Gold should get a liftoff from Fed hike after an initial turmoil
Tue, 08 Dec 2015 19:54:54 -0700
Gold had been inversely tracking this probability for some time now, and hence, it was no surprise to see gold prices move lower
The anticipation of an interest rate hike in the US continues to gain momentum, as Fed chair Janet Yellen called a rate increase at the December meeting a “live Possibility”.

Better-than-expected jobs data, hawkish Fed official comments and reinforcing Fed minutes lifted the market-assigned probability of an interest rate increase in the US at the December FOMC meeting to 72 per cent from about 50 per cent at the end of October.

Gold had been inversely tracking this probability for some time now, and hence, it was no surprise to see gold prices move lower. Gold prices ended the month at $1,064.77 an ounce, a 6.8 per cent drop for the month.

The Fed seems to be setting the stage and prepare everyone for the liftoff in December. Janet Yellen calling the rate increase in December a live possibility followed by other Fed board members reiterating the need to lift off soon.

Minutes from the Federal Reserve’s last meeting reinforced that policy makers could raise US interest rates at the next meeting. This came along better than expected jobs data increasing the odds of an interest rate lift off.

The addition of 271,000 jobs exceeded all estimates and median forecast of addition of 185,000. Also, average hourly earnings climbed from a year earlier by the most since July 2009. This helped increase the probability of the interest rate increase to more than 70 percent from 50 percent at end of last month and from 25 percent prevailing in the middle of October.

However, not all’s well with the US economy. We also saw data pointing out at signs of cooling US housing and manufacturing. Contract signings to purchase previously owned homes climbed less than forecast in October after declining the prior two months.

The MNI Chicago Business Barometer unexpectedly contracted in November. Institute of Supply Management (ISM) November Manufacturing PMI came in at 48.6, which signals contraction. It was the first time in three years that the PMI came in at less than 50.0 and it is the worst performance since 2009.

However, these weaker set of economic data were unable to scale back expectations of rate hike in December which seems to have been baked in but still called into question the extent to which policy makers will raise interest rates.

Gold has been out of favour this year, grinding lower as investors fear the metal with the impending Fed rate hike on the horizon. We’re back to the situation as we were early in the year in the metals markets.

This time around, there’s a hope that the Fed just gets it over, so traders can stop obsessing over and shorting because of a potential rate hike. The Fed minutes came out pretty much as expected, except that they suggested, if a rate increase were to be justified in December, the glide path for further rates would be shallow.

The argument that the Fed needs to raise rates to signal that they have confidence in the economy and to an extent it’s a matter of credibility.

In the US, all through this year, earnings have been falling dramatically barring the financial sector. Earnings for energy and metals companies have been the hardest hit. Earnings overall in the US are now in decline and likely to record two successive quarterly declines.

In other words, the US economy seems to be staring at an earnings recession. The strength in the dollar also seems to be contributing to this weakness. This is true not only because of a decline in earnings from uncompetitive exports, but also, with a strong dollar, consumers can purchase imported goods more efficiently as well.

Now, with most other regions of the world all engaged in massive QE and competitive devaluation of their currencies, a rate rise by the Fed now would only serve to cause the dollar to rise even further, leading to an even greater decline in profits. In short, with a strong dollar, the US is importing deflation and in the process hurting corporate profits.

The more important dynamics for gold remain the larger global growth challenges. With other major economies in easing mode and the Fed's limited ability to aggressively hike rates will highlight gold’s appeal as an important allocation as central banks embark on further experimental easing measures.

We expect the headwind for gold to ease noticeably in months following the Fed’s first interest-rate hike. When the rate hike happens there could be initial panic selling in gold on the prospects of further hikes and all talks of real rates moving higher.

However, the downsides could be limited as the Fed guidance is likely to be dovish as it will have an adverse impact on asset markets. After the initial rate normalization jitters, the environment will likely be far more positive for gold. It is thereafter markets would shift focus to the likely nature and extent of rate hikes.

We restate our view that as the market figures out that Fed will stay behind the curve and do only little and keep real rates negative for much longer, gold should start moving northwards. What may propel gold prices moving higher is the prospect of unwinding of short positions which can be expected after the Fed rate hike as the market starts focusing on the extent of rate hikes which are likely to be restrained than many anticipate.

Until then, we expect physical demand and central bank buying to support prices at lower levels helping limit downsides in gold. Even the global environment continues to remain positive for gold with a back drop of low growth and deflationary pressure which the central banks are trying to resist with unconventional monetary measures.

We reiterate that one of the reasons to own gold is just the sheer fact that it is one of the good portfolio diversification tools and thereby helping you to reduce overall portfolio risk.

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