Fed Rate Hikes Priced into Gold?
Wednesday, 2/18/2015 09:01
Put the US Dollar aside, and gold's fundamentals look quite bullish...
DAVID JOLLIE is a doctor of metallurgy, former editor of the platinum research at refiners Johnson Matthey, and is now strategic analyst at Mitsui Global Precious Metals in London, covering all the precious metals globally for the Japanese trading house.
Here he speaks to Hard Assets Investor's managing editor Sumit Roy about New Year 2015's surge in gold prices, why it's retreating, and what the strong US Dollar means longer-term...
HardAssetsInvestor: Last month saw the Federal Reserve come out with somewhat of a more bullish-sounding monetary policy statement than was expected. Do you think it will really hike interest rates soon?
David Jollie: Market consensus is very clearly of the view that interest rates will be raised at some point this year in the US, and the Fed itself has been fairly clear in its forecasts. The majority in the FOMC believe that the Fed funds rate will be higher at the end of the year than it is now.
But it's not a trivial thing to hike rates, as we can see from what's happened in Europe. Sweden, for example, tried to raise rates quite early and very quickly realized that was a mistake.
Clearly, the US economy is doing very well and could probably cope with a rate rise, but there are issues that make that difficult. For one, a lot of the economic growth has been driven by credit; a rate rise is certainly going to rein in growth to some extent. The level of federal debt and city debt is quite large as well. And again, raising rates is going to cause some issues there if and when that happens.
There are other issues concerning what's going on elsewhere in the world, which although they are not the Fed's responsibility, it has to take those into account as far as it may affect America.
Moreover, the issue is not simply whether it can hike rates, but it's whether it has to. There is very little evidence of inflation in the system, even though a lot of people think zero rates should be inflationary.
That's the question the Fed has to ask. It has a dual mandate, and part of it is keeping inflation close to 2 percent. At the moment, there are a lot of people who would argue that inflation might be too low and increasing rates is not the best way to generate inflation.
Our view is that there will be rate hikes, but they will come later than market consensus suggests. It doesn't mean they're not going to happen, but they'll take longer to arrive and they'll probably be slower when they do it.
HAI: And when the rate hikes happen, do you think there'll be any impact on gold prices?
David Jollie: A lot of it's already built in. We see a lot of deleveraging of positions across commodities in general following the first hint that tapering might happen in 2013. At that point, we knew what the game was going to be, and that we would see rates rise at some point.
You can say the same about the recently announced QE program from the ECB. In the lead-up to that, we saw gold perform pretty well. But since then, it's performed a little bit more weakly.
At the moment, expectations are focused on that first rate rise and where rates will be at the end of the year. If we see rate rises earlier, or if it seems likely that rates will rise more quickly than expected, then that could have a more interesting impact on gold.
HAI: What's your take on the situation in Greece?
David Jollie: Forecasting is always a challenging thing, particularly when you've got a government that's been newly elected, where we don't have any track record. There's always a possibility that something goes wrong and Greece falls out of the Euro. That said, I don't think it is what Greece wants or what the rest of Europe wants.
In some ways it's a less worrying possibility than before, partly because Greece is running a primary budget (before debt payments) surplus now. It still needs to refinance its old debt, but it doesn't have quite the same needs for new financing. Additionally, there are more systems in place to deal with a potential exit of a country from the Euro. Of course, it will still be a major disruption if it happened.
The question is, what does it mean for the Euro if the union fractures? For what's left of the Euro, it actually might be quite positive in the sense that it will show people that you can't just stay in the Euro without working hard. The Euro will have to be something you value and people will have to fight for it. On the other hand, the initial economic disruption from a Greece exit would be just massive.
Now for the precious metals, any risk event like that says to people that they should buy gold, or they should buy something that is not going to be revalued in any circumstances. If you're a Greek owning Euros, you might choose to own Dollars or some other currency, including gold. If you're a German and you don't know what might happen to the Euro if Greece left, you might feel the same way.
Gold's safe-haven role comes into play there. We already see some of that in the price, but there's certainly potential for more of that in the price as well.
HAI: We saw the US Dollar acting strong near 11-year highs at end-January. But at the same time, gold was hanging in there as well. Is that inverse relationship with the Dollar gone for now?
David Jollie: Long term, I would expect it to hold, but in the short term, it doesn't necessarily have to. There are a few explanations. One is simple seasonality. We expected to see gold strengthen in January because it has done so in recent years.
Some of it is also risk-based purchasing. If you were concerned about Europe's QE, it made sense to buy gold. If you were concerned about the Greece election, it also made sense to buy gold.
Additionally, we had a bearish situation at the end of last year where a lot of investors were short. They come to the year-end, saw that the Dollar's already gone way up, and figured maybe they should just run that short position down a little bit. So we saw some short covering. That's been responsible for a significant portion of the move up we saw.
Longer term, I would still say that a strong Dollar is going to put downward pressure on metal prices. But that doesn't necessarily mean that prices go down. It just means they might rise less than they would otherwise do. If we see a strong Dollar the remainder of the year, it will be challenging to see gold outperforming and rising from where it is.
HAI: What do you think it's going to take for gold to break out of this trading range that we've seen in the $1200s and $1300s? Are we ever going to see it move decisively higher or lower in the near term?
David Jollie: At some point, we will see gold move out of that range, but you pose a genuinely interesting question as to what could do that. It has to be something we don't expect because anything we do expect is already built into the price.
There are geopolitical issues that could strengthen gold. Rising prices for other commodities could strengthen gold. Falling US bond yields would be a positive for gold, as would negative bond yields in Europe.
On the other hand, if we see very strong equity performance, which we haven't seen so far this year, that's a rationale for some people to sell gold and buy stocks because they have a higher yield and perhaps better performance. Or if the Dollar continues going up, gold could get expensive in other currencies, dampening physical gold demand.
HAI: Is your base case for gold's trading range to hold this year?
David Jollie: My feeling is that gold's run-up in January was overdone. If normal seasonality resumes, we expect weaker prices in the middle of the year. That might be an opportunity for some traders to try and challenge $1200 on the downside and see if they can push it through there. There's a distinct possibility we could go below that level and test how strong the support really is.
But yes, I don't see us moving sharply higher to, say, the $1500 range in a sustainable way or sharply down toward the $1000 mark in a sustainable way this year. The market fundamentals don't justify that.
Aside from the US Dollar, fundamentals are probably mildly bullish for gold. We don't see a rationale for lots of investors coming and buying more gold, but we also don't see much of a rationale for people to get rid of gold if they already own it, which argues for a relatively stable price until one of those stimuli changes.
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