What happens to gold with rising inflation and central banks in action
by Peter Kinsella (UBP)
After the Federal Reserve meeting on January 26, gold prices fell from around $ 1,840 per ounce to lows of around $ 1,780. The cause of the decline was the marked hawkish turn by the Fed, which plans to raise rates four times in 2022, and has left open the possibility of raising them by 50 basis points if necessary. Markets believe the Fed can go even further this year by deciding five rate hikes.
The US Central Bank will terminate its quantitative easing program in March, and also made it known that a budget reduction program (the so-called quantitative tightening) during the summer. The reduction in the Fed’s balance sheet, through the sale of its bond portfolio, will increase the upward pressure on bond yields, especially in the long part of the yield curve.
The Fed’s position is justified by the fact that the inflationary dynamics has grown significantly in recent months. Headline inflation has reached a level of around 7% year-on-year, although it is expected to peak at 7.4% in March – then, in the remainder of the year, it will decline reflecting the base effect.
The combination of a rise in interest rates and a gradual decline in inflation represents one bad news for gold and other precious metalswhich trade on levels inversely proportional to real interest rates (inflation-adjusted rates).
Much will depend on the Fed’s communication, how determined it is to aggressively raise rates and the pace of any decline in inflation. The composition of future inflationary dynamics will also be important – much of the recent increase is due to rising energy prices and the supply chain – thus explains the Fed’s narrative on so-called “transitional” inflation. However, if inflation were to be caused to a greater extent by aggressive wage growth in the future, the tightening it will be more substantial and prolonged.
Gold, watch out for a possible dip
During the pandemic, investors turned to gold due to increased risk aversion and central bank quantitative easing policies. The withdrawal of these policies around the world poses a limit to the upside potential of gold prices. Still, it is curious to note how investors continue to hold very significant positions on gold and gold futures.
Over the past three years, yellow metal ETFs have seen huge inflows, and assets have grown to around $ 11 trillion. The futures market still shows a significant net long position on gold.
However, if markets were to price a more aggressive tightening pace from the Fed, there would be big risks for gold, because all investors could run for the door at the same time. This is why we believe that there is a risk of a decline in prices up to around $ 1,700 an ounce. Paradoxical as it may seem, the decline in gold, which is currently supported by the current phase of volatility in equity markets, could manifest itself once the latter stabilize.
The change in macroeconomic outlook is a worrying development also for i semi-precious metals such as silver, which trade at a high beta relative to gold. If the yellow metal falls, the silver falls to a greater extent. If the slowdown in China’s housing market continues, this could pose downside risks to China‘silver about $ 18 an ounce.