Gold: A Case of Excessive Pessimism

The rise in inflation is the principal financial event of the year and has affected different markets in various ways. The stock market continued its remarkable persistence in setting records, which must end someday – though which day that is remains to be seen. In the bond market, the change in the yield curve has been the primary effect. Expectations that the Fed will raise interest rates in response to inflation have caused short-term rates to rise more than longer ones, rather sharply in fact. Chart 1 compares 2-year vs. 10-year Treasury yields during 2021:

This change in expectations has had a significant effect on other markets as well. One of the larger such reassessments has been in the price of gold, which must compete with assets such as Treasury bonds. Rising interest rates may produce rising cash flows from bonds over time, reducing the attractiveness of gold. The gold price has fallen as a result.

We have expressed the view before that the market may be overestimating the latitude the Fed actually has to raise rates (The Fed’s Freedom to Tighten is a Paper Tiger, October 2021). Time will tell who is right, but in the short term the markets will do what they want. At some point, however, overshoots will appear. It would seem that has begun. One market that is worth watching at the moment is the futures market in the federal funds rate (the Fed’s policy target). That market is used
by various participants to hedge positions in other securities that will in their turn be affected by the Fed’s decisions. It tells us not what the Fed will do, but what the financial markets think the Fed will do.

The CME Group (parent of the Chicago Mercantile Exchange) provides an online tool that calculates what the market is pricing in today for the fed funds rate at the times of their scheduled future meetings. They publish the data in the form of a chart that inserts that data point on the Fed’s forecast of their own future decisions (Chart 2):

The market’s forecasts, as represented by the circled red dots for both 2022 and 2023, are well above most of the Fed’s own forecasts for the same periods. While the valuations of many financial markets are optimistic, reflecting the ebullience that has prevailed for the last 20 months or so, this is a much more cautious view. Futures are forecasting that the Fed will tighten monetary policy more in the next two years than is apparently priced into other markets. If those futures are correct, this may prove to be a source of future volatility. Tighter monetary policy has historically ended the partying in stock and other risk-asset markets.

Precious metals, however, appear to be pricing in similarly conservative, and perhaps excessive, Fed policies. We often compare the price of gold to the valuation of Treasury Inflation-Protected Securities, or TIPS, since those two asset classes are generally regarded among the best in reflecting expectations for inflation. Gold has underperformed TIPS since the June Fed meeting, reflecting the market’s concern at the prospect of Fed tightening (Chart 3):

Gold has overestimated the threat of higher interest rates before. This behavior prevailed in 2015-16, the last time the Fed was preparing to tighten monetary policy. The markets then, as now, reacted by selling gold. That proved to be excessive. When the Fed began raising rates on a quarterly schedule, the price of gold began to rise, as shown in Chart 4

It is likely that this is the script for the current episode. Gold’s reaction may be even stronger this time, in fact, because debt levels today are even higher than they were then and may constrain the Fed’s options even more. Our investment conclusion is to go long gold and patience.