Posted On Monday, May 08, 2023
Gold, barring some rangebound movement, held its ground for most of April as markets seemed to have priced in the Federal Reserve’s “final” rate hike in this tightening cycle to come in on May 3rd.
In the background, the US economy continued to witness mixed macros.
Headline inflation in the US cooled to 5% in March from 6% in the previous month. This reading was the lowest since May 2021. On the other hand, annual Core CPI edged higher to 5.6% from 5.5% in February. In the 12 months ending March, the Personal Consumption Expenditure index increased 4.2% after climbing 5.1% in February.
The March jobs report revealed that Nonfarm Payrolls rose by 236,000 in March, slightly below the market expectation of 240,000. Additionally, the Unemployment Rate edged lower to 3.5% from 3.6% while the Average Hourly Earnings, edged lower to 4.2% from 4.6%. The number of job openings in the US dropped to a nearly two-year low.
Consumer Confidence Index declined to 101.3 in April from 104 in March, the lowest reading since July 2022.
GDP growth expanded by an annualized rate of 1.1% in Q1, missing estimates of 2.0% growth and way below the 2.6% growth seen in Q4.The ISM Manufacturing PMI indicated contraction, but at a softer pace, edging higher to 47.1 from 46.3.
On the other hand, earnings season in the US was good. Majority of consumer facing companies, especially tech companies, did not see much weakness. But renewed concerns about the health of banking sector eclipsed the positive earnings.
Following the bank collapses in March, bank stocks in the US came under pressure again in the final weeks of the month after deposit outflows from First Republic Bank saw its stock price plunge. This is the second-biggest bank failure in US history and the fourth regional bank collapse since March stirring fears over the health of the sector. Things seemed to calm down when the bank was taken over by JP Morgan, though only till other regional lenders sank on concerns of contagion. The ongoing stress in the US banking system because of the aggressive rate hiking cycle has stirred risk aversion, weighed on US Dollar and Treasury yields and helped gold rediscover its momentum.
Hawkish comments from the European Central Bank policymakers boosted the Euro, hurting the US Dollar, and supporting gold.
Chart: Gold is inversely correlated to the strength in the bank sector; ceteris paribus
Source: Bloomberg; Data as of May 4th, 2023
Past performance may or may not be sustained in the future.
The de-dollarization trend got a fillip with many countries in Asia, Europe and Latin America attempting to break away from the dollar’s dominance by entering into bi-lateral agreements to settle trades in their currencies instead of the US dollar. This also weighed on the US currency and supported the yellow metal.
International gold prices closed the month at $1983 per ounce, 0.20% higher. Rupee appreciated by 0.50% as weakness in Dollar continued, pushing domestic gold prices up by 0.30%.
Concerns about the US Debt ceiling grew after US Treasury Secretary Janet Yellen warned the US government could default on some of its payments by June 1st if the debt limit is not increased. This hurt sentiment and weighed on US dollar and US Treasury bond yields as there is less than a month for policymakers to reach a resolution.
As expected, the Fed hiked rates by quarter point to 5.0-5.25%, the highest level in 16 years. The FOMC statements hinted at flexibility and opened the door to a pause by dropping “some additional policy firming may be appropriate” and instead saying future interest rate decisions will be made on a meeting-by-meeting basis. This was considered dovish by markets. Gold prices jumped up to $2060 levels in reaction. Powell however refrained from confirming a pause in rate hikes in June and dismissed rate cuts in 2023 given their view that it will take some time for inflation to come down. The FOMC also reaffirmed that it will continue to trim its balance sheet according to plan. Gold settled lower at $2040 levels post the Fed meeting as markets digested the comments and profit booking kicked in.
Outlook for May
We agree with market consensus that a Fed pause after May is likely. Worries about the impact of rising interest rates on financial stability will probably lead the Fed to be cautious hereon and possibly stop hiking sooner than they’ve been communicating. According to the CME Group Fed Watch Tool, markets are pricing in a nearly 90% chance of status quo from the Fed in its next meeting in June. Markets are also pricing in 3 rate cuts totalling 75 basis points in 2023, with the first cut coming as early as July, up from 2 that were being priced in prior to the collapse of the First Republic Bank.
After almost halving headline inflation over the past year, the Federal Reserve is finding it tough to cool inflation further. While food and energy prices are down, services inflation continues to be sticky. In case the Fed decides to act on its “prepared to do more” statement and proceeds with another hike, it risks overtightening and damaging the economy. While the unemployment rate hasn’t moved up, there is some negative momentum in the labour market. If this momentum gathers steam, joblessness could fast spiral out of control. The risks of a downturn have also risen following the collapse of regional US banks, which has tightened credit conditions further. This could result in a sharp, sudden pivot by the Fed over the coming months, similar to its reaction during past instances of financial market instability, emanating from macro concerns this time. A policy pivot with the background of sticky inflation will be an ideal environment for gold.
With visibility on peaking of interest rates, headwinds for gold look limited as the probability for US Treasury yields and US Dollar to move higher from here looks low. In the short term, markets will continue to readjust its view on expected interest rate trajectory and will continue to rally on any compelling signs of slowing growth, instability in financial markets and thereby a dovish fed.
In the medium to long term, the risk-reward dynamics look favourable for gold as we approach the end to monetary tightening, lower Treasury yields, a weaker US Dollar and deterioration in economic conditions.
Data Source: World Gold Council
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