This article was written by Idan Levitov, head analyst for anyoption.com.
Although gold has edged higher amid sustained losses in the US dollar and mixed economic data, key FOMC members are striking an increasingly hawkish tone, suggesting that further interest rate normalization may be afoot.
While the Federal Reserve has maintained that any decision would “data dependent” in nature, there are numerous figures that indicate the timing of another rate increase could be sooner rather than later. Besides heightened jawboning from regional Federal Reserve Presidents, core inflation and employment continue to trend towards the Fed’s longer-term dual mandate for the economy, demonstrating the potential for action sooner rather than later.
With the US dollar basket once more on the retreat as speculation of rate hikes subsides, gold has managed to reap the rewards. However, as September approaches, gold may once again find itself under fire, especially if hawkish attitudes prevail.
While minutes are due from the July FOMC meeting on Wednesday, in the period since the last decision to keep rates on hold, policymakers have struck an increasingly hawkish tone towards the outlook.
The statement that followed the decision was the first indication of the shifting attitude of officials, with the emphasis on “diminished risks” for the outlook. Additionally, Kansas Federal Reserve President Esther George’s dissented during the latest decision in her tacit call for a 25 basis point hike, marking the first dissenting vote in over a year.
Aside from George, one of the more openly hawkish members of the FOMC has been New York Federal Reserve President William Dudley. Since the last decision, Dudley has gone on record more than once as believing that the market is vastly underestimating the pace of policy normalization.
In his most recent remarks, Dudley has reiterated comments made earlier in the month, highlighting that financial markets are “underpricing rate hikes” and furthermore restating that a September hike remains a possibility.
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Although he admits that the pace of hikes was going to be slower than previously anticipated, he did maintain that they are approaching and also echoed the sentiment that the Brexit fears had been vastly overblown. The immediate kneejerk reaction to his comments was unrepentant bullishness in a US dollar after recent downward pressure exacerbated by weak fundamentals.
Echoing Dudley was Dallas Fed President Robert Kaplan who emphasized that September action was still possible despite a significant second quarter GDP underperformance. Although not a voting member this year, his words do carry weight as markets try and assess the potential for higher rates.
Core Inflation Echoes Hawkish Leanings
Outside of the more hawkish Fed commentary that has been slowly dripped to markets over the past several weeks is the data itself. Following two stunning nonfarm payroll reports and core inflation which has stood above 2.00% since last November, the diminished speculation of further tightening contrasts sharply with the all-important Fed data points.
Although the labor data is not as optimistic as the headline figures would necessarily imply and CPI is not the preferred gauge of Fed inflation, these two indicators do underscore the progress the economy has made over the last several years. While gold prices may reflect the recent uncertainty as to the path of rates, reclaiming its role as an inflation and risk aversion hedge, just as quickly as it has climbed over the last few months, so too can it fall with equivalent speed.
Though gold has classically been viewed as an inflation hedge, with an environment of global deflation, the only real driver of risk aversion is the potential for a black swan event to unfold. Granted there are numerous possible catalysts for another market downturn, but in the grand scheme of things, should the market be underpricing the risk of a rate hike, gold prices could face a tumultuous outlook over the coming months.
While a 25 basis point rate increase in September is viewed as highly improbable according to Fed Funds futures pricing, currently showing a nominal 18.00% likelihood, a more hawkish view than July’s could set the stage for a precipitous fall for the precious metal as the dollar benefits from a more certain policy outlook.
Even with growing risk aversion, even the outside chance of a rate hike continues to skew gold’s risks to the downside.
Waiting in the Wings
With the next labor data still weeks away, near-term determinants of expectations will rely largely upon upcoming durable goods data due next week followed by the first revision of second quarter GDP.
Although no major changes are expected for GDP, any downturn in the data could conceivably provide the impetus for a further delay to rate hikes, potentially preventing another raise before the end of the year. Although Fed members have largely cautioned that a rate hike may come sooner than later, lamenting market complacency, the devil is in the data.
Should data start to show a marked improvement over the coming weeks, the US dollar is likely to react in kind, pressuring gold prices back to the downside. Any new hints about a rate hike could mean a near-term top in gold that sees price once again retreat below $1300 per troy ounce.