Signs indicate gold bugs can reap rewards and enjoy the inflation ride

After a flurry of major central bank meetings and a strong US jobs report this month, markets have calmed, with equity volatility measures near their long-term lows.

The dollar has perked up and has reached new highs against low-yielding currencies such as the euro and Japanese yen. This is chiefly owing to increasing price pressures, which have been highlighted again by strong and persistent inflation figures out of the US.

In turn, money markets are pricing in the chances that the US Federal Reserve has to raise interest rates sooner than expected. In contrast to the third-quarter soft patch in economic data, there have been some eye-catching economic releases recently. This includes the solid US monthly nonfarm payrolls report, which had notable monthly upwards revisions. Last week’s US retail sales also beat expectations and point to household incomes and wealth still rising.

This should mean consumers continue to drive the economy during the final quarter of the year, with gross domestic product projected to print a healthy 6 per cent.

The upside surprise in the US October inflation data probably grabbed the most headlines, particularly the attention of monetary policymakers around the world who will be feeling under more pressure to tighten policy and raise interest rates.

The US Consumer Price Index outcome for October hit an annual rate of 6.2 per cent, a three-decade high and three times the Federal Reserve’s medium-term target of 2 per cent. In addition, there was breadth to the above, with the core reading that strips out more volatile food and energy costs climbing to 4.6 per cent.

Bond markets, which price in the potential interest rate moves of central banks, reacted swiftly to the bumper inflation data release.

Expectations of the first US rate rise have now moved to the middle of next year from 2023. Traders believe inflation will remain persistent for a prolonged period, forcing the Fed into action by raising rates soon after tapering its bond-buying programme.

More Fed officials are now shifting their “transitory” views as they take the inflation challenge more seriously. Essentially, we have inflation at a 31-year high, while rates are at their lowest they have ever been.

One interesting thing to note is that the timing of interest rate moves has been brought forward, but rate increase pricing for 2023 and 2024 remains little changed.

Using the 10-year US Treasury yield as a predictor of the peak US Fed funds rate for this cycle, forecasts remain modest with the current yield of 1.6 per cent well below the Fed’s longterm projection of 2.5 per cent.

The issue taxing many economists is how far prices might rise. Some believe headline inflation could rise above 7 per cent as pipeline price pressures show little sign of diminishing and expectations for inflation climb higher. But other analysts hope that the year-on-year impact of higher energy prices will start to fade in time, while other raw material shortages ease.

One asset enjoying the environment has been gold, with the precious metal making five-month highs recently. The commodity is traditionally regarded as an inflation hedge and would also benefit in periods of lower growth and higher inflation. This is so-called “stagflation” and fears that the global economy could be entering this phase are growing.

Higher global interest rates do reduce the appeal of holding a non-interest-bearing asset such as gold. A rising dollar should also dull the appeal of the precious metal. But central banks are not expected to raise rates so fast as to choke off the growing recovery.

This has led to real interest rates, that is those adjusted for inflation, remaining in deeply negative territory, which is attractive for gold bugs and those positioning for a more inflationary environment. Moderate inflation should mean a preference towards equities and away from bonds, while stronger levels point to precious metals and other commodities.

There is strong price support for gold at $1,834, with the June high at $1,917 a target for the bulls. Key will be whether we are close to a top in inflation expectations, which could signal that yields start to rise again and dull gold’s appeal.

There is strong price support for gold at $1,834, with the June high at $1,917 a target for the bulls