- As inflation falls and nominal rates are expected to rise, the outlook for gold is weak
- The Fed seems committed to another hike in December, leaving inflation as the key factor
- If Trump delivers the goods, expect gold prices to be supported
With tensions in the Korean Peninsula and doubts about another rate hike in the rear view mirror, gold has been selling off after peaking above $1,350. Given expectations that the Federal Reserve is looking to raise interest rates in December, the market has been eagerly anticipating today’s non-farm payrolls figures. As the Fed is mandated to maintain full employment, markets are particularly keen to understand how the Fed will interpret today’s big miss.
As reported earlier, non-farm payrolls numbers were expected to be heavily impacted by the recent hurricanes, and this turned out to be true. Despite today’s payrolls numbers missing expectations, Dallas Fed President Kaplan recently commented that labor markets were tightening. Now that the Fed has rationalized today’s poor jobs numbers as weather-related, a hike in December continues to look fairly likely.
Rising or falling real rates? That is the question
Gold has historically traded inversely to US inflation-indexed interest rates. In short, gold becomes less attractive relative to bonds as after-inflation yields rise, while becoming more attractive as after-inflation yields fall. Gold peaked in 2012 and has since made its most recent bottom at the start of 2016. This can be clearly seen in the graph below.
Gold rises and falls with real interest rates
With the Fed looking to ‘normalize’ interest rates, the outlook for gold depends on how inflation behaves in the near future. If inflation continues falling in rate-of-change terms for the rest of 2017 and the Fed raises nominal interest rates in December, real rates will rise. This should cause gold to fall and prices may re-test the previous bottom.
However, if the Fed is correct in its outlook for rising inflation in the near future (despite falling below target for most of 2017), then rising nominal rates may be matched by rising inflation. In this scenario, gold prices should stay stable and continue trading in a range. Thus inflation is the key variable today that will ultimately influence gold prices.
Inflation about to change its trajectory?
Looking at recent inflation data (below), US Consumer Price Index figures have been trending downwards since peaking earlier this year. While the impact from the hurricanes is clouding the outlook for Q3, year-over-over inflation continues to trend downwards. If the current trajectory for inflation changes after the expected Fed interest rate hike in December 2017, gold prices are likely to be well supported near current levels.
Low and lower: year-over-year inflation falling in 2017
As we discussed on our thought piece on crude oil, future inflation is highly dependent on expectations of increasing government spending. Thus progress in enacting Trump’s economic agenda (and particularly his tax reforms), will be critical for gold. Beyond substantial government spending (or war), there are few obvious catalysts today that can change the trajectory of inflation today. Year-to-date crude oil prices remain lower, while price growth in many inflation components such as healthcare continue to fall.
If Trump fails to deliver his fiscal agenda, the Fed may raise interest rates into falling inflation, causing gold to fall further. However if Trump delivers even a portion of his promised tax reforms, gold prices can stay supported on rising inflation expectations.