Gold goes through uncanny idiosyncrasies with different measures as per the US interest rate, popularly termed as Fed rate. The central monetary authority of USA, Federal Reserve, carries out the task once a month to drive global financial markets with its decision. When global recession hits USA, it reverberates across the globe as in the example of 2007-2008 when Federal Reserve acted swiftly imposing various tools at its disposal to reverse the harrowing effects. One of the tools was to lower the Fed rate which was sitting at 5.25%. In January 2009, the Fed rate was lowered to 0.25%, the lowest in decades. However, since December 2015, due to the strengthening numbers in the US economy, the Federal Reserve has increased the rates eight times with the latest hike coming in September 2018.
From late 2007 to 2011 Fed rates declined continuously resulting in the appreciation of gold. Since 2011, apart from sporadic bursts of increase, the prices have declined sharply. The Federal Reserve’s efforts to avert the US economy from overheating threatened to squash any rally hopes among the gold bulls, at least for the time being. Many market analysts expect another Fed rate hike in December 2018.
While the US standard rates marched higher, the yield on the 10-year Treasury note touched 3.24% in the early days of October, the highest in seven years. An appreciable number of analysts predict further downside for the gold market with the outlook for even higher interest rates and higher real yields dampening the appeal of the bullion.
For decades, traders and market practitioners have observed the bullion market’s performance against the benchmark interest rates. Gold is considered a safe haven against global uncertainties, so it is a good place to park money during the broader market turmoil.
The difference between nominal and real rates, inflation-adjusted rates is critical as is the opportunity cost calculus of gold versus fixed income assets. When the nominal interest rate is high because inflation is high, the real rate of interest turns low. Analysts opine that this is a good time to hold gold since the real return on the bonds was low. The opposite was true in the 1980s when the real interest rates coupled with the opportunity cost of holding gold was high. If the rates are rising even holding cash could generate higher return for traders as compared to gold.
In hindsight, there is a large bearish divergence between the London traded bullion prices and the real US five year rates. As gold prices fell and the rates increased, the gap between the two in recent days reached its widest point since late 2017. In the longer term, the markets could experience further upside in real yields and hence the further downside for the bullion.
Market pundits have opined that the gold market may be bottoming out in the short-term since central banks had stepped up purchases as prices fell. According to World Gold Council, the global central banks added a net total of 193.3 metric tons of gold to their reserves in the first half of 2018, an increase of 8% vis-à-vis the same period in 2017.
With the Federal Reserve continuing its stance of policy tightening, the bullion is likely to remain under pressure till the end of 2018. If the recent turmoil in the emerging markets continues to spread to other countries, it will only add more fuel to the fire leading to the strengthening of the greenback and consequently weakening of gold.
On the contrary, economic cycles and Fed tightening cycles will eventually run their course. In the future, the Fed will stop raising rates along with running the risk that the central bank might have run far ahead past the finishing line with a point of no return.
Vivek Risal is associated with Mercantile Exchange Nepal Limited in the capacity of Manager in Research and Development Department. He can be contacted at email@example.com