Gold And Japanese Yen Should Rebound As December Fed Rate Hike May Be Unrealistic

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Summary

The U.S. dollar index, or DXY, has skyrocketed since the beginning of October from the talk-up of a Fed rate hike.

The Fed downgraded U.S. GDP 2016 and a mixed bag of economic reports has been released by the government since late September.

A December rate hike by the Fed may be unrealistic if the U.S. economic outlook continues to deteriorate.

The U.S. dollar index appears to be overbought and overvalued. Gold and the Japanese yen should begin to rebound.

Concerns about a Fed rate hike and the announcement by the U.K. Prime Minister Theresa May that she and her government will trigger Britain's exit from the European Union, Article 50, by the end of March 2017 and begin two years of formal negotiations, have put buying pressures on the U.S. dollar and selling pressures on the Japanese yen and gold. The U.S. dollar index, or DXY, a weighted index of the value of the U.S. dollar relative to a basket of six major currencies and practically the USD/EUR exchange rate, has skyrocketed since the beginning of October and about to break out to retest the 100 level.

US Dollar Index Techncial Chart Click to enlarge

Both the JPY/USD exchange rate and gold price, which show a positive correlation (+0.90) over a 200-day period, have been on the rise since the Federal Reserve raised the target range for the federal funds rate by 25 basis points on December 16, 2015 to a range of 0.25% to 0.5%. Despite a recent sharp pullback, the Guggenheim CurrencyShares Japanese Yen Trust ETF (NYSEARCA:FXY) is up about 15.33% year-to-date, while the SPDR Gold Shares (NYSEARCA:GLD), which tracks the performance of the price of gold bullion, is up 18.58% so far this year.

JPY/USD Gold Correlation Click to enlarge

The minutes from the September 20-21 Federal Open Market Committee, or FOMC, meeting, released last Wednesday, revealed that among the voting members who supported waiting, the rate decision at the meeting was a close call as several said a rate hike was needed relatively soon if the labor market continued to improve and economic activity strengthened.

The Fed now says that U.S. GDP 2016 will only be in the range between 1.7 and 1.9%, instead of 1.9 and 2.0% previously forecasted in June, while the unemployment rate would rise from 4.7 to 4.9% this year, compared to the prior forecast of 4.6 to 4.8%. The Fed kept its expectations for personal consumption expenditures, excluding food and energy, or core PCE, inflation and the federal funds target rate unchanged at 1.6 and 1.8%, and at 0.6 and 0.9%, respectively, for this year, but cut the median federal funds target rate to 0.6% from 0.9% previously, meaning at least one possible rate hike in December.

Three out of ten FOMC members, including Esther L. George, Loretta J. Mester, and Eric Rosengren, dissented and preferred to increase the target range for the federal funds rate by 25 basis points at the meeting. George and Mester argued that the Fed could risk its credibility by waiting too long, while Rosengren believed that a failure to move now could require the committee to raise policy interest rates at a faster and more aggressive pace later on, which could shorten, rather than lengthen, the duration of the economic expansion.

DXY Gold Convergence/Divergence Click to enlarge

The Federal Reserve rate hike talk-up has put downward pressure on the Japanese yen and upward pressure on the U.S. dollar index, where gold prices have a negative correlation with the DXY.

Gold Technical Chart Click to enlarge

From our viewpoint, the U.S. dollar index, with RSI at the 70 level, is overbought and overvalued in light of the Fed downgrade of the U.S. economic outlook and the mixed bag of economic data released by the government since late September. Gold just bounced off the lower trendline of the symmetrical triangle chart pattern and may be heading for a breakout at the $1,320 per ounce level, while the USD/JPY currency pair could pull back from the trendline resistance, putting selling pressure on the U.S. dollar.

USD/JPY Technical Chart Click to enlarge

A December Fed Rate Hike May Be Unrealistic if the U.S. Economic Outlook Continues to Deteriorate

The Federal Reserve's statutory objectives for monetary policy, established by the U.S. Congress in the Reform Act of 1977, can practically be summed up as follows: maximum employment, stable prices and moderate long-term interest rates, which may be achieved by targeting an inflation rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, or PCE.

