International gold prices plunged 7% in June as the Federal Reserve signaled that it plans to raise interest rates by 2023, a year earlier than planned. This announcement came on the back of an encouraging economic recovery in the US and higher than expected inflation.
It raised market expectations of future interest rates. Bond yields thus increased, inflating the opportunity costs of holding non-yielding gold. The Fed's hawkish tilt also strengthened the US dollar, putting downward pressure on gold prices.
While tightening monetary conditions spells trouble for gold, the selloff seems exaggerated as the current accommodative policy persists - the Federal Reserve left its benchmark rate unchanged for now at 0% to 0.25% to continue its $120 billion monthly asset purchases. Instead, investors seem focused on the future, even though that future is a good time away.
The two proposed quarter-point interest rate hikes will come in a year and a half and will not bring real interest rates in the green as the central bank will begin catching up on inflation. And as per most market participants, tapering by the Fed is to start only in the first quarter of 2022 and will largely depend on how the economy behaves.
So, what is next for gold?
The pace and extent of policy normalization and the resulting outlook for gold will depend on whether or not the economic and market recovery continues undisturbed and whether or not inflation is transitory.
The US economy is recovering well from the Covid-19 recession, which is not good news for gold as investors increasingly prefer higher-yielding risk assets. With the amount of monetary and fiscal stimulus, the economy is sure to show traction. The question is: will the momentum sustain if the support wanes and beyond the pent-up demand we have seen so far? If there is sustainable growth and the Fed begins to tighten its monetary policy sooner, gold will struggle.
But what if the growth is not sustainable or is prone to downside risks? For instance, the softer job gains seen in recent months have kept US unemployment well above pre-pandemic levels. As such, premature tightening could at the very least throw economic recovery off track. Given the level of indebtedness in the post-pandemic world, even small increases in interest rates could be dangerous. It could trigger an Economic crisis by increasing the costs of servicing debts for businesses and governments and hitting asset prices. It would give good reason to the Fed to not pivot, keeping conditions conducive for gold prices.
New variants and outbreaks of Covid-19, inflation-related turbulence, bursting of bubbles in the stimulus-led stock or cryptocurrency markets, geopolitical and trade tensions are other threats to the economic cycle that could materialize in the future. Taking these into account, we expect to see ongoing allocations to portfolio diversifiers like gold.
To talk about inflation. On the one hand, the current high inflation - the US CPI annual rate jumping to 5% in May, can be taken with a pinch of salt due to the low base effects of April-May 2020, and we could see lower figures going forward. On the other hand, inflation may be more persistent due to structural changes. For instance, generous unemployment benefits in the US are deterring employees from returning to their jobs. Business owners are thus struggling to find workers. Thus, resulting in an increase in wages to attract employees. Moving forward, an increase in minimum wages and employers competing on wages to fill their workforce will feed into higher wage inflation which tends to be sticky and has a cascading effect on the prices and demand for goods and services.
With the background of higher growth and inflation, the Fed insists that inflation is merely transitory. If that is indeed the case, one should not expect significant hikes in interest rates as Fed would not want to risk derailing the economic recovery or increasing costs of servicing the ballooning federal debt. A more dovish Fed than is currently deemed could be good for gold.
And if higher inflation persists longer than the Fed believes, the US central bank will remain behind the curve. The delay in tightening could trigger even higher inflation, pushing real interest rates further down. In this case, gold may benefit from higher inflation and lower real interest rates.
In summary, the improved economic outlook and prospects of Central Bank tightening will prove to be headwinds for gold, limiting its price upside in the short term. But the uncertainty on the growth and inflation fronts and other tail risks to the economic cycle will generally support gold investment and hence prices over the medium term. Investors may use the price dip as an opportunity to build their allocations to this strategic asset.
Disclaimer: Chirag Mehta is Sr. Fund Manager-Alternative Investments at Quantum Mutual Fund. Views expressed are solely that of the author and should not be construed as a buy or a sell advice. This information is purely for information purposes and should not be a replacement for personalized financial advice from a SEBI registered financial analyst.