More than any other factor, changes in expectations for U.S. interest rates play a key role in determining short-term movements in the price of gold, and to a lesser extent silver and platinum. During much of the past two years, the correlation between the daily change in the prices of gold and Fed Funds futures, expressed as an interest rate (100 minus price), has averaged at around -0.6 (Figure 1).
Figure 1: Fed Funds Versus Precious Metals Correlation.
That correlation, however, has weakened in recent weeks as gold prices rallied almost $100 from their December 12 low of around $1,240 an ounce even as Fed Funds futures priced that the Federal Reserve will have interest rates 33 basis points (bps) higher than they had been priced when gold was at its December lows (Figure 2).
Figure 2: Soaring Rate Expectations In The U.S.
To a large extent, gold's recent bull run may be the result of the weakening of the U.S. dollar (USD) versus other currencies. The dollar's weakness is somewhat surprising given expectations for higher rates. Even so, the dollar might further weaken substantially should the markets de-price their anticipation of 2-3 Fed hikes in 2018 and further tightening in 2019.
One must wonder then if gold's lack of concern about the Fed possibly hiking rates three times in 2018 and an additional two times in 2019 might be positioning the yellow metal for a bull run in the event the Fed's actual rate hikes fall short of market expectations.
Despite rhetoric reflecting concern about inflation and wage pressures, the two factors are mysteriously absent from recent economic data. Core inflation during the second half of 2017 reached an annualized average rate of 2%, which is hardly alarming. Wage growth has picked up slightly in recent years but remains below 2.5%. Not exactly the stuff of 1970s' inflationary horror films.
What's particularly remarkable is that the gold options market is apathetic about volatility in general. At-the-money (ATM) options on gold are trading near historic lows (Figure 3) and unlike copper, whose out-of-the-money (OTM) options show significant fear of downside moves, gold's OTM options can barely stifle a yawn about either upside or downside risks (Figure 4).
Figure 3: ATM Options Volume Is Near Record Lows.
Figure 4: Looking At OTM Options, Gold's Implied Volatility 'Smile' Isn't Particularly Pronounced.
Gold OTM calls have only a slightly higher risk than ATM options. In the case of gold, the preponderance of risk may be to the upside, especially in the event equity and credit markets correct at some point, triggering a flight-to-quality rally that stifles expectations of further Fed tightening.
If Equities Or Risk Parity Blows Up, Gold Could Benefit
With the VIX volatility index trading near record lows and equities soaring, it's easy for Fed Funds futures to price in more and more rate hikes. An eventual equity correction, however, could sharply diminish the likelihood of Fed rate hikes and could send gold soaring. Equities are approaching a record high as a ratio to GDP (Figure 5).
Figure 5: Equity Valuations Often Move Inversely With The Level Of Treasury Yields.
While this does not guarantee a correction, especially given the unattractive level of bond yields, it may make them more vulnerable to shocks.
Also of note is the growth of risk parity. Given the high cost of being perennially long put options on stocks, one tempting alternative is to hedge the risk of being long equities with leveraged long positions in bonds. A levered fixed income + equity risk parity strategy would have worked well over the past several decades but is vulnerable to inflationary shocks.
If bonds sell off, it could take the equity market with it. As such, if inflation does begin to rise later this year, gold could prove an essential part of the portfolio. Many risk parity strategies, of course, include gold in their asset mix and if inflation does surprise to the upside, it could prove to be a valuable diversifier.
Lastly, in the past, as we have noted in our VIX-Yield Curve Cycle, Yield Curve-Credit Cycle and Yield Curve Unemployment Cycle papers, the Fed tended to raise rates until the yield curve flattens, volatility spikes, credit spreads widen and the economy falls into a recession.
As such, we'd closely watch both the Fed and the yield curve. If Fed Chair Jerome Powell and colleagues push rates higher, that might not be good for gold in the short term but, if excessive monetary tightening winds up causing a downturn as it did in 2001 and in 2008, gold owners will likely be among the primary beneficiaries when the Fed is forced to reverse course and ease policy once again.
The Fed has indicated via its "dot plot" that it favors three hikes in each 2018 and 2019. The market now more-or-less agrees with the dot plot for 2018 but only prices one rate hike for 2019. If they go through with six rate hikes this year and next, that should turn the yield curve flat, which could signal a risk of much higher volatility across markets ahead and possibly a major gold bull market.
There are two main risks to this scenario. First, inflation, despite tight labor markets, fails to materialize and secondly, the Fed becomes cautious about inverting (or excessively flattening) the yield curve. With respect to the second point, the Fed discussed the dangers of an inverting yield curve quite openly at its December 2017 meeting. If they stop short of flattening the curve too much, that could provide short-term relief for gold but might deprive gold of future upside (the economy might keep growing, obviating the need for an abrupt reversal of policy).
This will be harder for the Fed to pull off if inflation rises. With oil prices heading towards $70 per barrel, industrial metals prices rebounding and tight labor markets, an inflationary shock of sorts could be on the way. The Fed might keep raising rates akin to its 2017 (and suggested 2018) pace if inflation makes a move above 2.5%. Even if inflation does no such thing, the Fed might keep tightening anyway.
That's what the Fed did in 1999 and 2000. Despite core inflation being below 2%, the Fed raised rates to 6.5%, inverted the yield curve and helped to fuel the tech wreck recession and ensuing volatility. Likewise, despite both inflation expectations on Treasury Inflation Protected Securities (OTC:TIPS) and realized core PCE inflation between 2% and 2.5% in 2006, the Fed tightened policy enough to bring the yield curve to being flat for an entire year, which helped to choke off the supply of credit to the economy and usher in the Great Recession.
In 2006, one could argue that the Fed wasn't targeting consumer prices so much as it was targeting asset prices. With asset prices soaring again, could the Fed be tempted to attempt a repeat of these past episodes, tightening policy despite only modest upward pressure on consumer prices?
In any case, we're about to find out. With debt totaling 250% of GDP, as high as it has ever been historically, the U.S. economy may be more sensitive to small fluctuations in interest rates than in the past, meaning that the Fed's seemingly modest moves could have more impact on economic growth and financial markets than most people appreciate, at least after accounting for the typical 1 to 2-year lags between changes in monetary policy and their financial/economic impact.
- Gold prices have been rallying despite a runup in Fed Funds' rate expectations.
- This could create enormous upside for gold if those rate hike expectations diminish.
- Equity markets have returned to record highs as a percentage of GDP.
- If the Fed hikes too much and creates an explosion in credit spreads and volatility, gold could be a primary beneficiary.
- Gold options markets are pricing relatively low volatility, both for ATM and OTM options.