An End To Tightening Supports Gold

When I last discussed gold, I suggested that gold would benefit from any reversal in last year’s surge in real or inflation-adjusted interest rates. As rates, both nominal and real, have pulled back gold has rallied roughly 13%, making precious metals the top-performing commodity sector year-to-date (see Chart 1).

Change in direction

Gold’s rally has coincided with not only a drop in interest rates but also a significant pullback in the U.S. dollar. Since the November peak, the Dollar Index (DXY) has lost approximately -10%. At the same time, real 10-year yields have fallen by approximately 50 bps. Falling real rates and a weaker dollar have historically been the best backdrop for gold. As I have discussed in previous blogs, while many investors treat gold as an inflation hedge the relationship between gold and inflation is more nuanced. Historically, gold has been a decent inflation hedge, but only over the very long term. For shorter horizons, gold tends to trade on how rates and the dollar move relative to inflation. This can be seen in the historical relationship between gold, changes in real 10-year yields, and changes in the dollar.

Looking at the last five years, weekly changes in 10-year real yields and the dollar both have a -0.5 correlation with gold. In other words, gold has a strong tendency to rise when inflation-adjusted rates and/or the dollar are falling.

In the Fed’s hands

Assuming a continued softening in U.S. and global growth, the odds are the Fed has reached the end of its tightening cycle. If this proves true, flat to lower real rates should help gold, even more so if sticky inflation in Europe forces the European Central Bank (ECB) to continue to raise rates, further pressuring the dollar. Outside of monetary policy, gold would likely benefit, as it did in early 2022 if geopolitical tension rises. An escalation in the war in Ukraine or a prolonged negotiation on the debt ceiling would be supportive of gold.

What could end the rally? Ironically, stubborn inflation and/or wages would both probably hurt gold. If inflation proves more intractable than the market or the Fed expects, investors, will need to reconsider the rate cuts now priced in later this year. Under this scenario, real rates and the dollar would likely move higher, putting a dent in gold’s rally. But if growth and inflation continue to soften, gold can continue its ascent.

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