Where are gold prices headed? Good news seems to be on the way

Let’s consider the possibility of a bear market. In other words, the US Federal Reserve (the Fed) continues to tighten and succeeds in curbing inflation without hurting growth.

The August inflation print in the US was 8.3 percent year-on-year (y-o-y). This was higher than the consensus expectations, but lower than the 8.5 percent registered in July, and 9.1 percent in June.

Although the inflation has moderated a bit, it is far from the central bank's target of 2 percent. Thus, hot inflation numbers would continue to dominate the headlines for months to come, keeping the aggressive tightening window open for the Fed.

Fed Chairperson Jerome Powell explicitly stated during the Jackson hole Symposium in August that the Fed will do everything to combat inflation, even if that means compromising on growth, which may cause short term pain in terms of job loss and negative economic growth.

As anticipated, the FOMC (Federal Open Market Committee) hiked interest rates by 75 basis-points in September and indicated appropriate hikes in the future to tame the inflation.

Rising interest rates led nominal yields to surge, with the benchmark US 10-Year bond trading at 4 percent, before falling to 3.7 percent.

The rate hike has also triggered heightened volatility in equity markets. However, inflation expectations have been moving down after peaking in March (Graph A). This, in turn, has led real yields to surge, with the TIPS (Treasury inflation Protected Securities) yield currently above 1.5 percent, which has increased the opportunity cost for carrying gold.

With attractive bond yields, the US becomes a favoured destination for investments, which strengthens the dollar. A strengthening dollar makes gold, which is denominated in dollars, expensive. This hurts its demand and brings down prices.

Going forward, if the economy digests the tighter policy and the Fed manages to strike a balance between inflation and growth, the so called “soft landing,” we could see a downtrend in gold prices as inflation cools without much damage to the economy, and investors move money into risky assets such as equities.

If markets are bullish

Scenario 1: the Fed over-tightens, pushes the economy into a recession

Since the start of its tightening cycle this March, the Fed has raised the benchmark rate by 300 basis points (bps). It is expected that rates will end the year a massive 425 bps higher than at the start of the year.

Starting September, the Fed has begun to ramp up the unwinding of its $9 trillion portfolio by $95 billion per month. This aggressive tightening has begun to take a toll on the economy. The U.S. economy technically entered a recession by shrinking 0.9 percent (annualized) in the quarter ending June 2022, following a 1.6 percent drop in the March quarter.

The S&P Global US Composite PMI (purchase managers’ index) registered 49.5 in September, the third consecutive month of contraction. The US 10-year-2-year spread continues to remain inverted, solidifying chances of a recession (Graph B).

Gold has historically performed well during recessionary times as there is a flight of money from risk-on assets to gold on the back of risk aversion. If not an outright recession, the US could witness a sustained period of above-average inflation and below-average growth, which too will be supportive of gold prices.

Scenario 2: a slowdown in tightening or a pivot from the hawkish stance to balance growth and inflation

Despite the Fed’s current hawkishness, its conviction to tighten could be tested if the economic numbers show substantial deterioration. The latest Fed Fund Futures data suggests that investors are now expecting interest rates to peak at 4.5 percent in 2023.

The IMF, in its World Economic Update of July 2022, revised global growth estimates downwards to 3.2 percent in 2022, and 2.9 percent in 2023, 0.4 percent and 0.7 percent lower, respectively, than projected in April 2022.

An economic slowdown might compel the Fed to cut interest rates or reduce the quantum of hikes, and abandon or slow down balance sheet reduction. This would be a pivot from the current aggressiveness.

If because of the Fed prioritising growth over inflation, price pressures, which are currently at a four-decade highs (Graph C), spiral out of control or become entrenched, we can see inflation expectations getting unanchored, which, along with lower nominal yields, would bring down real yields and push gold prices up.

So, where are gold prices headed finally?

To sum it all up, gold prices will slip into bear territory only in an ideal scenario of a soft landing for the economy.

However, realistically, that could be very hard to achieve given that a lot of the current inflationary pressures are due to supply-side challenges which show no signs of easing and are beyond the pale of monetary policy, limiting the ability of the Fed to slow down demand.

This makes either over-tightening or premature tightening the more likely scenarios, which, as discussed above, will be bullish for gold. Therefore, regardless of the bull and bear case, to protect capital from macroeconomic uncertainties and financial market volatility, it is recommended to allocate up to 20 percent of one’s investment portfolio to gold.