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Here's what gold price did during 2011 debt ceiling crisis, and what to expect now

Kitco News

(Kitco News) The high-stakes standoff over raising the U.S. debt ceiling is gathering more political drama. But what does it all mean for gold?

The turbulent issue is often described as "political theatre," with a limited impact on many assets, including gold. However, as the issue gathers more importance, with parties unable to reach a bipartisan agreement to raise the country's de facto credit-card limit in time, the unthinkable U.S. debt default scenario starts to weigh on markets.

The U.S. has already hit its borrowing limit of $31.4 trillion in late January, and U.S. Treasury began to employ "extraordinary measures," including suspending investments for selected government accounts, to pay all the country's bills.

And if the debt ceiling is not raised by June, the federal government could run out of money. This is why calls from U.S. President Joe Biden, Treasury Secretary Janet Yellen, and Federal Reserve Chair Jerome Powell are getting more desperate.

On Monday, Yellen once again called on Congress to raise the U.S. debt limit, stating that failure to do so would trigger "an economic and financial catastrophe."

On Tuesday, Powell said investors should not count on the Fed to protect the U.S. economy if the debt ceiling is not raised in time. The Fed Chair also ruled out the trillion-dollar coin idea and stressed that there was only one way to deal with the issue: "Congress raising the debt ceiling in a timely fashion. That's what has to happen. If it doesn't, no one can think the Fed can protect the U.S. economy."

In his State of the Union speech Tuesday, Biden also appealed to Republicans for unity to raise the debt ceiling. "Some of my Republic friends want to take the economy hostage unless I agree to their economic plans," he said.

In an early attempt to resolve the issue, Republican U.S. House of Representatives Speaker Kevin McCarthy and President Joe Biden met last week. But the standoff continued as the two agreed to meet again. Congressional Republicans signaled that they would like federal spending cuts in exchange for raising the limit.

Analysts are warning that the path to a higher debt ceiling could be volatile. Credit Suisse's chief economist Ray Farris said that Republican' Freedom Caucus' lawmakers are asking for spending concessions, and those are likely to be the main obstacle.

"A resolution is unlikely any time soon," Farris said in a note. "Conditions are in place to make the journey to a debt ceiling increase difficult and increasingly stressful for markets … Markets have begun to price default risk but may need to price more."

What happened in 2011?

The last time the debt ceiling debate significantly impacted markets was in August 2011, when Republicans and Democrats could not agree and ended up raising the ceiling just hours before the deadline.

As a result, risk assets had a negative reaction as the U.S. dollar sold off, stocks sank, and credit spreads widened. Also, Standard & Poor's ended up downgrading the United States' long-term credit rating from AAA to AA+.

A similar scenario is not ruled out this time, as negotiations to raise the debt ceiling are just beginning. As politicians battle this out, analysts expect heightened market volatility, especially closer to the June deadline.

"The impact could be economically calamitous (through a potential global recession) and disruptive for investors (for instance, through persistently higher Treasury borrowing costs)," JPMorgan said. "If history is any guide, we expect policymakers to eventually find compromise and the impact to be short-lived."

Let's look at gold

When trying to analyze the impact on gold, it is helpful to look back at how the precious metal performed leading up to August 2011 and what followed. Gold ended up climbing in August and September 2011, breaching $1,900 an ounce for the first time and hitting a record high at the time of $1,910 an ounce.

However, the eventual resolution of the debt ceiling marked a peak in gold. The next time the precious metal was able to breach $1,900 an ounce was in July 2020.

A similar pattern could happen this time around, where gold would advance higher closer to June, and then once the debt ceiling is raised, prices would see a peak, at least for the near term, senior technical strategist Michael Boutros told Kitco News.

"In the scenario that our credit rating gets lowered or we [come close] to default or something that extreme, gold will be bid. But once the blowoff happens and you get a resolution, you must watch out for a larger selloff in gold — a quick liquidation in some of those long hands. From a timing standpoint, the debt ceiling resolution might actually be a near-term high that might hold the price for a while," Boutros explained.

The lessons learned from 2011 could be "buy the rumor, sell the fact," Walsh Trading co-director Sean Lusk told Kitco News.

"Anytime you've printed more of something that's worth less, you had a direct result in the dollar, and given the uncertainties in those years, you had gold take off above $1,900 an ounce before it started to come off again," Lusk said. "I'm looking at 2011 pricing, and gold ran up during the first part of the year and then took off down."

Lusk added that rate cuts and the lower U.S. dollar also accompanied the 2011 rally in gold.

From the short-term perspective, gold is likely to see more consolidation before its next big move higher, Boutros added.

"If we take a parallel to the price action that we saw in 2011. There are some similarities in the nature of the breakout. But even if we take that parallel overlay it on price, it would suggest a couple of weeks to a couple of months of consolidation before the next move," he noted. "One of the main levels I'm looking for is $1,807. That has to hold support over the next couple of weeks. If we're able to maintain and stabilize above that, you look sideways to higher."

Gold is one of the assets JPMorgan recommends holding during this time. "The potential for a disorderly debt ceiling episode adds just another kicker for global investors to rebalance U.S. overweights across asset classes. Consider currencies and precious metals like the Japanese yen, the Swiss franc, and gold," JPMorgan said in a report last month.

Gold is the asset many turn to during these unstable times because it is outside of the system.

"Anytime government spending comes up, it makes gold more attractive because it's a neutral asset. It's not subject to government policy in terms of going up or down in value like the U.S. dollar could," Gainesville Coins precious metals expert Everett Millman told Kitco News.

At the end of the day, given that the debt ceiling issue is mostly theatrics and grandstanding, the impact on gold will be temporary.

"They always end up raising the debt ceiling in the end," Millman said. "But the 2011 example is an interesting parallel because when there are fears that the financial system is on shaky ground, the debt ceiling can turn from a non-issue into something that makes people more fearful about the government's stability and the financial system's stability."

And gold has always been a safe way to store wealth. "It's the logical alternative to having to trust the government to manage the financial system. I wouldn't at all be surprised to see this drive some more interest in gold, perhaps from traders and investors who haven't been paying attention to precious metals," Millman added.

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