Gold and US real rates have long had an inverse relationship. Gold rallied to all-time highs while monetary policy was being made historically accommodative through quantitative easing. Then, as these measures were reduced and the Fed moved towards the beginning of a new tightening cycle a bear market in the metal began, leading the metal to almost halve from its prior highs.
However, gold failed to break to new lows when the Fed announced their first rate hike in December. When new employment data in January showed continued strength in the economy, making future hikes likely to come sooner, the metal again failed to break lower. Financial market mayhem has now made it highly unlikely that there will be more hikes in the medium term, which means that gold has no catalyst drive it lower. Instead, we believe that gold is in fact likely to have a major bullish catalyst this week: The Fed.
Why The Fed Will Not Hike
The rate hike last month was regarded by many, including us, as the beginning of a new tightening cycle for the Fed. However, since then we have seen market concerns around China’s currency devaluation and the future of the inflation situation escalate significantly, leading to mayhem in the financial markets.
This turmoil alone is enough to stop the Fed from hiking again. During the correction last year the Fed chose to not hike rates at their September meeting. The Fed reinforced that the tightening of monetary policy would be with respect to market sentiment with this decision. Investors were assured that the Fed would keep monetary policy highly accommodative and that tightening would be gradual.
This means that the Fed cannot hike during times of tumult in the markets as to do so would cost them credibility, and thus their ability to signal to their intentions. Therefore, it is near certain that the Fed will choose to leave interest rates unchanged at their meeting this week.
Disinflationary Pressures Will See a Dovish Fed
While China’s currency devaluation should not directly affect the Fed’s monetary policy decision, the effects of the devaluation will. The weakening of China’s currency means that other currencies, and in particular the US dollar, are now stronger. This means that US exports are more expensive, which makes them less competitive. The result is that economic growth in the US has the potential to be severely hurt. If growth begins to slow, inflationary pressures will fall also.
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