Is Gold About to Regain Its Glitter?

At a Glance

  • A strong dollar and tighter U.S. monetary policy have been bearish for gold.

The past seven years have been lackluster for gold. Expectations that the Federal Reserve’s post-crisis quantitative easing (QE) programs would stoke inflation failed to materialize. Gold’s bear market also coincided with the end of QE and the Fed’s tightening cycle.  Increased gold mining supply didn’t help either.

Indeed, gold and the Bloomberg U.S. Dollar Index still have a strong negative correlation. Although gold’s negative correlation to Fed funds futures has diminished somewhat, anticipation of higher rates is not good news for gold.


How Many Rate Hikes?

As such, the big questions for gold investors are how much longer will the dollar bull market last and how far will the Fed’s tightening cycle go?  Monetary and fiscal policies are pulling the dollar in opposite directions.  Relative to the rest of the world, U.S. monetary policy is tight and becoming tighter.  The Fed has already hiked rates eight times..  Moreover, its “dot plot,” a forecast survey of FOMC members, suggests that it will go another six times between December 2018 and the end of 2020.  Tighter U.S. monetary policy is sending the U.S. dollar higher versus most other currencies and against gold, which does not pay interest on holdings.

Fiscal Tug of War

By contrast, U.S. fiscal policy is becoming looser just as most other countries continue to reduce deficits.  Since the end of 2016, the U.S. budget deficit has expanded from 2 percent to 4 percent of GDP.  Normally, an expansion of U.S. budget and trade deficits bodes poorly for the U.S. dollar and is supportive for gold.

The December 2017 tax cut and the March 2018 spending increases were bearish for the U.S. dollar and supported gold for a while, but U.S. fiscal policy appears to be on a stable trajectory.

While monetary and fiscal policies may be in a tug of war currently, this won’t last forever.  Eventually, the Fed will stop tightening.  That alone could be bearish for the dollar and bullish for gold, as it will allow investors to focus on the widening U.S. fiscal deficit.

So long as the Fed keeps tightening, gold is more likely than not to remain under downward pressure. This will be especially true if the emerging market currency disruption broadens to include more countries, sending the dollar higher.  However, if the Fed overtightens, it could prove extremely bullish for gold when the central bank is forced to reverse course and ease policy.

Trade War Effects

Lastly, there is the issue of China and the trade war.  So far, the trade war has been bullish for the U.S. dollar and probably, on balance, not good news for gold.  Typically, foreign currencies react to news of higher U.S. tariffs by selling off, and a stronger dollar, as we have seen, is usually bad news for gold.

However, if the U.S.-Sino trade dispute sparks a slowdown in Chinese growth, this could ultimately prove to be bearish for every commodity in the world save one: gold.  China’s GDP growth rate correlates negatively with gold prices: stronger Chinese growth is often bearish for gold, whereas weaker growth is often bullish.

Falling U.S. interest rates, a weakening dollar and slower Chinese growth could be extremely bullish for gold, but none of these scenarios is happening yet. It may be 1-3 years too soon to call a gold bull market.

Erik Norland is a Senior Economist at CME Group.

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