Will Inflation Buoy Gold Prices While The Federal Reserve is on Hold?

A stable dollar, lower production costs and a neutral Fed should keep gold prices buoyed
David Becker
Close-up View Of Shiny Gold Bars

Are you considering an investment in gold? Gold has always been viewed as an asset that you can use to diversify your portfolio. When stock prices tumbled during the beginning of the great recession, gold prices rallied. Did you know that when the S&P 500 dropped 50% between December of 2007 and April of 2009, gold prices rallied 10%?

The question is whether we are currently at an inflection point where it is prudent to purchase gold. What is clear is that the US economy has experienced nearly 10-years of growth and Europe and Asia are experiencing declining growth prospects. The dollar is stable, inflation remains low, and yields are declining. Gold producers appear to be bullish and cutting production costs. With all of these factors as a backdrop, is it time to buy gold?

Are Gold Prices Likely to Increase or Decrease?

Gold is viewed as both a commodity and a currency. It is defined as a precious metal, along with silver, platinum, and palladium. Some view gold as a hard asset that increases in value as inflation rises. Others view gold as a currency, that is quoted versus the US dollar. The reality is that gold is both. As a currency, it is viewed as a safe haven especially when other currencies become less attractive.

Since gold is quoted in US dollars, it generally declines in value when the US dollar becomes more attractive. The reason this occurs is that when the dollar rises in value gold prices become more expensive in other currencies.

For example, if the US dollar increased by 5% versus the yen, it would require 5% more yen to purchase the same amount of gold as it did prior to the rise in the value of the US dollar. To compensate for this rise in the value of the greenback, gold prices will slide.

So, to determine the value of gold, you need to have a handle on the value of the dollar. Since hitting a trough in early 2018, the dollar index has rebounded approximately 10%. As the dollar increased in value, gold prices have moved sideways, first moving lower in early 2018 and then rising back to the level where it started that year.

The dollar continued to gain traction through the latter part of 2018 as the Federal Reserve continued to raise interest rates. In early 2018, the Fed pivoted. They decided that rates had increased to a level that was sufficient and economic growth was likely to moderate. The way that the Fed Chairman Jay Powell describes the tone of the Fed is that they are patient.

The central bank is no longer on autopilot. Additionally, the Fed mentioned in its last meeting that it would stop reducing its balance sheet. Recall, the Fed increased its balance sheet to record levels during the financial crisis. The unwind of this quantitative easing was referred to a quantitative tightening.

The Federal Reserve now appears on hold. The most recent economic data does not point to the need for additional tightening and in fact, an easing of interest rates could be in the cards. The current January 2020 Federal Funds futures places a small chance on a reduction of interest rates sometime in 2019.

What is the Next Move for the Dollar?

While the Fed is on hold, it appears that other central banks have decided to step up their monetary accommodation. The ECB announced in March that they would introduce new long term loans (TLTRO) which should help stimulate the economy. In addition, they have put off any thoughts of interest rate increases until at least the end of 2019. Given this backdrop, it’s hard to see the dollar falling against the Euro.

In Japan the data is mixed and in China, the data is coming in weaker than expected. The February trade data released in March show a surprise 20% drop in exports. Despite a slowing economy in the United States, it appears to be the best house on a bad block.

Will Inflation Buoy Gold Prices?

The real issue with inflation is that the Fed is mandated to keep it subdued. Powell has said that even if inflation ticks above the target range, the central bank will not feel compelled to increase rates. The most recent inflation data shows that inflation remains near the Fed’s target.

The February Consumer Price Index increased 0.2% month over month and 1.5% year over year. Excluding food and energy, the US CPI edged up 0.1% month over month and 2.1% year over year. The Fed has a 2% target rate and the core PCE, is currently running at 1.9% year over year for the latest print which was December.

Are Gold Companies Bullish on the Price of the Yellow Metal?

Gold producers appear to be bullish on the price and are attempting to drop production costs.  Some of the largest miners are scrambling to buy more gold assets. During the last week of February, Barrick gold launched a hostile bid for rival Newmont Mines. In early March the two agreed to a merger. Barrick dropped its hostile bid to purchase Newmont Mining and instead agreed to a joint venture that will combine the two companies operations in Nevada (US). The two companies say that the Nevada operation will be the worlds largest and based on production figures for 2018, the mines will produce 4.1 million ounces. The reduction in the cost to produce gold should put a floor under the price allowing gold prices to remain buoyed.

Conclusion

To recap. Gold prices have been rangebound during the past 2-years, with a cap near $1,390 and a floor near $1,060. Prices are closer to the highs of the range than the lows. The question for investors is whether prices will continue to grind higher and potentially break out.

There are several factors to consider. The first is whether the dollar is likely to strengthen or weaken or remain rangebound. The second is if production costs are likely to decline. Lastly, could there be geopolitical events that will drive investors to the safety of gold?

The dollar is likely to remain rangebound, and the market believes the Fed is more likely to cut rates as their next move rather than increase rates. This should help buoy gold prices. Gold producers are cutting production costs which should also help buoy prices. Lastly, geopolitics remains an uncertainty. Brexit is on the horizon and political strife is at a pinnacle in the US. With all of these factors as a backdrop, gold prices are more likely to grind higher than drop lower.

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