Though we kicked off July focusing on the risk issues in Greece and the swoon in China’s A-share market, last week’s Semi-Annual Monetary Policy Report to Congress returned investors’ focus back to the fundamentals.
Fed Chair Janet Yellen delivered what was, relative to her past presentations and market expectations, a generally upbeat assessment of the economy. And critically, during the Q&A session she made most clear her position on the coming rate “normalization” cycle, favoring sooner-but-slower rate hikes over an alternative of waiting longer but having to raise rates along a steeper trajectory.
The focus on a better economic outlook along with “sooner-but-slower” raises the likelihood of a September liftoff. And while we also expect this date, the market remains unconvinced, leaving some room for rates to rise into the September meeting, particularly in the front of the U.S. rate curve where more sensitivity (and given current pricing, more vulnerability) to higher Fed rates lies.
Shift to emphasis on fundamentals affects bond market, gold
We can also see the impact of this return to focus on fundamentals in the relationship between bond market expectations for the Fed and its impact on the pricing of gold. While many factors influence the outlook for gold, one long-term and reliable factor has been the “opportunity” cost of gold. That opportunity cost is what real return you can earn on your cash.
As the chart highlights, gold has shown a strong inverse relationship to market expectations of “real interest rates.” For example, during the first flare-up of the European sovereign crisis back in 2011 (when Greece really did hold systemic risk potential) and when U.S. political discord led to significant fiscal tightening, the Fed offset both of these with even greater policy accommodation. The result was an extreme movement into negative real interest rate expectations associated with record high levels in gold. The “taper tantrum” of 2013 unwound those moves, leading to sharp moves higher in real interest rates and a sharp move lower in gold.
While more modest in comparison to these movements, the recent new lows reached by gold reflect a renewed expectation for higher real interest rates as the Fed starts to raise rates. Those higher rates increase the “opportunity” cost of holding gold and weigh negatively on its price.
Recent declines in gold serve to validate the return of fundamentals to the outlook for financial markets following the “risk off” episodes of Greece and China. And while certainly a lower systemic risk environment negatively impacts the safe haven aspects of gold, its luster is further diminished in a world of normalizing interest rates.