Is Gold About To Break Out Of A Tight Trading Range? EJINSIGHT
Gold, traditionally seen as a bulwark against inflation, does not seem to have benefited from the recent surge in US consumer prices which rose from 2% to 7.5% YoY as much as one might have expected. wait there. Between the summer of 2020 and early February 2022, gold not only moved sideways, it traded in an increasingly tight range that technical traders sometimes refer to as a “flag formation.” However, from mid-February it recovered strongly before correcting in mid-March.
The recent behavior of gold leads to two questions:
1) Why didn’t gold rebound between April 2021 and January 2022 as inflation rose?
2) Why did gold suddenly start rising in mid-February only to correct in mid-March?
What held the rally gold?
While rising inflation might theoretically have boosted gold, the reality turned out to be more complex. The sharp rise in US consumer prices has produced a huge shift in investors’ beliefs about the future of US monetary policy. As recently as early October 2021, fed funds futures did not price a single rate hike for the next 12 months. In early February, traders were expecting about seven rate hikes over the next 12 months, followed by two more over the following 12 months.
Higher interest rates are anathema to gold. Gold can be considered as a quasi-money, but which does not earn interest on deposits. Thus, when investors anticipate an easing of monetary policy by central banks, the price of gold tends to react positively. The opposite tends to happen when investors expect tighter central bank policy: the prospect of higher interest rates on fiat currency deposits may make them more attractive relative to gold . This is evident when looking at the price of gold in a chart alongside expectations for the Fed Funds two years from now.
When correlating daily gold price movements with daily changes in Fed rate expectations, we see that gold almost always exhibits a negative correlation with changes in Fed rate expectations in two years.
As such, it seems likely that the Fed’s bid for higher rates kept gold from rallying until mid-February. Then, when the Russian-Ukrainian conflict began, expectations of rate hikes fell sharply for a few weeks, sending gold prices soaring. After the dispute dragged into the third week, however, the reality of much higher commodity prices as well as continued strength in US jobs and inflation data, led investors to expecting even more rate hikes than they did in mid-February, which led to a correction in the price of gold.
As of this writing, gold prices are still below their summer 2020 peak. Given the dramatic change in expectations for Fed rate hikes, it is impressive that gold prices also held up well, suggesting that gold may have benefited from higher inflation after all: higher inflation seemed to offset the impact of Fed rate hike expectations .
It’s also worth pointing out that the price of gold soared from early 2019 to mid-2020 as expectations for the level of Fed rates began to decline even before the pandemic began.
The Rise in Gold Options Volatility and the Outlook
Gold’s narrow trading range and lack of realized volatility may also explain why the implied volatility of gold options fell to such low levels in mid-February, even as the cost of options on d ‘Other markets, such as stocks, had already begun to rise. Gold’s bullish breakout from mid-February to early March coincided with a substantial increase in risk perceptions, as measured by implied volatility.
Perhaps the most striking feature of the global economy is the combination of runaway inflation, supply chain disruptions and rock bottom bond yields in the US, Europe, Japan and Australia. Across the entire curve, real rates are still strongly negative. While some central banks, such as the BoE and the Fed, have started to tighten policy, many others, including the European Central Bank, Bank of Japan and People’s Bank of China, are maintaining loose policy. At the same time, stock markets, although off their highs, remain historically expensive in many markets. Thus, many investors may be looking for safe havens and some might view gold as a safe haven in an uncertain and inflationary environment, especially since gold has underperformed most other metals and financial assets since the start of the pandemic.
• Until recently, gold was trading in an increasingly tight range
• Gold failed to rebound during recent inflation spike
• Gold may have broken higher on doubts over the pace of Fed rate hikes
• Gold options remain historically inexpensive, especially compared to stock options
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