The US treasury yields have been rising rapidly at the start of 2022 and with rates currently on hold at 0.25% and inflation running above 6%, the real yields are negative. This has been good for gold over the last 18 months but what happens when the US Fed starts its rate hike cycle?
Commodity Analysis - Gold
There are several factors that determine the price of gold, making it especially difficult to predict the next rise and fall in the precious metals markets. Supply and demand are obvious factors as when there is greater supply than demand the price falls. Vice versa for when demand outstrips supply. It is however the speculative factors that move gold prices more on an intraday to medium-term basis.
Gold is priced against the US dollar, though some would use the Aussie or euro. But fluctuations in the greenback as it is the global reserve currency move the precious metals as it does to all commodities. Bond yields, politics, and central banks' monetary policy also greatly affect the price of credit which is reflected across all goods and services. The real yield may have the greatest impact on gold prices and just from observing a chart, we can see that the relationship is inverse.
Real Yields vs. Gold
This graph compares the dollar price of gold with the ten-year real yield. They are negatively correlated. From the above chart since the Global Financial Crisis of 2008, there is no doubt that gold and real yields move in opposite directions.
Inflation-adjusted real yield measures the actual return of a bond or any interest-bearing asset. If a bond yields 2%, but the inflation rate is 3%, the real yield on that bond is negative. In such cases, inflation has reduced the value of the asset by more than it yielded. The real return on a bond yielding 3% is 5% if the economy experiences 2% deflation (-2% = the opposite of inflation). Due to deflation, the asset's value has increased along with its yield.
A decline in real yields leads to an increase in gold, and a rise in real yields leads to a decrease in gold. This relationship explains why inflation is gold's best friend, but rate hikes are its worst enemy.
When interest rates increase, real yields also increase assuming inflation starts to drop. Higher rates tend to enhance the value of the dollar by making it a higher-yielding asset, which may have been priced in by the market when we look at the rise in the US dollar index since the Fed became more hawkish in June 2021.
Currently, the price of gold is hovering around the $1800/oz price level. The expectations are that the US Fed will raise rates after the March 2022 meeting and possibly at the March 2022 meeting if they are able to taper their asset purchases quick enough.
The schedule for the 2022 FOMC meetings will be May 3rd-4th, June 14th-15th, July 26th-27th before moving into September, November, and finally December. The US mid-term elections are on the 8th November 2022, so it is unlikely that the Fed will want to be seen to give any political side a talking point or edge, so I think it is unlikely that any policy adjustment will happen around the September meeting and definitely not in the November meeting which is the week before the mid-term elections.
That would leave a possible March, but a more likely May, June, or July window of opportunity to raise rates. Analysts predict that there could be up to 3 rate hikes before the end of 2022 after the latest FOMC dot plot from the December 2021 summary of economic projections.
The Federal Reserve left interest rates unchanged in December but are ending the QE asset purchases before May and are signaling the prospect of three interest rate hikes next year rather than just one. Upgraded GDP and inflation forecasts show the Fed feels the economy can weather the Omicron storm and the latest observation of Omicron is that the latest variant is not as severe as Delta but is the dominant variation currently.
The CME Fed watch tool expresses the current market predictions on when and by how much the Fed will raise rates over the coming months.
Inflation, as measured by the CPI and PCE indices, is at levels not seen since the early 1990s. At 6.8% inflation has been increasing since the 2020 COVID-19 crash and the monthly rise at the last reading was 0.8%. The current level of interest rate is 0.25% so using the calculations for real rates, the US real yield is -6.55%. This means you need to find an asset or security that yields above 6.55% to break even and not lose any real wealth.
The Fed had been talking about inflation as being transitory and that they expect to see inflation dropping over the course of 2022. But recently they began saying that the higher levels of inflation are likely to stick around for longer. If the FOMC raises by 25 bps at the first-rate hike announcement and inflation hasn’t come down, we’d still be witnessing negative (-6.30%) real rates.
Gold had been a good hedge against the dropping real rates as the yellow metal delivered a 27.96% return in 2020. Unfortunately, it returned -4.2% in 2021. A negative return compounded with a rising US dollar and dropping real interest rates dropped the price of gold into a $200 trading range.
All of this is happening ahead of the Fed raising rates, which does not bode well for gold in the short run. US benchmark yields will rise and so will real yields if the Fed raises rates quickly and inflation drops rapidly. Then gold will probably plummet. For some reason, if the Fed does not raise rates and inflation continues its exponential rise (the trend points to 8% inflation), gold stands a chance of rising in the inverse relationship as we have seen for the past 14 years.
I would recommend trading smaller trading ranges on smaller time frames due to the many unknowns. On the H1 chart, the downside is below the support level of $1798/oz. The upside reversal trigger is above $1821/oz. The only problem with going long or short at those levels is that there is a swing low and high very close by. The other trade to look for would be for the 50-period mid-level to hold at $1815/oz as resistance to go short or for the break higher of the significant swing high at $1831/oz
While we are waiting for the latest economic data to show the direction of inflation and rates, we should concentrate on the US dollar.
The US dollar index on the H1 chart had made a new higher high this morning and at the end of yesterday a new lower low. This means we need to wait for some more price structure to form. Ideally for those looking for a decline in the price of gold, you would see the US dollar index making higher highs and higher lows.