Gold has historically rallied for at least 100 trading days after the first hike by the FOMC, but as HSBC's Jim Steel explains, this time it could be longer. Steel sees three key reasons to remain bullish and forecasts USD1,300/oz this year (though warns that beyond that level, physical demand may weaken and help curb further rallies.)
Tightening and gold
Background: The end of the long-run bull market
A perceived change in Fed policy brought the most recent long-run gold bull market to an end. After 12 consecutive years of positive performance, gold posted its first year of losses in 2013. Gold entered a bear market in April 2013, when bullion prices collapsed more than USD100/oz over a two-day time span. Sensing a shift in Fed policy, investors began liquidating bullion in earnest in April. Gold lost almost 14% of its value within two days after unprecedented amounts of futures were sold short, triggering several stop loss limits that caused a further cascade of selling. Heavy gold ETF liquidation also occurred.
Fed policy perception played a key role in the selloff. In May and June 2013, expectations of a Fed tapering of its QE program led to rising real interest rates and falling inflation expectations that, in turn, set off more gold selling. By the time the market steadied – due almost entirely to unprecedented China-led emerging market physical buying as prices slumped – gold had declined by almost a 25% in the second quarter alone. Declines continued over subsequent months but at a more moderate pace. Nonetheless, the market remained on a downswing up to December 2015, when prices fell to a cycle low of USD1,045/oz.
Fed tightening and gold: bullish at the start of the cycle
Gold prices resumed the upswing this year. But the resumption of Fed tightening raises concerns that the recent rally may be snuffed out by Fed rate rises. Tightening Fed policies, however, do not necessarily mean the end of the current rally. The role of the Fed’s tightening cycle is important in determining USD levels (and therefore gold) and the shifts in US rate expectations continue to influence the greenback. HSBC’s FX team has pointed out in previous reports that history suggests the USD tends to weaken after the Fed raises rates. Looking at the previous four Fed tightening cycles that have happened over the past 30 years, the USD has fallen in the period immediately after the first rate rise.
The converse happens for gold. Charts 1-4 below and on the next page show that gold prices tend to rally as Fed tightening cycles get underway. Gold prices weaken going into a tightening cycle and then rally for the next 100 trading days. We seem to be well into this period but given that rate hike expectations continue to be pushed into the future (HSBC economists expect a hike in June), we expect the gold rally to last even longer.
Gold and rate hikes
This time we see room for the gold rally to be extended
Gold is still recalibrating after the 2013-2015 sell-offs. This notwithstanding, gold has already rallied more than USD200/oz, or more than 20%, since hitting cycle lows in December 2015 and the ceiling for gold may be approaching. Our top-end forecast for gold is USD1,300/oz this year. Beyond that level, physical demand may weaken and help curb further rallies.
Three reasons to remain bullish gold:
- Dovish FOMC,
- Bearish view on the USD
- Negative rates
A more dovish FOMC
A major plank in our thesis that gold is likely to remain reasonably well-bid rests on our view that the gold market is adjusting to fewer potential Fed rate hikes and, in totality, a very shallow hiking cycle. This week’s scaling back by the FOMC of its forecasts for lifting interest rates later this year triggered a gold rally and the ratcheting down of rate hike expectations to two 25bp point increases from four previously, is likely to keep the market buoyant. Simply put, the longer the Fed holds its fire in raising rates, the better for gold.
USD to weaken
How the financial markets and, more specifically, the foreign exchange markets react going forward, will be of key importance for gold. Given that this week’s FOMC meeting was more dovish than expectations means it could spur on the broader theme of USD weakness that HSBC’s FX strategists have highlighted was already getting traction. This is bullish for gold. According to HSBC FX research, some of the bull USD argument is predicated on anticipated Fed rate hikes. The Fed, however, has commented repeatedly on the negative impact of a strong USD on import prices in depressing inflation. Although off its recent highs, the USD is still 20% stronger than it was two years ago. A stronger USD reduces the need for Fed tightening. If this is the main reason to buy the USD, it may become self-defeating at high USD levels. This runs counter to the argument for a stronger USD predicated on rate tightening and is, therefore, gold bullish. The USD gained (and gold weakened) last year on the divergence of monetary policies. This is no longer happening and we are now seeing more of a convergence. The US Fed has revised its rate projections lower, while the ECB and Bank of Japan are no longer chasing their currencies lower. HSBC FX research continues to expect EUR-USD to finish the year at 1.20, which supports our view of firm gold prices.
Negative rates
A third pillar of support for gold is the global phenomenon of negative interest rates. As we highlighted in Gold rally: Gold glows in a negative rate world, 11 February 2016, gold is one of the few beneficiaries of negative interest rates and deteriorating risk sentiment. With an increasing number of central banks implementing a negative rates policy, and this reflecting continued economic weakness, we expect gold to be supported by this backdrop. Negative rates are a sign of distress, which may increase flight-to-quality demand for gold. They lower the opportunity cost of owning gold and therefore encourage purchases. If the negative rates are deep enough or persist long enough they may encourage the hoarding of cash and gold. Gold may be a better alternative to cash in some cases as gold does not carry the risk of central bank ntervention by a monetary authority wishing to limit its currency’s appreciation.
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