Updated Look at Gold’s Fundamentals

Gold is inversely correlated to the trend in real interest rates. As a result, Fed rate cuts and/or rising inflation and inflation expectations are the catalysts for declining real interest rates.

The shift in Fed policy, which occurred in only eight months was the catalyst for recent gains in precious metals. The 2-year yield, which is a proxy for the Fed Funds rate, declined from a peak of 2.98% to a recent low of 1.43%. 

While the Federal Reserve will cut rates to 2.00% this coming week, there is some question as to what comes next. The 2-year yield has rallied up to 1.79%. That implies only one additional rate cut, following September.

The real 5-year yield (as measured from the TIPS market) had declined roughly 1.25% but in recent days has increased by roughly 0.30%. See the yellow circle in the chart below.

During a period of rising yields, Gold can perform well only if the yield curve steepens. That implies long rates rising faster than short rates and increasing inflation expectations. 

In other words, the 10-year yield has to rise faster than the 2-year yield. The Fed would need to let inflation run and not hike rates on the short end of the curve. 

The fundamentals for Gold have been bullish but for now, they are in flux. 

Expectations for rate cuts are dwindling as yields rise. That is temporarily bearish.

However, if the Fed has to continue rate cuts immediately after September or resume cutting rates even in 2020 after a pause, that would put precious metals in position for higher highs. 

If the Fed pauses but doesn’t do anything in 2020 as inflation picks up and the yield curve steepens considerably, then that is also bullish for precious metals.

Ultimately, beyond the next few months, most scenarios would be bullish for Gold and precious metals. 

For now and for the remainder of 2019, Gold’s fundamentals are not bullish and that (along with the technical overbought condition) explains the current correction.

If you missed the recent run in precious metals, don’t panic. It’s best to be patient and let this correction run its course. 

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