Gold loses to its nemesis: The Fed

BY DEB SHAW | 

After hitting its most recent peak above $1,350 in the second week of September, gold has since weakened and is now down below $1,300. The precious metal earlier rallied on expectations that the Federal Reserve’s ‘dot plot’ would be forced to yield to the reality of low inflation. Yet Fed members including Chair Yellen have re-iterated wariness regarding hiking “too gradually”, strongly hinting that another rate hike is in store for 2017. Unlike previous years, where the Fed has lost to low inflation, this time it is determined to hike.  

Given gold’s sensitivity to real rates, it has unsurprisingly weakened on rising expectations of another rate hike. The precious metal first fell below $1,300 on September 26, following Yellen’s last speech. Despite disappointing Core PCE figures last Friday (the Fed’s preferred measure of inflation), gold has continued to fall and is now trading just above $1,275.

 

Low inflation = gold higher?

Gold typically rallies on falling rates of inflation, as markets reduce their expectations of future interest rate hikes. Yet 2017 is shaping up to be an interesting year, with the Fed Chair determined to hike despite inflation far below the Fed’s 2% target. Earlier in 2017, Yellen dismissed low inflation as “transitory”, explaining that inflation was below target due to one-time price decreases in areas such as telecom services. In her last speech, she went further by suggesting that the Fed’s understanding of what drives inflation may not be correct (calling it “misspecified inflation dynamics”).

With the Fed willing to overlook low inflation, it is no surprise that gold has been spooked. An overview of historical US CPI figures are shown below. The last reading for CPI in August 2017 was 1.9%. 

Inflation far from recent peaks, and even farther from the Fed’s target

10-2-2017
Source: US Bureau of Economic Analysis

 

Where to from here?

Whether or not gold can achieve new highs or fall much lower will ultimately depend on the path of future inflation. Looking at the chart above, gold has sold off when inflation has increased in rate-of-change terms while strengthening on falling rates of inflation. This is because the Fed tends to hike rates when inflation is high while lowering rates when inflation is low. 

If the Fed is right, today’s low inflation is indeed “transitory” and inflation rates are at the cusp of an inflection point. Thus gold can go much lower from here if strong inflation is around the corner. If the Fed is wrong, gold’s recent fall is a head fake (as prices 'never move in a straight line') and markets should anticipate a gold rebound in the near term. Looking at a daily chart of the precious metal, gold has already experienced a small rebound after looking oversold earlier today.

Today, inflation rates around the world remain weak. Only time will tell whether or not gold's sell-off is the right path forward for the precious metal.

Topics: Gold