Maximum employment is vaguely defined by the Fed but is benchmarked with the natural or normal unemployment rate, a combination of frictional and structural unemployment, to determine if the level is achieved. As of September 2016, the FOMC estimates the longer-run normal rate of unemployment to range from 4.5 to 5.0% and have a median value of 4.8%.

Earlier this month, the U.S. Labor Department released a disappointing September nonfarm payrolls report, showing a seasonally adjusted increase of 156,000 jobs that missed Wall Street economists' median forecast of a 172,000 gain. The U.S. unemployment rate jumped to 5.0% in September, as the labor force participation rate increased to 62.9%, meaning some 94 million Americans are not in the labor force. The number of people who are not in the labor force but want a job now, climbed to 6.09 million in September from 5.83 million registered in August.

U.S. Total Nonfarm Payrolls Click to enlarge

Total nonfarm payrolls grew 1.71% year-on-year to 144.75 million during the third-quarter 2016, the slowest since the second-quarter 2014. Hourly wages have been growing steadily to $25.74 per hour in the third-quarter 2016 at a compounded annual growth rate, or CAGR, of 2.53%, despite a rise in minimum wages in some states and cities. The slowing in payroll gains and modest pickup in wages could be because the labor market had little or no remaining slack, as suggested by some FOMC members. Core PCE in the second-quarter 2016 grew just 1.61% on an annualized basis, well below the Federal Reserve's inflation target of 2%.

JOLTS Click to enlarge

The Labor Department said last Wednesday that their Job Openings and Labor Turnover Survey, or JOLTS, data carefully watched by Federal Reserve Chair Janet Yellen, showed a 6.7% drop in job openings to 5.44 million in August from 5.83 million in July. There is a warning sign of a weaker job market, as the decline in job openings, about 223,000, occurred mostly in the high-wage professional and business services sector. Job openings could have already been topping out since April 2016, when the job openings hit a record high of 5.85 million.

The Federal Reserve Bank of Atlanta trimmed its third-quarter 2016 GDP forecast by 20 basis points last week, to 1.9% from 2.1% previously, while the Federal Reserve Bank of New York revised its fourth-quarter 2016 GDP forecast 30 basis points upward, to 1.6% from 1.3% previously. The revised forecasts came after Friday's U.S. Census Bureau's report which showed that retail sales excluding food services rose 0.6% last month, compared to a 0.32% decline in August, but still missed economists' forecast, surveyed by MarketWatch, of a 0.7% increase. On a quarterly basis, third-quarter 2016 retail sales declined 0.83 percentage points, to 0.65% from a 1.48% gain during the previous quarter. Taking the latest Fed forecasts into account, the pace of U.S. GDP annual growth could be about 1.4% year-on-year, the slowest compounded annual growth rate since the end of the deep recession in 2009.

US Real GDI Click to enlarge

In fact, the U.S. economy might already be heading for a recession. In late September, the Commerce Department revised the U.S. second-quarter GDP 2016 in its third estimate to 1.4%, from 1.1% previously, but took down the real gross domestic income, or GDI, used by the Federal Reserve to gauge economic activity based on income, to negative 0.2% from 0.2% previously. The difference between GDP and GDI, which is called statistical discrepancy, represents the net sum of all of the measurement errors in estimating their respective components, 7 components for GDP versus 10 components for GDI.

Conclusions

Concerns about a Fed rate hike and Britain's exit from the European Union have put buying pressures on the U.S. dollar and selling pressures the Japanese yen and gold. The DXY is overbought and overvalued in light of the Fed downgrade of U.S. GDP 2016 and a mixed bag of economic reports released by the government since late September. A December Fed rate hike may be unrealistic if the U.S. economic outlook continues to deteriorate, as the U.S. GDI already began contracting in the second-quarter 2016, and the GDP 2016 is the lowest since the deep recession. In our view, gold should head for a breakout at the $1,320 per ounce level, along with the JPY/USD currency pair.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long bullion gold coins as an investment.