Gold Prices And A March Rate Hike: What’s Next?

Following yesterday’s statement from the Federal Reserve, the odds of a rate hike are soaring according to the CME’s FedWatch tool. The current market-implied probability for a hike on March 21, 2018 (the next Fed meeting) is 83.1%. One month ago, on December 29, 2017, the odds of a March hike were just 50.7%. According to prevailing wisdom, the Federal Reserve has significant control over monetary conditions. By raising interest rates, the Fed increases the cost of short-term borrowing, thereby making US dollars more expensive to borrow. All else being equal, the US dollar should strengthen accordingly. In turn, gold should weaken in response.  

Given the history of gold and the US dollar, we argue that this simple logic is not particularly helpful when forecasting gold prices. For now, the US dollar remains in a bear market, and gold is likely to continue making new highs over the longer term as a result. Despite rising US yields, the dollar has been languishing relative to foreign currencies and commodities. As “nothing moves in a straight line”, the gold bull market will certainly face speed bumps along the way. This being said, the overall trend for the precious metal remains bullish.

Strong ex-US growth + easy financial conditions = US dollar bear market

In a previous article, we illustrated why the US dollar tends to sell off during global economic booms. In short, this is a natural occurrence given the US dollar’s function as the world’s reserve currency. More specifically, the US dollar is a liability currency, meaning it is borrowed heavily for cross-border investment purposes. Approximately 2/3 of all cross-border lending is dominated in USD. When optimism for global growth accelerates, investors borrow US dollars and chase international investment opportunities. This issue is compounded by the fact that the currency is made available very cheaply via offshore lending markets (known as the “Eurodollar” market). When economic conditions are benign, Eurodollar credit taps flow freely. As more and more US dollars chase investment opportunities, the currency weakens relative to assets such as gold.