Gold Monthly View for September 2023

Recap

International gold prices fell below the key $1900 mark in September even as Jerome Powell and his team left interest rates unchanged as expected, ending the month ~3.7% lower. Weighing on the precious metal were rising US Treasury yields and the US Dollar index which were boosted by the Federal Reserve’s ‘higher for longer’ stance. After the forecasts released by the central bank pointed to one more rate hike in 2023 and just two interest rate cuts in 2024, down from the prior projection of four cuts, there was a strong bullish effect on both the dollar and yields which touched 10-month and 16-year highs respectively. Risk assets retreated pricing in a protracted period of higher US interest rates, which further supported flows into the US currency. The Indian Rupee depreciated by ~0.5%, limiting the downside in domestic gold prices to ~2.9%.

Overview

Based on the Fed’s latest projections, headline inflation will be at 3.3% at year end, compared to June's forecast of 3.2%, falling to 2.5% by the end of next year. Core inflation, which excludes volatile food and energy prices, is now expected to fall to 3.7% by year's end, better than the 3.9% forecast in June. Fed also doubled the GDP growth rate for this year to 2.1% this year, a striking upgrade from the 1% growth projected in June. It also lowered the expected unemployment rate to 4.1% from 4.5% projected in June.

If the US economy does avert a recession as the Fed is expecting it to, interest rates in the US will remain high next year even as inflation comes down, translating into higher US real interest rates. Futures markets are expecting the first rate cut to come only in July 2024. This raises the opportunity cost of holding gold and will be a headwind for gold prices. The so called ‘soft landing’, if manifests as is increasingly being priced in by markets, will also result in flows into risk assets and away from portfolio diversifiers like gold.

However, if the Fed overtightens and the world’s largest economy falters as a result of the most aggressive increase in interest rates in decades, we can expect to see a quick reversal in the Fed’s hawkish stance. Resulting rate cuts and an expanding Fed balance sheet will put downward pressure on US yields and the US dollar and will be bullish for gold. A growth setback will also drive-up risk aversion and attract investor attention to gold.

Outlook

The next couple of months are critical for the US economy. The lagged impact of policy rate hikes will be evident in 2024, as interest rate changes generally work with a lag of 18 months. In addition, historically, US recessions have followed 6-18 months after yield curve inversions, and we are now 12 months into the inversion. As such, the Fed’s current hawkishness could get tested sooner than it anticipates.

While some indicators like Services PMI, Non-farm payrolls and Durable Goods orders are showing signs of robustness, other measures such as Consumer confidence, ISM Manufacturing PMI, Industrial production, Retail Sales & Unemployment rate are showing signs of weakness.

While a big chunk of the housing loans in the US have been fixed at lower levels and hence there isn’t much stress in the housing market yet, the growth in the housing market will be challenged due to prevailing interest rates. Further, at the consumer level, the credit card debt has been ballooning which now stands in excess of 1 trillion dollars will also be unsustainable at current or higher interest costs. Higher interest costs, high debt and dwindling pandemic era savings could bring the consumption driven economy to a screeching halt. If that pans out, the soft-landing rhetoric will soon turn to a growth nightmare compelling the Fed to pivot.

Stagflation risks are ramping up with higher oil prices which are trading above the $90 mark thanks to supply cuts by leading producers. Higher energy prices are vicious as they tend to both hurt growth and propel inflation. US Consumer Price Index showed signs of stickiness in August coming in at 3.7% up from 3.2% in July. The Personal Consumption Expenditure Index too inched up to 3.5% in August from 3.3% in the previous month.

As the Fed’s balance sheet unwinding continues and foreign ownership of US Treasuries continues to fall, a big test for the US economy will be how markets absorb the US Treasury’s expanding funding requirements, driven by a widening fiscal deficit. If supply of US government bonds overshoots demand, yields could move up to unsustainable levels pushing the economy off the cliff and putting the US Government’s creditworthiness into question. The U.S government debt is more than 122% of GDP at 33 trillion dollars and much of this debt will start to come for repricing after 1.5 years. With interest rates increasing fourfold from where they were during issuance, the US government does not have the fiscal room to accommodate such high interest payments. The government will thus force the Fed to look at much lower levels of rates when the roll over starts.

Action Plan

Some of the recent strength in US dollar can be attributed to European and British central banks indicating they are done tightening and the Japanese central bank continuing to be dovish. At the time of writing, markets are pricing in only a 28% and 38% chance of a 25-basis point hike in November and December respectively. Bank of Japan is likely to intervene if their currency further depreciates relative to the dollar. Most importantly, a higher US dollar amid rising US government debt and deteriorating fiscal situation is not justifiable. So, this strength could be temporary and should come off, helping gold.

Higher US Treasury yields are just not the consequence of interest rate trajectory but also now a function of higher US Market borrowing and falling foreign ownership of US Treasuries. Markets are likely to take note of this nuance which could take some pressure off gold.

Most of the negatives are in the price now. This interim period of price weakness can be used to build gold exposure because it is probable that while the threat of more hikes or fewer rate cuts hangs over markets pressuring prices in the near term, prospect of peak policy rates and risks of over tightening will keep this asset class relevant.

Data Source: World Gold Council

Above article is authored by Quantum.

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