Global risks are rife; fertile ground for gold to grow By CHIRAG MEHTA, QUANTUM MUTUAL FUND Gold prices got hit as Fed talks up interest rate hike expectations. Hawkish Federal Reserve rhetoric and strength in the US dollar and stock market are pressuring US dollar gold prices. A run of better U.S. economic data plus the minutes of April’s FOMC meeting convinced traders that a rate hike is looming. Markets now assign a 52% probability of rate hike in July from 26% at the beginning of May. This year, demand for gold has come overwhelmingly from investors, making the rally vulnerable to swings in sentiment. With the inability of prices to cross the $1300 an ounce mark and rising probability of a rate hike by the Federal Reserve, gold succumbed to profit taking by speculative investors. For the month, gold prices lost 6.01% lowering this year’s gains to 14.5%. A pickup yet again in Fed tightening expectation and this leads to a selloff in gold; sounds like 2015 all over again? Also, the very notion of Fed communiqué to get hawkish isn’t a new thing after a run up in stock markets and signs of stability in credit markets. But, this time is different. Rather than the timing of rate hike; be it in June, July or September, the markets are more focused on the extent of rate hikes. As expected, talks of rate hike were bound to cause a correction in gold prices especially given some hot money flows went into gold. Two regional Fed chiefs said last month, “the central bank risks stoking an asset bubble by delaying action for too long” and that’s precisely the reason for increasing interest rates and not the strength of the economy. The World Bank downgraded its global growth forecast this year to 2.5 percent from 2.9 percent. Given the backdrop of slowing growth and falling inflation expectations, the G7 leaders wrapped up their meeting with a commitment to use all policy tools to ensure global growth. This means that global monetary easing will continue and possibly accelerate. Japan’s Prime Minister, Shinzo Abe, went as far as warning that a global crisis similar to 2008 is becoming a real possibility. This would be enough excuse to propagate further unconventional monetary policies. Outlook While we believe that the Fed should continue with its interest rate normalisation as lower rates would not resolve the current economic problems and will be unable to bring back growth. The current rate of 0.25%-0.50% range is well below historical norms. Even with two rate hikes this year would still pull the funds rate to a still well below 'normal' rate level. Given historical comparisons, U.S. monetary policy will continue to remain extremely accomodative and even at a 1.00% level after two rate hikes would be at the lower bounds seen during recessions. Prior to the current easing cycle, the last time the federal funds rate stood as low as 1.00% was June 2003 and that marked the bottom of the easing cycle. Given this context, we believe that the Fed will likely act twice this year. The first move will likely be in July and the second near the end of the year post the elections. The next Fed meeting in June is just days before the “Brexit” referendum and the poll suggests that the vote is still too close to call and given it carries severe political risks, the June meeting will likely see no hike. However, the Fed will continue to build on the rate hike momentum and prepare the markets further for a rate hike in July. There will be high volatility in gold markets until July as markets continue to assess central bank moves based on uncertain economic data and its resulting impact on global currencies. Post the rate hike, things will start looking better for gold as markets shifts focus from rate hike speculation to fundamentals. Real interest rates will probably stay low even if the Federal Reserve raises borrowing costs in response to higher inflation. Gold tends to perform well in declining or negative real interest-rate environments. The fundamental view here remains that U.S is witnessing anaemic recovery and far from levels seen in a post recessionary rebound. The growth stands on weak pillars of easy monetary policies and cheap liquidity and hence not sustainable in the long run. This is evident in the sluggishness seen in consumption growth which is not only hit by lower wage growth but more so by rising cost of non discretionary spend. Healthcare and insurance costs have seen substantial increase and also the rental costs have been increasing much faster than the headline inflation. These costs really pinch in a low wage growth environment hitting other non discretionary spends and slowing economy further. Uncertainty over global central bank policies is deepening. Investors seemed to be concerned over eroding effectiveness or far reaching negative consequences of unconventional monetary experiments like quantitative easing programs and negative interest rate policies. As a response, we have seen some real big smart money move into gold. Also, retail investment demand has been strong in Japan and Europe in response to negative interest rates as such policies undermine investor confidence in economy and central banks alike. Physical buying has been slow in India and China. With the recent correction in gold prices we expect physical demand to pick up momentum. Demand from China can accelerate as concerns surrounding the economy and currency increase. We anticipate more buying to emerge on any meaningful pull backs supporting prices. Global risks are definitely rife. Commodity and debt bubbles in China; a U.K. vote to leave the EU popularly known as “Brexit”; Donald Trump’s campaign for the U.S. presidency; and the potential for central bank easing to amplify inflation fears. Given the macroeconomic picture, gold will be a useful portfolio diversification tool and thereby helping you to reduce overall portfolio risk.