Gold prices trended lower in 2022 after peaking in Q1. The yellow metal came under pressure as the dollar started to trend higher. The impetus for lower gold prices was the Federal Reserve’s changing stance on interest rates. As the United States central bank started a campaign to tighten rates and reduce inflation, the dollar rallied, weighing on gold prices. While many see gold as a hard asset that is a store of value when inflation rises, the yellow metal acts more like a currency. Like most currencies, gold faced pressures during 2022 as investors flocked to U.S. dollars and the Federal Reserve started to raise interest rates. Looking forward, there are signs that the Federal Reserve might curtail its campaign to raise rates. If short-term interest rates stop rising rapidly, there is a chance that gold prices could gain a foothold and begin to bottom.
Why Did Gold Start Trending Lower?
Gold prices started to trend lower after Q1 2022. The impetus was a breakout in the U.S. dollar, which bottomed and began to rise during this period. The change in the trajectory of the greenback was due to a quick turnaround in the view of the Federal Reserve that inflation was a problem and no longer transitory. In Q2 2021, the Fed saw inflation starting to percolate but viewed the uptick in prices as temporary. Inflation was 4.3% in April 2021, which was still slightly above the Fed’s target of 2% but it was not running away. The Fed thought it had plenty of time to use the tools at its disposal to rein in inflation if it started to accelerate.
What Led to Inflation Rising Rapidly?
As governments worldwide fought the impact of the COVID-19 pandemic on economic growth, they introduced fiscal stimulus programs that would allow consumers to spend money, even if they lost their jobs. Central banks cut interest rates to zero and started bond purchase programs to calm consumers’ nerves. The Federal Reserve was one of these central banks, and it did its part by slashing interest rates and beginning a quantitative easing program that buoyed economic growth.
The move by the Fed came in conjunction with a massive $2.2 trillion U.S. fiscal stimulus bill that put money in consumers’ hands. The view of the Fed was that too little support from the consumer would not move the needles and would leave the economy to stall. The massive $2.2 trillion stimulus was followed by a $900 billion relief package passed by the U.S. Congress and signed by President Biden. While the government spent about $5 trillion to buoy growth, the Fed added $3 trillion to its balance sheet to help liquidity.
There was little fear of accelerating inflation at the time as the government and the Fed were more concerned with economic growth and job losses. The Federal Reserve thought that inflation would be short-lived and used the term “transitory” to describe how long they perceived the impact of inflation on the U.S. consumer. The Federal Reserve continued to purchase bonds and stimulate economic growth into 2022. At the beginning of Q2 2022, the Fed realized its inflation assessment was wrong. Part of the problem started with the surge in energy prices after Russia invaded Ukraine. Additionally, staples such as grains also started to rally significantly, eventually spilling over into other foods like poultry, which eat grains, as well as beef, pork, dairy, and eggs.
Why is Inflation Bad?
Rising prices are usually not welcome, especially for consumers on a fixed budget. For example, if you receive $3 thousand per month to pay all of your bills, and prices increase by 8%, but your income remains the same, you will likely need to cut some of your discretionary budget to survive. Older consumers who have stopped working and receive social security payments or fixed bond coupons see their spending ability eroded by rising inflation.
How Does the Fed Fight Inflation?
To combat the surge in inflation, the Fed started to raise interest rates. In March 2022, the Fed began to reverse its liquidity stance and raise its benchmark interest rate by 25 basis points. The move by the central bank was the first increase in interest rates in more than three years. At the same time, the Fed said that this was likely the first step in an aggressive path to raising rates. Fed officials reduced their view on economic growth and increased how high inflation could rise. The move by the Federal Reserve brought the borrowing rate to 0.25-0.50%, which increased financing costs slightly.
Despite the expectations that rates would continue to rise, Fed officials penciled in raising interest rates to 1.9% by the end of 2022. They had no idea that rates would eventually have to increase so quickly. In March, the Fed expected to begin to reduce its balance sheet in May, but their statement had no immediacy. The Fed also boosted its inflation expectations to grow to 4.1% by year-end, and if you exclude food and energy, inflation could increase to 2.3% year over year. It was evident in hindsight that the Fed did not expect inflation to rise as rapidly as it did, and it grossly underestimated the rise in prices.
In November 2022, just seven months after the Federal Reserve increased interest rates for the first time in more than three years, the Fed raised its benchmark borrowing rate by 75 basis points to a level between 3.75-4%. This rate rise of 75 basis points was the 4th increase of this magnitude in a row. In the wake of the move, some bulge-bracket banks, such as Goldman Sachs, said that the Fed could increase rates up to 4.75-5% by March 2023. The market currently has priced in about a 50% chance that Fed funds will be at the level between 5-5.25% by March of 2023. The market view of Fed funds can be evaluated using the CME Fed Watch Tool, which uses Fed fund futures contracts to determine the value of future fed rates.
How Do Higher Rates Impact the Dollar and Gold?
The rapid rise in interest rates led to a rally in the U.S. dollar. Currencies like the dollar tend to rise as interest rate differentials favor money. The interest rate differential is the difference between two countries’ borrowing rates. Money tends to follow higher interest rates. As U.S. borrowing rates rose, the dollar benefited. Money flowed into the dollar to higher yields received by higher treasury yields. The interest rate differential generally rises when one country is increasing rates at a faster pace than another country. For example, suppose the Federal Reserve raises interest rates by 3.75% while the European Central Bank increases rates by 2%. In that case, an investor will earn 1.75% less on its money if he purchases short-term bonds in Euros relative to U.S. bonds. Having to pay away interest is a deterrent that could generally create a continued rally in the U.S. dollar.
Why Does a Stronger Dollar Impact Gold Prices?
A stronger dollar usually has a negative impact on gold trading. Gold is viewed by many as a commodity, but it is also considered a currency. Since gold prices are usually quoted in U.S. dollars, a stronger dollar tends to weigh on the price of gold. The dollar has rallied as the Fed continues to raise interest rates and the expectations of higher rates continue. Once market participants believe that the Fed could be finished increasing rates and the differential between other currencies starts to subside, gold prices may gain traction and move higher.
The Bottom Line
The upshot is that gold prices have trended lower as the dollar gained traction starting in Q2 2022. As the Fed raises rates faster than its counterparts, the dollar has continued to rally. When the dollar stops rallying, gold prices will likely stop falling and gain a foothold and possibly rally. According to the CME Fed Watch Tool, market participants believe the short-term interest rate peak is likely to come in June 2023, near 500-525%. Current short-term interest rates are closer to 3.75-4%.
A surprise could occur if higher interest rates in the United States start to reduce economic growth at an accelerating rate and weigh on inflation expectations. A move like this would pressure the dollar and allow gold prices to gain traction. After making a mistake on how quickly prices would rise, the Fed seems vigilant in reducing inflation expectations. The Federal Reserve has continued to say that it wants to reduce inflation back into its target range near 2%. Core inflation, which excludes food and energy, is hovering near 6.6%, well above the Fed’s target. Unfortunately, the changes to monetary policy have a lagging impact on inflation. When the Fed realizes inflation is declining, a recession is likely to be underway.