Is Gold About To Break-Out Of Narrow Trading Range?

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AT-A-GLANCE

• Until recently gold was trading in an increasingly narrow range
• Gold failed to rally during the recent surge in inflation
• Gold may have broken to the upside on doubts about the pace of Fed rate hikes
• Gold options remain historically inexpensive, especially compared with equity options

Gold, traditionally considered a hedge against inflation, doesn’t appear to have benefited from the recent surge in U.S. consumer prices that have gone from 2% to 7.5% year on year. Over the past 18 months, gold has not only moved sideways, it has been trading in an increasingly narrow range that technical traders sometimes refer to as a “flag formation.” However, in mid-February 2022, it may have broken out decisively to the upside (Figure 1).

Figure 1: Has gold broken out of its “flag formation” of increasingly narrowing trading ranges?

Gold’s recent behavior leads to two questions:

1. Why did gold not rally between April 2021 and January 2022 as inflation surged?
2. Why did gold suddenly begin to move upwards in mid-February? 

What Held Gold Back from Rallying?

While perhaps rising inflation should have theoretically boosted gold, reality proved to be more complex. The sharp increase in U.S. consumer prices produced an enormous change in investor beliefs about the future of U.S. monetary policy. As recently as early October 2021, Fed Funds futures did not price even one rate hike for the following 12 months. Now, just four and a half months later, those same futures anticipate six rate hikes in the coming 12 months (Figure 2).

Figure 2: Since early October there has been a sea change in investor expectations for the Fed

Higher interest rates are anathema to gold. Gold can be seen as a quasi-currency, but one that does not pay interest on deposits. As such, when investors anticipate central banks’ easing monetary policy, the price of gold tends to react positively. The opposite tends to happen when investors come to expect tighter central bank policy: the prospect of higher interest rates on fiat currency deposits can make them seem more attractive compared to gold. This is apparent when looking at the price of gold in a chart alongside expectations for Fed Funds two years out (Figure 3).

Figure 3: Gold prices often move the oppositive direction of Fed rate expectations

When one correlates the day-to-day movements in gold prices with the day-to-day changes in Fed rates expectations, one finds that gold almost always displays a negative correlation with changes in expectations for Fed rates two years from the present (Figure 4).

Figure 4: Daily changes in gold prices correlate negatively to daily changes in Fed policy expectations

As such, it seems likely that the trend towards expecting higher Fed rates held gold back from rallying. Given the sea change in expectations for the Fed rate hikes, its impressive that gold prices held up as well as they did, suggesting that gold may have benefitted from rising inflation after all: the rise in inflation appeared to cancel out the impact of expectations of higher Fed rates.

It is also worth pointing out that the price of gold soared from early 2019 to mid-2020 as expectations for the level of Fed rates began falling even before the pandemic began. 

Why has gold been rallying in February?

Expectations for tighter Fed policy peaked, at least temporarily, on Monday February 14. That day, Fed Funds futures priced a Fed policy rate of 1.74% one year in the future. Over the next few days that expectation dropped to 1.59%. Expectations for rates two years ahead fell from 2.18% to 2.09%. Minutes from the Fed’s January meeting suggested that the central bank may not raise rates as quickly as some investors expected, leading them to pull back on expectations that the Fed might hike rates in 50 basis-point increments, opting instead for smaller 25-bps moves. (Gold was also supported by the escalating tensions over Ukraine as investors sought the yellow metal as a safe haven asset).

While the Fed’s minutes brought relief to investors worried that the central bank might raise rates too quickly, it simultaneously created another concern: that the Fed might not act quickly enough and fall behind the curve when it comes to combatting inflation. These thoughts may have been accentuated by a rash of recent data from payrolls to inflation to retail sales which cumulatively paint the picture of a strong economy with robust employment growth, surging consumer spending and inflation. A go-slow approach to tightening policy appears to have pleased short-term bond investors and gold bugs simultaneously.

Gold’s narrow trading range and lack of realized volatility may also explain why the implied volatility on gold options fell to such a low level, even as the cost of options on other markets, such as equities, began to rise in recent months. If gold has broken out of its trading range and makes a strong directional move, the cost of gold options might begin to increase as well (Figure 5).

Figure 5: Gold option implied volatility lags the rise in equity index options implied volatility