The price of gold has fallen back after touching near record highs in March and in 2020, and we believe that monetary metal prices are poised to rebound should the US Federal Reserve (Fed) «pivot’’ and ease off its current hawkish path.

 

The Fed has promised to do whatever it takes to tame inflation – which means open-ended tightening. Inflation in the US has been running above expectations – 9.1% y/y in July – and the market has swiftly priced in more aggressive pace of rate hikes. This has brought about a surge in nominal yields — the US 10-year Treasury yield rose to its highest level in more than a decade in June — as well as a strong dollar and a selloff across many asset classes.

By implication, the Fed is saying that real interest rates, or the interest a bond pays after accounting for inflation, will move from deeply negative today to positive in the future. This has hit gold prices, which move inversely to forward real rates. In the forward market investors still presume that current inflation will disappear and all the promised rate hikes will happen. 

Overtightening   

It’s an interesting time for monetary metals bulls like me. Should we believe the Fed? Can the rate setters really do what they say they’re going to do? I’m not so sure. Inflation was the biggest worry for markets through the first half of this year, but what’s starting to dominate market discussions now is the data showing slowing economic growth and the potential for a recession. Many economists are pencilling one in.

 

The worry is that the Fed will overtighten and then have to pivot. A dovish shift by the Fed could be driven by an economic «hard landing’’ or even by data showing further easing of inflation, whereby the Fed says it doesn’t have to raise interest rates anymore.

 

This is where the value of holding alternative currencies such as gold and silver will come good, in my view. Gold and silver are bets that future real rates are not going to rise as much as the market thinks because the Fed won’t be able to pull it off. 

Too painful 

The most likely scenario in my view is that economic conditions get sufficiently weak so that continuing to hike rates becomes too painful. This scenario is likely to result in rate expectations dissolving in the yield curve more quickly than inflation expectations.

 

A hard landing or recession won’t necessarily make inflation go away – think about stagflation. On the other hand, rate hike expectations would disappear pretty quickly, in my opinion. That would be good for gold and silver.

 

It’s worth noting that the price of gold priced in dollars has declined in part due to the dollar’s strength in foreign exchange markets this year. Gold priced in yen, euros and sterling remains very elevated. 

Breaking through 

We are back at historic lows of participation in the gold market. That creates the best kind of entry point for investors, in my view. Gold is trading around $1,700/oz and to get to $2,100/oz, as it was in March, it would again be challenging the inflation-adjusted all-time high. I think that gold has a very good chance of breaking through the $2,100/oz record. Records are made to be broken, and dollar strength will not last forever.

 

The market is motivated by waves of hawkishness and waves of dovishness. Looking ahead, I think the conditions are right for a move back to a more dovish environment and a Fed pivot. That’s why I believe it’s the perfect time for prudent investors to own gold and silver. 

Falling real yields mean a higher gold price

Source: Bloomberg, as at 31.05.2022

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