Fed Policy and Gold

Posted On Monday, Feb 01, 2016

It’s been a tumultuous start to the year for most asset classes. At such times, gold can come to the rescue and so it did this year with gain of close to +5%. Slowing global growth with China in particular, and its currency devaluations are a cause of concern and have the potential to trigger competitive currency wars. The Fed interest rate hike and the rhetoric of more to come has signaled a policy normalization attempt which could put pressure on easy and cheap liquidity. All this much evolving economic concerns weighed on global markets and drove a rush to gold.

The Fed’s policy action will continue to be a dominating driver for gold price. December`s rate hike came in many ways as an attempt to send the message that the economy is chugging along strongly and enough to absorb a rate hike. But the Fed knows that even with a 0.25 percent hike, it`s pushing against the wall as the global economy has just been heavily reliant on cheap liquidity; at least the asset markets.

Post the first interest rate hike in almost a decade, the market is now poised towards measuring the extent of the rate hike from speculating the timing of the rate hike. The Fed forecasts four 0.25% rate hikes in 2016, four hikes in 2017, and three in 2018. Their median forecast for December 2016 was 1.375 percent -- the equivalent of four 0.25 percentage point increases from the current level of between 0.25 and 0.50 percent. Markets never bought that forecast, and they buy it even less after the recent FOMC meeting where in Fed attempted a u-turn by trying to scale back their aggressive tightening stance.

In what was a modestly more dovish tone, the Fed quietly downgraded its assessment of the economy by removing the reference from its previous statement that the risks to the economic outlook were balanced. The Fed took stock of a more perilous international picture that could alter its plans for further raising rates. Fed officials issued a statement after their latest policy meeting that suggested they might reduce the pace of future rate hikes if market losses and global weakness persist. This is intended to lull us into lower expectations as to when the next move is going to come. A plunge in the stock markets and more intensified concerns about China`s slowing rate of economic growth have led to hopes that the Fed would ease off the brake pedal of monetary policy normalization.

Those who want the interest rates to be continually suppressed so that economic activity could be encouraged may not even realize that this is literally the cause of bubble creations, and not that of a productive economic activity. The new money remains with the realms of Wall Street pushing up asset prices rather than helping the real economy. By raising rates, the most that the Fed could do is to undo previous policy errors and help in deflating asset bubbles.

As the global economy continues to limp along, central bankers will look to more easing, even if it isn’t the best solution. The level of divergence in the Fed`s stance compared to the rest of world would diminish or at least stabilize. This would ease the downward pressure on the price of gold. As the Fed walks back their own expectations that should eventually support a rebound in a broader basket of assets closely tied to the value of the dollar.

U.S. economic health is in question, and the Federal Reserve could soon tone down its projections and rhetoric about rate expectations for this year. The U.S. dollar could weaken from its elevated levels as a result. U.S. equities are still trading at high valuations and therefore offer a less attractive option for both U.S. and foreign investors. Thus, investors -may do well to recognize the shifting economic landscape by allocating a portion of their portfolio to gold. In a volatile asset environment and an era of experimental central banking, it’s difficult to forecast whether or not the bottom in gold is seen but this year will likely mark an inflection point in the yellow metal.

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