Gold prices currently trade at a 5-month high of $1290 on the back of fear… fear of US-Russia tension over Syria escalating… fear that the United States may do a preemptive strike on North Korea or North Korea may hit the US first.
The metal remains well bid on account of rising political uncertainty and negative real rates environment. It is no brainer that geopolitical risks could destabilize the financial markets and force Fed to delay interest rate hikes… and delay the process of normalizing interest rates.
The yellow metal looks set to fly high; well above $1300 levels if the geopolitical tensions rise.
Is it a bull trap?
Geopolitical risks are clearly the main factor behind the recent rally in gold. However, one needs to take into account what is happening on the inflation front. The following factors are a risk to gold rally-
- The great reflation trade was set in motion by the spike in the Chinese PPI in Q3, 2016. Trump’s victory and his promises to embark on the expansionary fiscal policy turned out to be the icing on the cake.
- However, the Chinese PPI seems to have topped out. In fact, the speculation is gathering pace that inflation may have peaked across the advanced world. Furthermore, markets are slowly losing confidence in Trump’s ability to deliver on his promises on the fiscal front.
- This is evident from the pullback in the inflation expectations. The US 10-year breakeven inflation rate topped out on January 30 at 2.07%.
Gold and US 10-yr breakeven rate comparison chart
The above chart clearly shows gold has rallied despite the pullback in the inflation expectations.
Fed’s Balance Sheet normalization
- The chart above shows Gold rose in line with the expansion in the Fed’s balance sheet size.
- The initial rally was in on speculation that a rapid expansion of the Fed’s balance sheet would lead to hyper inflation. However, it only ended up inflating the stock markets; hence gold decoupled from the Fed’s balance sheet size and resumed the downturn in late 2012.
- The metal suffered sharp losses during the Taper tantrum. However, QE hasn’t really ended. The Fed still reinvests the proceeds of its bond holdings.
- Now the central bank is planning to normalize its balance sheet. The first step would be to end reinvestment of the proceeds, followed by a offloading the bond holdings.
- That means the liquidity would be sucked out of the system, which is bearish for gold.
Gold could continue to rally if the geopolitical tension rise… else the fundamentals – falling inflation expectations and downsizing of the Fed’s balance sheet size – suggests the yellow metal is in for a pullback.
- The descending trend line (drawn from 2011 high and 2012 high) is still intact. Long-term view would turn bullish if the prices close above the trend line resistance.
- On the downside, breach of the December low of $1123 would signal the continuation of the larger downtrend.