Gold, the dollar, bond yields and inflation

By David Morrison  |  16/01/2018 15:00

This article looks at gold and how its price is influenced by the dollar, bond yields and inflation expectations.

US yields rise, but dollar falls

If last week’s move in US Treasuries taught us anything, it’s that rising bond yields don’t always lead to a stronger dollar. Bonds sold off sharply following a Bloomberg story that China was considering halting or even reducing its purchases of US Treasuries. The news unnerved investors as China is the biggest foreign holder of US debt, having recently overtaken Japan. Bond yields jumped on the announcement in a move which is typically positive for the dollar. However, the dollar fell sharply as the news was considered specifically negative for the US.

Gold/dollar relationship holds

But in line with conventional wisdom the dollar’s sell-off triggered a sharp rally in gold. Interestingly, bond yields and precious metals held on to their gains, despite China’s State Administration of Foreign Exchange (SAFE) dismissing the Bloomberg story as “fake news”. It appears the statement from SAFE didn’t go far enough and investors remain convinced that the original story contains a scintilla of truth. Maybe China has just fired a warning shot across Trump’s bows, reminding him of their power should he threaten them over trade.

Searching for yield

Gold is priced in numerous different currencies, but when it comes to trading we’re most used to seeing it valued in dollar terms. Conventional wisdom says that rising interest rates are bad for gold, and generally an increase in fed funds weighs on the dollar price of gold. The argument goes that gold doesn’t generate income. So when interest rates rise, people prefer to seek out yield or buy anything which gives a decent return for acceptable risk.

Adjust for inflation

But gold can rally even when the Fed raises rates. The reason is that it’s not the nominal fed funds rate that is important. Rather, it is the “real” interest rate – that is, fed funds adjusted for inflation. Inflation reduces the buying power of a currency. So when inflation expectations rise holders of cash rush to convert it into something more tangible, whether that be equities, works of art, vintage cars, jewellery or gold. Inflation eats into the value of savings, unless of course, the interest you’re earning on your cash exceeds the rate of inflation. For example, if the annual inflation rate is running at 5% but you’re getting 7% in interest, then you are still making 2% if you keep your savings in the bank. But if inflation is at 5% but your bank only pays 2%. it makes sense to take on more risk with your investments, or even spend your money now rather than save it. It’s this environment in which gold does so well.

Dollar weakens despite Fed

At the moment the fed funds rate has an upper band of 1.5%. Inflation in the US is currently running at 1.5% as measured by Core PCE - the Fed’s preferred inflation measure – or 2.2% if using Headline CPI. Under either measure we can see there’s little reason to keep one’s cash at the bank, particularly as we know the Fed is forecasting Core PCE to pick up towards 2%. Now the central bank is expected to tighten monetary policy further this year. But the problem is that the dollar continues to weaken even as the Federal Reserve predicts 75 basis points-worth of rate hikes in 2018. Why? Because suddenly investors are reassessing the outlook for the Euro zone, China and Japan. In every case growth is picking up and inflation with it. While the European Central Bank (ECB), Bank of Japan (BOJ) and even the People’s Bank of China (PBOC) are behind the Fed when it comes to tightening monetary policy, they’re not as far behind as they used to be. And this is helping to drive the dollar lower.

Gold slips

We’ve just seen a hiccup in the gold rally which has been running with little interruption for a month now. US traders are returning to their desks following the long Martin Luther King Day weekend and while US stock indices continue to surge higher, they’re taking the opportunity to book some profits on their short-dollar positions. This in turn has triggered a sell-off in precious metals with gold pulling back sharply from $1,340 - the four-month high hit on Monday. For most of last week gold traded in a range between $1,310 and $1,320 before breaking out to the upside. If the current round of profit-taking continues then we shouldn’t be surprised to see gold retest support around $1,310 – the 61.8% Fibonacci Retracement of the September-December sell-off. But last week the Dollar Index fell below 91.00 – an important level of support and the low from last September. At the same time the EURUSD broke above significant resistance around 1.2100. If these levels hold – now as resistance and support respectively – then this is evidence that the weak dollar trend that began just over a year ago has further to run. If that’s the case then we should expect gold to continue to push higher, at least until there’s a change in sentiment towards the greenback.

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