt in dollars. A strong dollar makes it more expensive to service this debt.
To cover their dollar obligations, foreign governments will need to sell their Treasury holdings, thereby increasing the supply of Treasuries on the market. This is a problem because the supply/demand equation for US Treasuries already looks quite lopsided, as demonstrated by the huge increase in Treasury yields.
The US government is struggling to find sufficient buyers for its debt, no matter how much they offer to pay in interest. If the US government can’t find bond buyers, Treasury yields will continue to move higher, which makes it more expensive for the US to service its own debt.
Kicking the debt down the road
According to the US Treasury, the government has spent $659 billion on interest payments so far this year, which equates to 15% of total tax revenues. That is to say, 15% of your taxes are being paid out to the owners of US Treasuries (mostly foreign governments, the Fed, banks, and investment funds) rather than funding productive services.
This figure will continue to rise as the Treasury rolls over its existing debt at higher interest rates and issues new debt to cover government spending deficits.
As the debt trap continues to escalate, we may see the Fed compelled to step in and buy Treasuries to suppress interest rates, thereby reigniting the risk of inflation and undoing its recent hawkish monetary policy.
The current situation serves as a stark reminder that gold excels as a hedge against monetary instability and geopolitical unrest.
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