Gold and the inflation conundrum
16 September 2022
In this week's market report:
Markets fall after higher-than-expected US inflation print
US Federal Reserve set to implement large rate hike next week
Gold hit hard and falls toward key support
Several catalysts could spark turnaround in precious metals
ABC Bullion Market Data Snapshot
Dear Investor,
It’s been another tough week for global asset markets, as US inflation data, which came in hotter than expected, sparked a widespread sell off, with stocks, cryptocurrencies and precious metals all falling after the inflation results were released.
Markets have since pared some of the losses, though gold in particular remains under pressure, down 3% over the last five trading days. Silver has fallen from highs closer to USD $20 per troy ounce (oz) on the 13th Sep, though is still +3% over the last week, with the gold silver ratio falling from 92 to 87.
The weakness in the gold represents a continuation of the trend that dates back almost six months to late March 2022, with gold and silver now -14% and -23% in USD term respectively since the end of Q1.
Gold is now delicately poised, having fallen through what looked like a critical price level near USD $1,680oz, a price that has acted as support in recent times. The precious metal is now almost exactly 20% below the all-time high of just over USD $2,065oz that was seen just over two years in August 2020, as highlighted in the below chart.
(Click to enlarge) | Source_: LBMA, ABC Bullion_
Why did investors react to the US inflation data?
Markets were expecting the headline US inflation rate to decline from 8.5% in the year to end July to 8.1% in the year to end August, while also expecting core inflation (which strips out food and energy) to come it at 6.1% for the year.
They were right in that headline inflation rate did fall, but not as much they were hoping, with the actual result to end August coming in at 8.3%, driven by a very strong core inflation print of 0.6% for the month of August alone (double market expectations for a 0.3% result).
Median and mean inflation results, also continued to rise on both a monthly and annual basis, as evidenced in the chart below from the Cleveland Federal Reserve.
Given the inflation were higher than what the market was expecting, it was little surprise to see stocks, commodities, and cryptocurrencies all come under immediate pressure, as the result raises the likelihood that the US Federal Reserve (Fed) will need to;
Increase rates more aggressively than they otherwise might have, and
Keep rates at a higher rate for longer than they otherwise might if inflationary pressure was falling away faster.
This view around the inflation result, and its impact on interest rates is neatly summarised in the below extract from a recent Bloomberg article on the subject.
Rates traders are now betting the Federal Reserve will lift its benchmark rate by at least three-quarters of a percentage point next week, with some chatter that the increase might need to be even bigger than that after consumer-price inflation data came in hotter than expected.
Some commentators including ex Treasury Secretary Larry Summers are openly suggesting the Fed should consider raising rates by a full 1% at their next meeting, with market pricing now suggesting interest rates will rise to 4.3% in this cycle.
Why hasn’t gold reacted
Given gold’s well-established credentials as an inflation hedge, it’s understandable that some investors may be frustrated the precious metal remains in correction mode, despite the inflationary storm that is currently raging.
There are several points worth noting on this subject.
We don’t think investors should give up on gold as an inflation hedge, as while it hasn’t rallied (in USD terms) this year, its track record in environments that consumer prices are rising sharply is very good. We cover this in detail here
Even if inflation rates do continue to decline, that’s no reason to give up on the precious metal either, as it often does well in low inflation environments too.
Finally, and perhaps most importantly given recent price action, there are several factors that explain why gold hasn’t rallied in USD terms this year, despite the inflation pressure we are seeing. These factors includeA still strong US Dollar, which is up 14% for the year. The importance of the USD to gold price strength or weakness is something we’ll explore in more detail in a subsequent market update, but it’s worth noting that some surveys suggest that investors now believe the USD is the most overvalued on record, while long USD positions are now amongst the most crowded trades. A reversal in fortune for the greenback, which shouldn’t be ruled out, would almost certainly act as a boost for the entire precious metal complex
An increase in nominal and real yields across the maturity spectrum, which has raised the opportunity cost of owning gold. As an example, the US 10-year bond yield has more than doubled, rising from close to 1.6% at the start of the year to almost 3.5% now. The real yield on the same bond has risen from -0.97% to 1.02% over the same time period.
The markets unwavering belief that the current inflationary surge remains a largely temporary phenomenon. This is best seen in breakeven inflation rates in the United States, which have declined significantly in recent months. As an example of this, 5 -year breakeven inflation rate (what the market expects inflation to average over the next five years) has dropped from 3.34% to 2.56% between March and early September, while the 10-year breakeven inflation rate has dropped from 2.88% to 2.44%.
Indeed, on the inflation front, we now face an almost record gap between what the current annual inflation rate is sitting at, and what the market expectation of future inflation, based on the 10-year breakeven inflation rate.
This can be seen in the chart below, which shows the headline inflation rate minus the 10-year breakeven rate (dark gold line), as well as the USD gold price (light gold line).
(Click to enlarge) | Source: ABC Bullion, Cleveland Federal Reserve, St Louis Federal Reserve
This chart highlights that going forward, even if inflation falls a long way, it could still end up being a lot higher than what the market thinks it will fall too. A scenario like that would likely be gold bullish.
Indeed, the only other time we’ve seen an inflation gap anywhere near as large as the one we see today was in the lead up to the Global Financial Crisis, back in September 2008. For the record, gold was trading at USD $884 oz at the time. Three years later it had almost doubled, having climbed above USD $1600 oz by late 2011.
The fact that financial markets aren’t prepared for higher inflation today, coupled with how well gold performed last time we faced a similar discrepancy between current and future expected inflation rates, only reinforces the potential value of holding the precious metal as a safe haven asset and inflation hedge in a portfolio.
Given this backdrop, bargain hunting investors may see the recent weakness in the gold price as an opportunity, and one not to be missed.
A final word on silver
While silver has been in the doldrums alongside gold in recent months, there are signs that the market may be approaching a turning point.
One of these is positioning in the silver futures market, which shows that managed money speculators are net short the metal, meaning there is more money invested that will make a profit if prices fall, compared to the amount of money invested that will make a profit if prices rise.
This positioning can be seen in the below chart, which was created by Kevin Muir, and shared via Twitter
As is clear from the chart, it’s a relatively rare occurrence for managed money to be net short silver, with this positioning evidence of how poor investor sentiment toward the precious metal is today.
What makes it even more interesting is that this is happening in an environment where commercial players using the futures market are net long, which almost never happens.
For contrarian investors, this may be interpreted as a bullish sign. Combine it with silver's outperformance in the last week, and it suggests a meaningful turn in the precious metal market could soon be upon us.
Inside the office this week...
This week we have seen all channels of client interaction increase, with a surge in office foot traffic. The products that drove this strong increase proved to be the ABC 50g and 1kg Gold Cast Bars, whilst the 1oz Silver Britannia led the charge for silver.
Warm regards,
The ABC Bullion Team
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