The price of gold has risen sharply during the past two years. More recently, Jerome Powell’s August speech at Jackson Hole, Wyoming — where he signaled the Federal Reserve would begin lowering interest rates — has turbocharged gold’s ascent. Indeed, investors are considering whether the dramatic appreciation signals a flight to quality, reflecting a widespread loss of confidence in American monetary, fiscal, and trade policies. That is, does gold’s performance reflect a “debasement” of US (indeed, global) financial assets, including a loss of confidence in the dollar?

Alternatively, perhaps gold’s rally simply reflects a generalized “risk-on” market optimism based on the prospect for lower interest rates, combined with resilient US (and global) economic growth and low (albeit “sticky”) inflation. However, propelled by AI euphoria, equity market valuations are near those associated with the internet bubble (Chart above provided by Yardeni Research). If you believe, as I do, the US economic and corporate profit growth will decelerate in the year ahead, and “core” inflation will remain sticky around 3%, then further equity market gains will rely on lower US bond yields. Will Fed rate cuts produce the needed bond market rally?

So far, the surging gold price largely reflects strong fundamentals and “risk-on” market optimism. However, the “debasement” alternative is likely to emerge at some point in the year ahead; suggesting continued upside for gold. And, the US bond market’s performance may signal the transition between these two scenarios.

Gold: Solid Fundamentals…Debasement to Come?

There are good reasons for markets to speculate about the “debasement” scenario. Indeed, the adverse effects of the Trump 2.0 tariffs will intensify during the next 12 months. In particular, US inflation is likely to remain around 3% during the next year. To be sure, the Fed projects core inflation at 2.6% in Q4 2026 — well above the 2% target. Likewise, I expect US GDP to decelerate to 1% in 2026: even slower than the Fed’s 1.8% estimate. With inflation “sticky”, and facing daily criticism from the Trump Administration, the US central bank’s decision to lower interest rates has cast doubt its independence and credibility. Furthermore, The One Big Beautiful Bill keeps US fiscal policy on an unsustainable trajectory. The current government lockdown illustrates America’s struggles to come to grips with its surging indebtedness.

However, the US bond and equity markets, along with the US dollar, have all rallied since Chairman Powell’s speech in Wyoming — classic “risk-on” reactions. Recent changes in the drivers of the gold price reenforce this conclusion. Indeed, the strongest correlation is with the S&P 500, and the link has gotten closer in recent years (Chart above). Gold’s traditional positive association with inflationary expectations has weakened recently. Likewise, historically, gold prices have declined when inflation-adjusted bond yields have risen. That’s not been the case lately.

In recent years, the dominant drivers of the demand for gold have been financial market investors and central banks. Gold’s strengthening link with the S&P 500 may reveal mainstream investors are allocating permanently a greater share of their portfolio to precious metals. I believe this process is still in the early phase. Similarly, since the Global Financial Crisis, central banks are diversifying their reserves away from US dollars into gold. However, the Chart above suggests that only a handful of countries have dominated this trend. Again, while central bank diversification away from the US dollar is progressing slowly, gold’s role is likely to continue to expand. For instance, gold’s proportion of international reserves remains very low in many key countries compared to Europe and the USA (next Chart). Therefore, both investor and central bank demand for gold look set to provide ongoing support for gold prices.

Will Bonds Fuel Next Phase of “Risk-On” Rally?

In addition to having expensive Price/Earnings ratios, the S&P 500 is at best fairly valued compared to the US bond market (Chart above provided by Yardeni Research). In the coming year, I believe the consequences of tariffs on both GDP and earnings growth will becoming increasingly evident. Therefore, given the rich valuations, continued equity market rallies will need to rely on declining bond yields.

Can fixed income markets deliver? A decomposition of US bond yields provides some clues. The Chart above illustrates despite the imposition of tariffs, inflationary expectations have remained well-anchored. As inflation is likely to remain sticky for the next year, breakeven inflation is more likely to rise than decline.

Meanwhile, real interest rate (measured by the TIPs market) have only risen to levels existing before the implementation of quantitative easing following the Global Financial Crisis. At present, strong AI-related capex is boosting private sector investment. At the same time, America’s bloated budget deficit promises an ongoing supply of Treasury securities. With strong private and public sector demand for credit, it’s hard to see real rates decline substantially unless the economy slips into recession.

To be sure, the Federal Reserve is poised to cut interest rates. Indeed, the Fed expects the federal funds rate to decline to 3.5% by the end of 2026. Meanwhile, the market (and I) has discounted the target rate at 3%. Therefore, the biggest impact will be a steepening of the yield curve. And, the Chart above illustrates the US yield curve is not especially steep at present. Therefore, I expect the equity market will be disappointed by now little bond yields decline in the period ahead, despite easier monetary conditions.

Lessons from Global Bond Markets

Since the cyclical peak in May 2024, The Bank of England and the European Central bank have reduced short-term interest rates by 125bp and 235bp respectively. However, this has not translated into lower bond yields. Indeed, German 10-year held steady, and French and UK bond yields have actually risen during the period. Instead, throughout Europe (and Japan also), yield curves have steepened considerably (Chart above). The European bond market performance has been worst — and yield curves steepened the most — in countries with large budget deficits and uncontrolled increases in public sector debt, e.g. France, Italy, and the UK especially. In addition, political risk in France, UK, and Japan also contributed to rising bond yields.

Therefore, the US fixed income market’s rally may be disappointing, despite the expected sharp decline in short-term rates. And, the US yield curve is much flatter than in Europe, despite America’s more uncertain inflation outlook. In addition, the US fiscal position remains precarious, and government debt continues to spiral. Also, US political risk may escalate before the 2026 mid-term elections.

Debasement: Spiraling Debt the Likely Trigger

If the outlook for the price of gold transitions from a “risk-on” story to one driven by “debasement”, spiraling public sector debt will be the most likely trigger. As the Chart above illustrates, debt is rising unsustainably in virtually all countries. The United States’ fiscal position is amongst the world’s most precarious. As Trump 2.0’s OBBB, the current political turmoil in France, and the speculation about the UK’s November budget announcement illustrate, there’s little appetite for fiscal austerity. I believe a crisis is looming. The timing is uncertain. But, bond markets (and US dollar weakness) will signal the transition to the debasement theme.