This Gold Rally Has Recent History on Its Side – 23 March, 2017

Gold has staged an impressive rebound since the Federal Reserve raised interest rates last week and reiterated that the pace of increases will accelerate. But is a rally logical?

Some would argue that higher rates portend faster inflation and that gold is a good hedge against inflation, thus validating a long gold position. On the flip side, post-rate hike rallies in gold can be seen as counter-intuitive for two reasons, the first being that the precious metal doesn’t generate a yield. Warren Buffett once said during one of his Berkshire Hathaway annual meetings that if you owned all gold in the world, “you could climb on top of it, fondle it, and declare yourself king, but you couldn’t earn anything on it.”

The second reason is that when interest rates rise, the appeal of that nation’s currency tends to increase, causing it to appreciate. But a stronger U.S. dollar is generally bearish for commodities, as most global commodities, gold included, are priced in U.S. dollars. What likely happened that speculators went long the dollar in anticipation of the widely expected rate hike and shorted gold. Once Chair Janet Yellen confirmed the rate increase, the speculators unwound their long dollar positions,  covered their short gold positions – likely at a profit.

This practice, common during rate hike scenarios, was evident in the last two long-awaited quarter-point increases in December 2015 and December 2016. In fact, both of those cases resulted in bull runs not only for gold, but for other precious metals and for mining stocks that persisted for a few months.

The Fed also stuck to its forecast for at least two more rate increases this year, unchanged from its December forecast for 2017, but Yellen’s tone continues to lean towards caution. That leaves policy makers room to maneuver in case U.S. growth falters, inflation tapers, or President Donald Trump’s policies become economically disruptive.

So will there be another extended gold rally and will this same scenario play out during the anticipated hikes later in 2017? The answer may be more easily derived from flipping a gold coin as a myriad of factors, both macro-economic and geo-political, could feasibly reverse gold’s direction. It is likely, nevertheless, that the trading scenario above will be repeated and even more likely that anticipation of additional rate hikes will heighten volatility in both the gold and currency markets.

But the problem with gold in many of these recent rallies is that, much to the dismay of gold bugs, the metal has continued to face resistance. Just when gold looks like it’s braced for a sustainable move up, it loses steam and trends back down.  This “gold ceiling” arises for a number of reasons, with the most obvious being good old supply and demand. Today the dominant perception is that there’s simply too much of it around to get investors worried, particularly while gold’s price is well above miners’ marginal cost of production.

Additionally, U.S. equity markets are performing well (outside of recent days)  and emerging markets are providing decent investment opportunities, thus there’s no evidence of a strong flight to quality. And those who mistrust fiat currency regimes are flocking to bitcoin as an alternative.

Gold is like a Hollywood celebrity.  Sometimes it’s hot and in the limelight while other times its waiting for its next big role. With a dearth of news in the gold markets, and investor distraction over things like U.S. Presidential tweets, the Russian playbook and European populism, gold is not making enough front page news. The advisable way to trade gold during this Fed cat and mouse rate game is to trade in and out of it. It’s wise to try and gauge the interest-rate language around Fed statements to determine which way the  dovish/hawkish scale tilts.

A good practice is to always maintain a long gold position along with an above-the-market sell-limit order.  Once the sell order is executed, wait for a dip in price and start all over again.  The same exercise can be accomplished by selling out-of the-money gold calls against a long gold position, whereby one not only gains from gold’s upside, but also takes in option premium.  There’s no substantial reason for gold to drop precipitously from current levels but as a hedge, a stop limit sale below the market is as advisable.

Source: Bloomberg