There's been a lot of activity the past couple of weeks and it may be time to exit gold outright or trim the hedge. In the United States, the Federal Reserve has laid out an aggressive plan to reduce its balance sheet and we may see a third rate hike this year. In Europe, many questions remain, but the plan for tapering QE further should be released later this year. The United Kingdom is seeing an intense amount of instability following the recently narrow election, but Brexit negotiations begin this week. This could lend support to the dollar and cause gold to dip. In general, as the summer dawns upon the markets, longer-term factors are beginning to take the stage, creating downward pressure on gold and gold-tracking ETFs, like the SPDR Gold ETF (NYSEARCA:GLD).
The Global Rate Environment
The Federal Reserve last week chose to raise short-term interest rates for the second time this year and for the third time in the last six months. Markets had priced in this move weeks before it actually happened, as is the case with most live meetings. Right now, the future is uncertain, but not in the traditional sense where that uncertainty could lend support to gold. The market isn't pricing in a third move until perhaps the December FOMC meeting. If the market gets a third rate hike this year, that's going to be a large headwind for gold. Right now, the probability of such a hike happening is 36.3%; however, a few months of solid reports either in line or modestly surpassing market expectations will allow that probability to elevate. Additionally, the Federal reserve is still on the path to "normalizing" interest rates, so the pressure is on to pick up the pace.
One key factor that came out of the June meeting is the fact that balance sheet reduction pacing is going to be faster than expected. The $4.2 trillion balance sheet that has been scaling up rapidly since the financial crisis, will start to unwind sometime later this year to the tune of $10 billion per month. Now, $10 billion per month is nothing as it's about a quarter percentage point being taken off the top each month. Yet, the Federal Reserve plans to scale that to $50 billion in twelve months time after the initial reduction month. Taking away $50 billion a month starting in late 2018 really helps to take about 1.25% off of the balance sheet each month (based upon the initial size). At some point, the Federal Reserve could scale up and take, say, $75 billion to $100 billion off of the balance sheet by continuing to not reinvest the proceeds from their Treasury security investments. The shrinking of the balance sheet in and of itself doesn't move the needle on gold. Rather, it's the guidance that the Federal Reserve provides at future meetings (and the relative hawkishness or dovishness) that'll move gold.
Headwinds to the dollar, however, are also present. The morning of the second day of the FOMC meeting this past week, inflationary reports pointed to a weaker than expected outcome. In particular, Core CPI falling to 1.7%, against an expectation of 1.9%, on the last report was viewed as a sharp negative and increased the demand for gold. I've said it before in other articles, but I'm not going to try and call a bottom on the dollar, let alone any security. While timing is everything, it's a fool's game to try and pinpoint the exact bottom. However, the dollar is moving more sideways right now than it is down and this choppiness has been building up over the past couple of weeks. Momentum has even slightly ticked up. Perhaps it's time for a turnaround in the dollar, as we're around the same level as the dollar was prior to the election.
While there's a large amount of uncertainty abroad in the UK where the election a few weeks ago resulted in a much closer race than expected, that's actually helping the dollar out. The pound has been rallying over the past six months, but the elections have taken some of the pressure off the dollar, as this is one of the most important G7 pairs. That could be the start of a multi-month prop-up for the dollar. Brexit negotiations start tomorrow, with the Conservative party still leading the way, but there will undoubtedly be complications as the Labour party has a significant number of seats now. Pound weakness will help the dollar retain its current level and not fall further, ceteris paribus.
As for the ECB, the last meeting was nothing more than smoke and mirrors. The short-term interest rate was left unchanged and any clues into when the ECB might start to further taper the QE program were left undiscovered. While we may receive more color on how the ECB plans to move away from QE as soon as the July Meeting, a late Q3 or early Q4 meeting seems more likely for the market receiving such information. The risk, here for gold, is to the downside, as moving away from QE towards a tightening policy reduces the need for gold. However, it's important to consider the euro relative to the dollar. The longer the ECB holds off on providing color on tapering QE, the stronger the dollar will be against the euro. That creates a short-term headwind for gold; however, once we get a better idea of where Draghi plans on taking the current program, the euro will have a clear track to trend higher, creating pressure on the dollar - which is good for gold.
What To Do With Gold
The weakness abroad is providing short-term support for the dollar and that's going to directly weigh on gold prices over the next couple of months. The support from the Federal reserve will help to passively change investor allocations away from gold and towards riskier assets. Gold is at an interesting point right now. The uptrend that has been in place since the election has oscillated quite evenly over the last six months, with the base being moved up each time gold hits a fresh 2017 peak. However, gold has failed to breach $1,300/oz the last two peaks now, and that may mean there is strong resistance present in the marketplace preventing gold from going higher, despite the plethora of risks globally. While this uptrend in gold has been happening, a sharp downtrend in the U.S. dollar has also amounted, potentially creating the perfect contrarian trade.
So, investors should think about trimming the hedge, if long a gold ETF already, or exiting the position outright if speculating. The simplest, most liquid gold ETF that I use when the opportunities present themselves is the SPDR Gold ETF, GLD. It's an easy hedging instrument to use, but right now, I'd say exiting it is the best option. It was interesting to see that back in mid-May, a death cross occurred - where the 200 DMA moved under the 50 DMA - yet, the market brushed it off and GLD moved higher towards $124.
Yet, like gold, it has failed to eclipse its previous peak and with momentum on the downtrend, I'm looking for GLD to go below its current 200 DMA in the next few weeks. If GLD falls further than $117, I'd be a buyer, but if it falls through core support at $116, a reexamination of the fundamental scenario is warranted, as that completely changes this post-election uptrend.
The current environment for gold is quite interesting as inflationary data in the United States isn't on par with continuing to raise interest rates. However, the Federal Reserve is playing catch-up in an attempt to normalize interest rates with current economic conditions. There should be passive support for the dollar in that regard. Meanwhile abroad, the uncertainty in the United Kingdom regarding Brexit discussions and political support for the conservative party can cause the pound to depreciate versus the dollar over at least the next couple of months, creating a headwind for gold. Additionally, in Europe, the ECB is trying to move away from QE and towards short-term interest rate hikes, but for now this is one of the few factors supporting gold as there are few details to go off of.
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.