The gold market has run up sharply since the early days of November 2022. Those gains have been driven by expectations of a recession, softening inflation, a slowing in the Fed’s pace of interest rate hikes, and an eventual reduction in the federal funds rate by the end of 2023. These expectations have driven gold prices to levels seen in 2020, when the pandemic had bought the world to a standstill, and to levels seen when Russia invaded Ukraine in 2022. While there are reasons for the strength that is being observed in gold prices, the present gains seem to be excessive and make gold prices vulnerable to weakness in coming weeks.
Inflation has been showing signs of cooling over the past few months, however, it is still too soon to say with certainty that the issue of high inflation is resolved. Much of the softness in inflation that has been observed of late is tied to a decline in goods inflation with services inflation still showing strength. Services inflation tends to be stickier in nature and a combination of still healthy labor markets and high housing costs should keep services inflation elevated.
Additionally, various factors that contributed to rising inflation such as the war between Russia and Ukraine, and Covid, which disrupted supply chains, are still in play and could potentially derail progress made so far on inflation. The reopening of China, after an end to its zero-covid policy, is a double-edged sword for inflation with high demand for various commodities like oil and copper adding upward pressure on inflation on the one side and a reopening of China’s factories further easing some of the pressure on global goods inflation.
All of the above stated risks related to inflation complicate the Fed’s effort to control inflation and are likely to solidify the Fed’s resolve to keep rates at their presently projected average terminal rate of 5.1% for longer than the market is expecting. Based on CME Group’s FedWatch tool, the market is presently expecting the Fed to raise rates by another 50basis points (bps), 25 bps at each of its next two meetings, and then reduce rates by 25 bps toward the end of this year.
The markets are projecting a decline in the federal funds rate based on concerns of an economic recession. While economic growth should be expected to strongly slow this year, a recession, if one does occur, is likely to be shallow, or it is also quite possible that a recession is completely avoided, with only a sharp slowdown in growth. While interest rates have increased sharply over the past year, current rates still are at historically low levels and may not be sufficient to precipitate a recession.
One of the biggest risks to the gold market at present is the disconnect between the Fed’s forecasted path for monetary policy and the market’s expectation of what monetary policy will look like over the next year. The Fed has been fairly clear and consistent that it does not plan to reduce rates this year. Nonetheless, the market is projecting a decline in rates based on its expectations of a recession. At least some of this disconnect can be attributed to the Fed losing credibility with the market, when the Fed did not tighten policy soon enough on the belief that inflation was transitory, which then took inflation to multi-decade highs. The Fed is unlikely to reduce rates this year unless there is a drastic decline in inflation or employment, neither of which seems likely at this time.
Furthermore, if the markets are correct and the Fed does need to reverse policy during the last quarter of this year, the Fed’s reason for reducing rates would be important. If rates are reduced due to a recession, it would be positive for gold. However, if the reduction in rates is because inflation has come under control, gold may not benefit as much. What happens to gold, if rates are brought down because of declining inflation, will depend upon how much inflation declines and how much rates are reduced. These two factors determine the impact on real rates. If real rates decline, that is nominal rates decline faster than inflation, then it would be positive for gold. But this is a low probability scenario because inflation is unlikely to decline at a strong enough pace to encourage the Fed to reduce nominal rates aggressively.
The more likely scenario is that inflation moderates, and interest rates are raised and held steady. This would result in real rates rising and prevent gold prices from continuing to rise strongly. Ideally, the Fed would like positive real rates across the yield curve to create a sufficiently restrictive environment to bring inflation down to its goal of 2%, but in reality, the Fed is not going to be able to raise nominal rates sufficiently to create a positive real rate environment without causing the economy to slip into a deep recession. The Fed is, therefore, more likely to hold its rates steady, as it has stated it plans to, until inflation gradually declines, which will cause the real rates to rise and act as headwind to gold prices.
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