How will gold bullion react to a Fed rate hike?

The US economy has been performing strongly in 2016, despite its apparent weakness in nominal terms. Compared to the global economy, US economic growth has been stable and consistent. The annualised Q1 gross domestic product growth rate of 0.5% was rather lacklustre, but for an economy the size and scale of the US, it was notable given the state of the global economy. Housing prices in the US continue to rise and the jobs market remains robust. The domestic economy is countered by weakness in the global economy.

This is being fuelled by widespread retrenchment in the oil industry and declines in the manufacturing sector. The size of the US economy continues to expand, fast approaching $17 trillion at constant prices.

The GDP per capita is also increasing in a gradual way. While growth remains tempered, the US economy holds the mantle as one of the world’s richest countries, even per capita.

Moving into Q2 2016, analysts are expecting the growth of the US economy to continue to improve. GDP growth for the current quarter (Q2 2016) is likely to grow at 0.97%, with a quarter on quarter growth rate of 1.62%. The Industrial Production Report from the Board of Governors and the Residential Housing Report from the Census Bureau presented analysts with positive Economic Data. Over the next year, the Office of Management and Budget anticipates that the US economic growth rate will largely remain stable, but gradually decline. For the remainder of 2016, the US economy’s growth rate is likely to top that of the UK and the euro zone.

On Friday, May 27, gold was trading at $1,212.75 per ounce, down 0.09% to $1.05. The precious metal has endured sharp losses over the past 30 days, shedding $35.40 per ounce or 2.83%.

Gold was closing in on $1,300 an ounce in May, but has lost as much as $90 during the month. The sharp losses experienced recently are a direct result of the perspective shared by Federal Reserve Bank presidents and governors and members of the FOMC. The tone in recent weeks has shifted from a dovish one to a hawkish one and this has fueled speculation that a June 14/15 policy decision will go in favour of a rate hike.

The importance of interest-rate hikes cannot be understated: The current federal funds rate is 0.25% – 0.50% and a policy decision could raise that interest-rate by possibly 25-basis points. One of the measures used to gauge public sentiment when it comes to the likelihood of rate hikes is the CME Group FedWatch tool. This indicates the likelihood of a rate hike based on consensus forecasts. For Wednesday, June 15, the implied probability of a 0.75% federal funds rate (FFR) is 28.1%. The implied probability of interest rates remaining at their current level of 0.25% – 0.50% is 71.9%. In April, the implied probability of a 0.5% interest rate was 86.9% and that of a 0.75% interest rate was 13.1%. The big jump in favour of a rate hike is an indication that many more market participants are jumping on the bandwagon of a June rate rise.

The next Fed meetings will take place on the following dates:

- July 27, with a 0.5% interest rate likelihood of 39.3% and a 0.75% interest rate likelihood of 48%;

- September 21, with a 0.5% interest rate likelihood of 32.2% and a 0.75% interest rate likelihood of 46.4%. The remaining percentages anticipate a 1% interest rate and a 1.25% interest rate;

- November 2, with a 0.5% interest rate likelihood of 29.6% and a 0.75% interest rate likelihood of 45.2%. A 1% interest rate is expected by 21.3% of respondents and a 1.25% interest rate is expected by 3.7% of respondents;

- December 21, with a 0.5% interest rate likelihood of 19.7% and a 0.75% interest rate likelihood of 40%. 1% interest-rate is expected by 29.3% of respondents and a 1.25% interest rate is expected by 9.6% of respondents.

An important development has been taking place with hedge funds of late. Prior to Janet Yellen’s speech at Harvard University on Friday, May 27, hedge fund managers made a concerted effort to disinvest from gold, anticipating the worst. May has been a particularly trying time for investments in the precious metal, as the likelihood of a Fed rate hike gathers momentum. The US economy continues to show signs of improvement and this does not bode well for the price of gold, or the demand for gold as a safe haven investment. Demand for gold typically thrives when equities markets are in trouble or when the US economy is slipping.

For the year to date, gold has been performing strongly, but the mood of the moment has turned against the precious metal. When Janet Yellen gave her speech, she was unequivocal in her comments to the effect that a Fed rate hike in the summer was imminent. Since gold is a non-interestbearing commodity it cannot offer the same returns to traders and investors who choose to invest their money in fixed-interest-bearing securities. As interest rates rise, so the USD rises relative to other currencies and this to does not bode well for the demand for gold. While it is not entirely true to say that gold has lost its lustre, there is clearly less of an appetite for the yellow metal.

For the year to date, a decline of 26% took place in the net long position for gold futures (ending on May 24). Gold futures dropped 2.9 percentage points and closed at $1216.70 an ounce. It is the improved performance of the US economy that is weighing heavily on the demand for and the price of gold bullion. The increase in GDP during Q1 2016 was larger than anticipated, and this upset gold momentum. Gold reached a high in April, closing in on $1300 an ounce, but has since shed much of its gains. While Janet Yellen never provided an exact timeframe for the next series of rate hikes, she did indicate that it would take place within months. But 2016 has hardly been a bearish market for gold, with the gains for bullion approaching 15% despite the sharp losses in May. Traders are expecting the Fed to increase interest rates to 0.75% in July by a far greater margin than those anticipating a rate hike in June. For now though, gold has lost favour, but may well recover off to profit-taking drops the price and buyers flock back to gold once again. The pullback in gold bullion is to be expected given the profits that have been generated.