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The outlook for gold
Two weeks into the new year, and gold prices have already hit two all-time highs, continuing their hot streak from 2025. One way to read this is that it reflects higher global uncertainty, following US President Donald Trump’s shocking strikes on Venezuela and the Department of Justice’s criminal investigation into Fed chair Jay Powell. Chart from Jim Paulsen at Paulsen Perspectives:
As the bright green warning in the chart points out, if uncertainty pushes gold up, the risk for gold investors is increasing global sanity. Paulsen writes:
Considering that the master of uncertainty — President Trump — still has three more years as leader of the US — it appears likely that chaos & uncertainty will remain elevated. But . . . even if uncertainty remains high by historical standards any lessening from its recent peak levels will likely cause the price of gold to decline
But that’s not the only risk to gold. Gold has also become a momentum trade, with retail investors joining in. Global gold ETFs had their strongest inflows on record in 2025 of $89bn, compared to just $4bn in 2024, according to the World Gold Council. Here’s a closer look at daily retail flows into some gold-related funds over the past year:
Retail investors won’t wait for geopolitical stability to jump off the gold train. Broken price momentum would be enough. Meanwhile, central banks, which ignited to gold, are buying less of the metal on a year-over-year basis:
Remember that over the long run gold has not been a particularly good investment asset; until the past few years, it has only really shone at times of acute crisis. Angelo Kourkafas at Edward Jones notes that with the exception of the 1970s, the 2000s and the past few years, gold has mostly moved sideways. “The case for gold is not about seeking above-average returns, but rather its diversification and stability benefits,” as Kourkafas writes. In the two decades between 1984 and late 2003, for example, gold did not appreciate at all in nominal terms. The past few years, in short, have been a major anomaly.
(Kim)
Central bank’s trilemma
In the past few days I have been writing about Fed independence; whether fiscal dominance makes it irrelevant; and whether fiscal dominance is ultimately caused by central banks themselves. By happy coincidence, two Fed economists, Burcu Duygan-Bump and R Jay Kahn, have published a short paper, The Central Bank Balance-Sheet Trilemma, that provides an excellent framework for thinking about these issues.
The authors argue that central banks can only have two of the following three things at once: a small balance sheet, low volatility of short-term interest rates and limited intervention in markets. You can’t have all three, because if the balance sheet is small — that is, if the government does not force a bunch of cash into the financial system — you have to either accept volatility or intervene when volatility threatens markets.
Every choice imposes costs. Having a large balance sheet keeps volatility low but
can crowd out private sector money market activity such as interbank lending or money market fund lending to dealers. As a result, a large balance sheet potentially reduces price discovery for short-term rates, weakens market discipline, and may deprive markets of the information that could be provided by an active interbank market.
When cash injections mean the cost of money is almost always stable, market participants leverage their trades more, knowing that they will always be able to “roll” their debt financing easily and cheaply.
So why not let short rates move a bit more? Well,
high volatility in short rates can weaken the central bank’s control over interest rates and complicate monetary transmission. When short-term rates fluctuate for reasons unrelated to policy or fundamentals, funding costs for banks and firms become less predictable, potentially creating frictions in payment-system functioning and making it harder to plan investments. Persistent volatility can also spill over to longer maturities, as investors demand higher term premiums to compensate for short-rate uncertainty . . .
Intervening in markets poses a similar risk. Currently, the Fed (for example) has created standing credit facilities for market participants to use, at prices that represent “ceilings and floors” for the market. But
frequent use of these operations might lead to weakening of market discipline and distortion of market signals — concerns that are similar to those associated with a large balance sheet
One thing that the paper does not mention, but which looms in the background, is the relationship between potentially dangerous volatility in money markets and large government deficits. As Unhedged has put it in the past, big deficits mean big Treasury issuance. If anyone is going to buy all those Treasuries, they will need financing — usually short-term financing. So a large central bank balance sheet encourages both high government deficit spending and highly leveraged trading (especially “basis trades”) by markets’ participants. Like Michael Corleone and Senator Pat Geary, markets and the government are “both part of the same hypocrisy”.
My use of that metaphor will make it clear which horn of the trilemma I believe we need to accept: higher short-term rate volatility. I will write more about this soon.
(Armstrong)
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