Gold Bounces Back on Vague Fed, May Consolidate Above $1,830 by Year-End

Gold Bounces Back on Vague Fed, May Consolidate Above $1,830 by Year-End

Gold recorded its best day in about three months on Thursday, July 29, following the Federal Reserve’s reluctance to provide more details about the tapering of its bond-buying programs, which was interpreted as a dovish signal by most analysts. On Wednesday, the Fed’s Federal Open Market Committee (FOMC) left the interest rate unchanged and didn’t want to give any hints at when and how policymakers are going to reverse the economic support. (FED ARTICLE)

Many investors expect that the central bank may not rush with the tightening of the easy policy given the surge in COVID-19 cases caused by the Delta variant, which means more free money injected into the economy and thus more support for the precious metal. Currently, the Fed is buying $80 billion of Treasuries per month and $40 billion of mortgage-backed securities.

As a rule, when the Fed is dovish, i.e., it shows readiness to inject more cash into the economy by purchasing bonds and other securities, scarce assets like gold are increasing in value, driven by the expansion of the money supply. Thus, under this scenario, the US dollar is losing ground against the metal and against majors, as it gradually devalues. This is because the economy ends up with more cash versus the same amount of assets, which is one way to explain inflation.

There is a close relationship between the change in inflation and the price of gold. For example, there is an inverse relationship between the price of gold and the effective federal funds rate (EFFR), which is calculated as a volume-weighted average of overnight federal funds transactions reported in the FR 2420 Report of Selected Money Market Rates. The EFFR (green line on the chart) drops whenever the Fed cuts the interest rate and implements its quantitative easing (QE) programs to stimulate the economy.

The inverse relationship is even more obvious when we compare the price of gold with the so-called breakeven inflation rate, which is a gauge of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities.

Given that gold is one of the scarcest assets, it accurately reflects the inflation change. The fact that it updated the record high last year tells us that the Fed took unprecedented measures to stimulate the economy during the COVID-19 pandemic, resulting in a significant increase in the money supply.
Just take a look at the M1 money supply chart, which represents the supply of all US banknotes and coins along with demand deposits at commercial banks and savings deposits – we have to warn you that it’s eye-bleeding:

Thus, gold is mainly used as a hedge against inflation rather than an investment channel for generating high returns. The best thing the precious metal does for investors is to store value in the long term.

Gold Price Surges Almost 2% on Thursday, Ends July Higher

After a disastrous June, when gold futures fell about 7%, from $1,900 to $1,769, the metal is bouncing back in July. Last month, the Fed surprisingly turned more hawkish, saying that it would likely start increasing the interest rate earlier than expected. The announcement put pressure on gold prices and supported the US dollar. June was the worst month for the metal since November 2016.
Still, gold prices managed to rebound due to the rapid surge in COVID-19 cases related to the new Delta variant, while the Fed’s last meeting gave an additional impulse.
On Thursday, July 29, gold futures rose over 1.7% to $1,835, offsetting the losses incurred during the previous two consecutive bearish weeks, during which the metal dipped to a low of $1,789. The Thursday surge helped the metal secure the best week since late May.

Meanwhile, data released Thursday showed that the US economy fell short of expectations in the second quarter of 2021. The gross domestic product (GDP) rose only 6.5%, while analysts polled by the Wall Street Journal expected an expansion of 9.1%. The disappointing data failed to support the US dollar, leaving a free hand to gold.

Global Gold Demand Stays Flat in Q2

The World Gold Council said in a recent post that gold demand (excluding over-the-counter operations) for the second quarter was close to Q2 2020 at 955.1 tons, down 1%. Jewelry demand experienced a second straight quarter of strong year-on-year growth, driven by global economic recovery and improving sentiment. Elsewhere, Q2 investment of 283.9 tons was down by over 50% compared to the same period in 2020 due to a sizable decline in ETF inflows.

What’s Next for Gold?

The Fed’s vagueness will provide the much-needed support for the metal in the coming weeks. A survey carried out by Reuters on July 29 concluded that gold futures would consolidate above $1,830 for the rest of the year and then edge lower in 2022 as the global economy continues to recover, and central banks will be forced to tighten the monetary policy.
Julius Baer, analyst at Carsten Menke, told Reuters:
“Safe-haven demand should fade further as global growth recovers and inflation turns out to be temporary.”
In the short-term, gold prices are driven by several factors, including:
A recovery in demand for jewelry;
Dovish signals from the Federal Reserve and the European Central Bank;
Weakening dollar as emerging markets recover;
A higher-than-expected increase in inflation, even though the Fed says it’s temporary.

According to the median responses of 38 analysts and traders participating in the poll, gold prices will average $1,835 in the current third quarter and $1,841 in Q4. In 2022, prices will average $1,785. In general, the latest predictions are slightly higher compared to a similar poll conducted in April.
In the short term, disappointing GDP data and the slow recovery in employment will likely force the Fed to maintain its dovish stance. On Wednesday, Fed Chairman Jerome Powell said that the labor market still had “some ground to cover” before the central bank decides to reverse the economic support.
David Meger, director of metals trading at High Ridge Futures, told CNBC:

“You’re going to see inflation heat up moving forward because the Fed is more focused on employment and is not going to fight them in the near-term and that is a positive environment for precious metals. This is not a flash-in-the-pan type rally but a more sustainable one because nothing is standing in gold’s way.”

To conclude, it seems that the precious metal will stay strong for the rest of the year despite the June collapse. Still, it probably won’t be able to switch from red to green in annual terms, as it started the year close to $1,900.

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