IAUM - Gold Is Pricing In Too Many Rate Cuts

2023-06-05 12:37:20 ET

Summary

• Gold prices face a deteriorating outlook as short-term borrowing costs increase, keeping inflation expectations subdued and real bond yields elevated.
• Interest rate markets expect significant rate cuts over the next year, but strong job reports and risk asset breakouts may moderate these expectations, negatively impacting gold prices.
• Spot gold is currently resting on uptrend support, but a downside break could lead to significant losses as speculative longs are unwound.

The gold price outlook continues to deteriorate as short-term borrowing costs move higher. High rates are keeping inflation expectations subdued, meaning real bond yields - the key driver of gold prices - remain elevated. At the same time, interest rate markets are expecting significant rate cuts over the next 12 months. Friday's strong jobs report and the breakout in risk assets suggest these easing expectations will moderate, which could deliver a huge blow to gold prices as was the case in the late-1990s.

In my previous gold article in May, I noted that gold's fair value based on the metal's correlation with US 10-year inflation-linked bond yields since 2006 stood at around $1,400 (see ' As Gold Loses Grip On $2000, Further Losses Await '). 10-year real yields have been broadly unchanged since then, but short-term rates have resumed their rise, which raises the risk of renewed upside in long-term yields as the yield curve is now at near-record inverted levels.

Interest rate markets are no longer pricing in cuts by the end of the year but continue to see a full 156bps of cuts in 2024. These cuts are expected to continue into 2025 and beyond, and explain why the yield spread between 6-month and 10-year USTs is now 175bps, its highest level since the shock rate hikes seen under Paul Volcker in 1981.

This yield curve inversion actually makes sense if breakeven inflation expectations are to be believed. Based on the yield spread between 12-month inflation-linked bonds and regular bonds, inflation is expected to average just 1.9% over the next 12 months, which would mark a sharp drop from current levels.

However, with Friday's strong jobs report fueling a bullish breakout in US stocks, and Tech stocks in particular once again showing signs of bubble-like behavior, the Fed may find it difficult to cut rates without fully reigniting the equity bubble. This is the predicament the Fed found itself in the late-1990s when the Fed was forced to continue hiking rates despite CPI being below 2% in order to quell the equity bubble. This caused gold to decline to deeply undervalued levels.

Spot gold is currently resting on uptrend support from its November lows and despite a 6% fall from its peak net non-commercial futures positioning shows investors remain heavily net bullish, equivalent to 27% of open interest. This suggests a downside break could lead to significant losses as speculative longs are unwound.

Note that I do not expect gold to ever actually touch the fair value figure of $1,400 noted above. Gold's fair value will rise over time as inflation remains positive to whatever degree, and I continue to believe that real yields will ultimately be forced much lower over the coming years, which will also raise gold's fair value. However, even flat gold prices over the coming years would lead to significant underperformance relative to cash if these high rates persist. I will remain short the metal until we see a significant drop in prices or a major decline in real bond yields.

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