Facing Facts: Rising Debt, Fiscal Constraints and the Enduring Bull Case for Gold

By Debajit Saha  Research Lead, Metals, London Stock Exchange Group

Federal Reserve Chair Kevin Warsh’s hawkish remarks on inflation at the Jackson Hole symposium have fuelled considerable speculation over whether the Federal Reserve will raise interest rates in September or delay action until later in the year.

At the same time, market sentiment weakened following renewed military escalation in the Strait of Hormuz, which pushed energy prices higher. Meanwhile, long-dated Japanese government bond yields rose to 3% for the first time in 30 years, heightening concerns about a potential domino effect across the global economy.

These developments have left investors weighing competing forces. On one hand, the prospect of higher US interest rates has strengthened the case for holding income-generating assets, traditionally a headwind for gold. On the other, rising geopolitical tensions and concerns over global financial stability have reinforced demand for safe-haven assets. As a result, gold prices have experienced heightened volatility, reflecting rapid shifts in market expectations and risk sentiment.

Nevertheless, the broader macroeconomic fundamentals continue to support gold’s role as a portfolio stabiliser.

Hawkish Federal Reserve Reinforces Higher-for-Longer Narrative

Financial markets broadly interpreted Chair Warsh's Jackson Hole speech as hawkish. He emphasised that inflation remains above the Federal Reserve's target and warned that policymakers would act if price pressures fail to moderate further.

Importantly, Warsh refrained from providing forward guidance on future policy decisions, including the September Federal Open Market Committee (FOMC) meeting. He argued that markets should not depend on pre-announced policy paths and reiterated the importance of maintaining flexibility in monetary policy. Warsh also reaffirmed Core PCE inflation as the Federal Reserve's preferred inflation measure.

The speech reinforced expectations that US interest rates may remain elevated for an extended period. Consequently, US Treasury yields and the US dollar strengthened. For gold, this development is generally bearish, as higher real yields increase the opportunity cost of holding non-yielding assets.

Jobs Are Holding Up. Wages Aren't. Which Will Warsh Choose?

The US economy added 162,000 jobs in August, according to data released by the Bureau of Labor Statistics, while the unemployment rate remained unchanged at 4.1%.

Although the headline payroll figure appears robust, wage growth continues to show little momentum, with average hourly earnings rising at an annual rate of just over 3.1%.

In our view, the key question for policymakers is whether Federal Reserve Chair Kevin Warsh will focus primarily on the resilience reflected in the headline employment data, or place greater weight on the lacklustre growth in workers’ earnings.

The answer could prove pivotal in determining whether the Federal Reserve proceeds with a rate hike at its mid-September policy meeting or adopts a more cautious stance.

Middle East Escalation Adds to Macroeconomic Uncertainty

The resumption of conflict in the Middle East has further undermined risk sentiment and heightened concerns about global energy supplies. Persistent threats of further escalation continue to support crude oil prices and raise concerns about renewed inflationary pressures.

The global economy has already been grappling with inflationary pressures linked to geopolitical disruptions. Just as energy markets and supply chains were beginning to normalise, the latest escalation has complicated peace efforts and increased uncertainty over the inflation outlook.

While geopolitical tensions typically support gold's safe-haven appeal, the inflationary consequences of higher energy prices may also reinforce expectations for tighter monetary policy, creating conflicting forces for the precious metals market.

Japan's Bond Market Signals a Potential Policy Turning Point

In Japan, the benchmark government bond yield has risen to 3% for the first time in three decades amid growing concerns over inflation and fiscal sustainability. Meanwhile, the Japanese yen remains close to a four-decade low against the US dollar.

The Bank of Japan has faced increasing criticism for lagging behind other major central banks in normalising monetary policy. This process is expected to include gradual reductions in its substantial holdings of

Japanese Government Bonds (JGBs).

At the same time, Japan's public debt burden has exceeded 200% of GDP, intensifying concerns regarding long-term fiscal stability.

Against this backdrop, further monetary policy tightening appears increasingly likely.

Implications of Higher JGB Yields for Gold

Rising Japanese government bond yields can affect gold prices through several transmission channels.

Firstly, higher JGB yields may encourage Japanese investors to reallocate capital from US Treasuries into domestic fixed-income assets. Reduced demand for US Treasuries could contribute to higher US bond yields, thereby increasing the opportunity cost of holding gold and exerting downward pressure on prices.

Secondly, rising Japanese yields could strengthen the yen and narrow the yield differential between the US and Japan. A stronger yen and weaker US dollar would generally support gold prices, as gold becomes more affordable for non-US investors.

Third, if higher JGB yields generate broader financial market volatility or raise concerns about global financial stability, investors may seek traditional safe-haven assets, including gold. In such a scenario, safe-haven demand could outweigh the negative effects of higher interest rates.

The overall impact on gold will depend on which of these transmission channels becomes dominant. Market reactions in bond, currency, and risk assets will therefore remain critical indicators for precious metals investors.

US Treasury Response and Yield Management

These dynamics may partly explain the US Treasury Department's recent decision to accelerate buybacks of long-dated bonds. The programme appears aimed at improving liquidity conditions and containing upward pressure on long-term yields.

By limiting excessive increases in Treasury yields, policymakers may also seek to maintain broader financial stability and support demand for US dollar assets.

The US election in November could play a crucial role in determining gold's performance over the next eighteen months. The current administration's key policy objectives included reducing government waste, accelerating economic growth, limiting certain categories of federal spending, and improving the fiscal balance through higher tariffs and other revenue-generating measures.

In practice, however, federal spending has not declined materially, and government debt has continued to grow. US federal debt has now reached nearly $40 trillion, equivalent to around 120% of GDP.

The fiscal pressure stems primarily from three factors: (a) rising Social Security expenditures, (b) increasing healthcare and medical costs, and (c) growing interest payments on existing debt. Among these, the third factor is particularly important.

The United States faced a similar challenge between 1970 and 1992, a period marked by the global oil shocks and the collapse of the Bretton Woods system. During that time, federal interest payments peaked at 4.77% of GDP in 1992, while gold delivered exceptionally strong performance.

Today, interest payments have risen to approximately 4.03% of GDP and are projected to increase further to 4.28% by 2027.

The key challenge for policymakers is whether they can contain debt growth while simultaneously accelerating economic growth. The answer to this question could have significant implications for gold’s outlook over the coming years.

Conclusion

Gold is likely to remain highly volatile in the near term as markets navigate competing influences from monetary policy expectations, geopolitical developments, inflation dynamics, and global bond market conditions.

However, we remain constructive on gold over the medium term. The structural macroeconomic and geopolitical challenges discussed above – particularly elevated debt levels, rising interest burdens, persistent fiscal deficits, and growing geopolitical fragmentation – are unlikely to be resolved quickly.

In this environment, central banks are expected to remain supportive as part of their reserve diversification strategies, while institutional investors and portfolio managers are likely to increase allocations to gold as a hedge against fiscal, monetary, and geopolitical risks.

As a result, we believe the broader bullish trend in gold remains firmly intact despite the likelihood of periodic corrections and heightened volatility along the way.

Source: https://www.lbma.org.uk/