- Gold continues to sell off from its most recent highs above $1,300 and looks weak
- When growth and inflation are both accelerating, gold tends to weaken as real rates rise
- The economic backdrop is starting to resemble Q4 2016, and that's bad for gold
As gold continues selling off following its latest high above $1,300, the medium-term outlook for the precious metal today looks bleak. As we have mentioned a few times in the past, gold is highly sensitive to real interest rates. In forecasting gold prices, one has to correctly identify the trajectory of inflation in rate-of-change terms as well as future interest rates. Together, these ingredients determine the real interest rate. Gold’s inverse relationship with real interest rates is illustrated below, which shows gold prices relative to 10-Year US Treasury Inflation-Indexed bond yields:
Clear inverse relationship between real interest rates and gold
Even if the next Fed Chair is a dove, economic backdrop is negative for gold
Looking at the immediate future, real rates looks set to rise thanks to accelerating US GDP growth and rising inflation. Although the current debate regarding the future Federal Reserve Chair is relevant for gold in the short-term, the precious metal can fall in the longer term even if Trump selects Jerome Powell to lead the Fed (who is known for advocating relatively low interest rates). This is because the Fed has historically hiked rates more aggressively in an environment where both economic growth and inflation are accelerating simultaneously.
In our previous take on the next US Fed Chair debate, we argued that the Chair usually has a limited influence on the direction of monetary policy, given that monetary policy decisions are subject to a vote by members of the Federal Open Market Committee. We would argue that rising real rates look inevitable regardless of who is selected to be the next Fed Chair.
Strong growth = all-clear for the Fed
Today’s Q3 GDP announcement shows that year-over-year growth is currently tracking at 2.3% (the reported figure of 3% in the media is the annualized quarter-over-quarter figure). Since Q2 2016, when growth bottomed at 1.2%, US GDP has continuously accelerated in rate-of-change terms. Forward-looking economic indicators such as survey data (PMIs), capital expenditures and industrial production all suggest that strength in the economy is set to continue.
As the Fed digests accelerating growth and falling unemployment rates, the likelihood of future rate hikes is increasing. Looking at the odds for a December hike, almost 97% of futures speculators are betting that the Fed will hike rates by another 0.25%.
Crude oil and tax reforms = accelerating inflation
While Janet Yellen has been perplexed by accelerating growth coupled with decelerating inflation for much of 2017, this phenomenon is likely to be nearing its end. In a commentary we published earlier this week, we argued that the lack of crude oil supply is likely to keep prices strong. Given the significance of crude oil in the broader economy, higher crude prices eventually work their way into the broader economy, resulting in higher prices for most goods and services. As crude rebounds from its lows from last summer (when WTI traded under $45 per barrel), CPI figures are likely to shoot up in Q4 2017 and beyond.
Beyond crude oil, Trump’s tax reforms are also looking more and more likely. Now that the House has passed the budget resolution, the odds of Trump getting tax reforms through the Senate have significantly increased. While markets have been skeptical of Trump for most of 2017, this looks set to change as inflation expectations start to rise.
Similar to what was seen in Q4 2016, growth and inflation are once again set to accelerate in tandem. As markets prices in a more aggressive Fed and rising real rates, gold is more likely to fall for the remainder of the year. Thus a trading strategy that goes short when gold hits overbought conditions is more likely to make money than going long the precious metal.