Gold Outlook: Fed credibility takes a hit, but buyers aren't biting

SEATTLE (Scrap Monster): Gold is sitting just above a major support zone in an environment where, under normal circumstances, it would often be flying. US real yields have declined sharply, albeit remaining at elevated levels, the dollar has softened a little, and the Fed's commitment to bringing inflation back to target has yet again come under scrutiny. Yet despite those apparent tailwinds, bullion has struggled to bounce.

The question is whether the price action reflects temporary factors, including forced liquidation in other asset classes and month-end positioning, or whether something more significant is suppressing its ability to recover. With gold now moving in line with its historic nemeses, being US Treasury yields and the dollar, it creates more confusion than clarity.

Fed talks tough, but actions fall short

While earnings results from Microsoft and Alphabet may have stolen the headlines in the equity universe, for other asset classes, Wednesday's key event was the Fed's October interest rate decision.

The Fed's decision to leave policy unchanged in a split 10–2 vote hardly came as a surprise. What markets expected was a hawkish hold, with Kevin Warsh setting the tone for a likely hike in December. Instead, while offering no explicit forward guidance, his commentary raised a few eyebrows, particularly on inflation at a time when price pressures remain acute.

Despite acknowledging that inflation was too high, economic growth was strong and business investment was expanding rapidly, Warsh repeatedly pointed to improving inflation expectations and market-based inflation compensation as signs that the Fed's efforts were working.

That's a lot of faith to place in expectations when inflation has remained above target for more than five years. And market-based measures are hardly beyond criticism, given the potential distortions created by years of central bank asset purchases and other interventions.

Warsh also highlighted tightening financial conditions as evidence that monetary policy was having its intended effect. There's merit to that argument, but our proxy for the Fed's Financial Conditions Impulse Index shows conditions have only become progressively less accommodative over recent months, not restrictive overall. At −0.690, the index remains firmly in accommodative territory.

Upon review, it felt like a reversion to the old Fed, just with a new leader, repeatedly promising to bring inflation back to target in the future without actually doing anything to do so.

The decision to reduce the number of policy meetings each year, starting from 2027, does little to extinguish that concern, providing longer gaps between actual rate decisions. While that fits with Warsh's view of wanting markets to do more of the work for the Fed, it only works if you don't have Fed officials constantly looking to influence market expectations, as we saw before this meeting.

Following September's rate increase, markets were heavily favouring a follow-up hike in October only for senior officials to start talking down those expectations. New York Fed President John Williams reverted to his former dovish self, arguing there was no urgency to raise rates again, while Governor Christopher Waller sowed the seeds for staggered increases, suggesting hikes weren't necessary at every meeting.

It meant the subsequent September CPI and PPI reports, which should have reinforced what markets were thinking beforehand, became almost irrelevant for Fed pricing, only reinforcing concerns about the bank's willingness to follow through on its inflation-fighting rhetoric.

Markets question Fed's inflation credentials

Perhaps I'm being a little cynical after watching the same old story play out for years. But judging by the market reaction to Warsh's press conference, I wasn't the only one questioning the central bank's commitment to restoring price stability.

US two-year Treasury yields fell sharply, the 2s10s yield curve steepened and the dollar weakened, suggesting the Fed may have lost a little more of its inflation-fighting credibility.

Gold's traditional relationships turn upside down

While gold managed to climb during Wednesday's session, extending the rebound seen a day earlier, there wasn't much gusto behind the move, which was a tad surprising given what we've seen in similar periods in the past.

That may be explained by what we've seen recently when it comes to gold's historical relationship with the US dollar and US Treasury yields. Normally, you'd expect gold, which is priced in dollars and offers no yield, to move inversely to these markets. But what we've seen recently is that it's moving in the same direction, with the positive relationship strengthening over shorter timeframes.

Over the past five sessions, gold has maintained a positive correlation of 0.85 with daily changes in US ten-year Treasury yields, while its correlation with the dollar index stands at 0.59. The relationship with Treasury yields extends beyond the shortest window, with the 20-session correlation at 0.24, compared with a negative reading of −0.19 over 60 sessions.

As for what's going on there, you only need to look at the calendar and see that it's October 29, raising the possibility that month-end flows are playing a role. There have also been reports of gold being liquidated to cover losses in other asset classes, including short positions in Treasuries and technology stocks that were under the pump earlier this month.

Given gold has historically been heavily influenced by broader liquidity conditions, you could also make the case that dollar liquidity is tight at this point in time, contributing to its inability to bounce strongly. We don't have enough evidence to establish that, but it's another possibility worth considering.

Whatever's going on, it looks to be capping gold at a time when normally you'd expect it to be starting to catch a bid.

$4,000 remains the line in the sand

Courtesy: www.forex.com