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Recent trends in western economies indicate a marked decrease in inflation rates, prompting shifts in monetary policy expectations. Specifically, the US Federal Reserve (The Fed) reduced its key policy interest rate by 0.5 percentage points just last week. This environment of lower interest rates can be particularly conducive to the appreciation of gold prices, whilst offering investors a hedge against economic uncertainties, and recessionary risks.
Inflation, which soared to multi-decade highs in the wake of the COVID-19 pandemic and the subsequent supply chain disruptions, is finally showing signs of abatement. The Consumer Price Index (CPI) inflation data from the US, UK and Eurozone have shown a deceleration in price increases. Factors contributing to this decline include improved supply chain efficiencies, stabilisation in energy prices, and the effects of prior monetary tightening.
Interest rates have a profound effect on gold prices due to the latter's status as a non-yielding asset. Higher interest rates increase the opportunity cost of holding gold, as investors can earn higher returns on interest-bearing assets. Conversely, lower interest rates reduce this opportunity cost, making gold more attractive.
There are several elements to consider when assessing the effect of changing economic fundamentals on the gold price:
- Reduced Opportunity Cost
The US Fed surprised the market with a 0.5% percentage drop in its policy rate. This is particularly remarkable as rates are usually moved in increments of 0.25%. This lowered the opportunity cost of holding gold and, in fact, the reaction in the USD gold price since the rate announcement demonstrates this relationship, with the price now trading more than $70 higher (2.8%).
2. Weaker US Dollar:
Lower US interest rates often lead to a depreciation of the US dollar. The dollar had previously risen 20-year highs into the beginning of 2022, and this will have restrained gold price increases, owing to much of the bullion trade taking place in the world reserve currency.
A weakening dollar, as observed in the last 2 years, has made gold cheaper for holders in other, local currencies, thus boosting global demand and supporting higher prices. Hence why we have seen such a strong move in the USD gold price over this period – up nearly 45%.
What’s more, for UK investors in the short term, a relatively strong gold price has held back GBP gold price advances, and this could present an opportunity should the pound weaken from these short-term highs.
3. Inflation Hedge
Despite the current downtrend in inflation, the spectre of inflationary pressures and currency volatility remains a concern for many investors.
Interest rates are the monetary policy tool of choice for Central Banks looking to influence the demand for money and borrowing, and thus aggregate demand in the economy as they seek to incentivise spending and avoid recessions. However, inflation can also be brought on by supply chain disruptions and financial dislocation, as we saw during the pandemic. These ‘supply side’ inflationary risk must also be borne in mind when deciding on suitable portfolio diversification.
Gold's historical role as a hedge against the evolving inflation landscape ensures its continued appeal in portfolios seeking to preserve value in real terms.
The interplay between inflation expectations, US Federal Reserve policies, and gold prices is complex but typically follows observable patterns. As the market adjusts to the new lower inflation paradigm and revised interest rate expectations, conditions for gold have turned even more supportive.
- Investor Inflows: Exchange-traded funds (ETFs) backed by gold have seen renewed inflows as institutional and retail investors increase their exposure to the precious metal. Global gold ETFs saw inflows four months in a row: all regions recorded positive flows with Western funds being the largest beneficiary.
- Price Trends: Gold prices have shown resilience and upward momentum, reflecting increased demand. Analysts forecast continued strength in gold prices if current economic conditions persist.
The decline in inflation rates across western economies over the past 18-months, and the resultant lowering of interest rates and the expected path of rates, have created a supportive environment for gold prices. As a non-yielding asset, gold benefits from lower interest rates and a weaker dollar, bolstering its appeal as a safe-haven and inflation hedge. Investors are likely to continue turning to gold, anticipating stability and potential appreciation in value amidst ongoing economic and geopolitical uncertainties.
Sources
Federal Reserve Board - Federal Reserve issues FOMC statement
Gold hits record high as Fed signals potential rate cuts | Wealth Professional
