The price of gold exploded, the Fed is losing market confidence – FAEI.cz

Around October 2022, a bullish trend started for gold after a sharp decline in the same year due to rising interest rates from the US Federal Reserve. This bullish trend continues to date and the price of gold has just exploded above the upper edge of the growth channel to 2,280 US dollars per troy ounce (more than 1,700 CZK/gram).

What is behind it? Probably three factors: Central bank purchases, a developing market, and the Fed’s declining credibility. By all accounts, it looks like this trend may continue for years to come.

How to perceive gold?

Gold can be seen as two things: As a commodity and as a currency. Gold is a commodity in the sense of using the metal for industrial purposes, for the production of jewelry, decorations, etc. It is a currency in the sense of a historically reliable store of value.

If we stick to the second point of view, then in the modern monetary system the attractiveness of gold is assessed in relation to the real returns of individual currencies, especially the US dollar. The real return on the dollar is determined by the amount of US corporate and government bond yields (which are dependent on Fed interest rates, author’s note) adjusted for inflation.

So if the 10-year US Treasury bond is now yielding 4.2 percent per year, how can one justify a preference for gold, which has a negative return against mainstream currencies (investors pay for safety). This can be justified, for example, by the fact that inflationary expectations have risen.

Then, in the eyes of gold buyers, the real return on the US dollar is lower and the negative return on gold is milder, so they decide to buy gold. So is the meteoric rise in the price of the yellow metal this year a reflection of higher inflationary expectations?

We believe that partly so. Higher-than-expected US inflation data in January and February and a dovish Fed are factors leading to rising inflation expectations. However, geopolitical disputes and central banks’ purchases of gold at a multiple rate in recent years compared to the pace before the pandemic also play a role.

The US dollar is perceived as a riskier currency after the sharp decline in the value of US government bonds in previous years. Central banks are therefore diversifying this risk and very slowly replacing “risk-free” US government bonds with gold. So do the residents of developing countries, who now perceive the US dollar as riskier and the only alternative for them is often gold.

The average consumption of the yellow metal is also growing due to the growing wealth of developing countries. In China, however, as a result of poor developments in the capital market and the economy, more and more consumers are seeking refuge in gold, according to a survey by Goldman Sachs.

The Fed is losing credibility

The market is looking at the actions of the US Fed with increasing skepticism after the latest release of the dovish Macroeconomic Forecast (SEP) and the related press conference by Fed Chairman Jerome Powell.

To the surprise of many market experts, the Fed has so far ignored the highly relaxed financial conditions this year (increasing credit availability, strong stock growth, irrational behavior around tech stocks and cryptocurrencies). In addition, it also refuses to attach importance to slowing goods disinflation and higher-than-expected inflation in the US for the months of January and February.

Jerome Powell argues that financial conditions are not loose and inflation may be falling despite the aforementioned, as it was last year. However, the economic recovery, the growing confidence of consumers and entrepreneurs, markets at record highs and now inflation, which is growing above expectations, is making some market participants nervous.

Usually, when the central bank loses credibility, it can be traced, for example, to rising nominal yields of government bonds or inflation-indexed bonds. Although both have been growing at a moderate pace in the United States since the beginning of the year, there has been no significant increase now.

However, as we have seen all of last year, the US government is manipulating the bond markets and keeping yields on longer-dated government bonds artificially low. It does this simply by massively issuing bonds with very short maturities, thus reducing the supply of those with longer maturities. So the question is how credible is the development in the bond market now.

However, what is more difficult to manipulate is the gold market. The Fed, and therefore the US government, can issue any amount of bonds at any time and thus affect their yields. But this cannot be done with gold. So gold is ahead and predicts that real yields will fall (whether due to high inflation or falling interest rates)?

Perhaps a combination of both, if the Fed refuses to push inflation down and starts to loosen monetary policy this year, we think that could lead to a significant increase in inflation. Therefore, a healthy Fed will not make such a decision, and this year we can talk about at most one reduction in interest rates, and that is towards the end of the year.

However, gold is skeptical of the Fed. This is one possible sign of the Fed’s declining credibility. That gold is reacting to the Fed could be seen, for example, after Jerome Powell’s latest speech (March 20 this year)when gold responded with a steep rise of up to 50 US dollars per troy ounce in one day.

The author is an analyst at BH Securities
(Editorially modified)