- Inflation expectations are the key driver for gold prices
- More risk aversion triggered by the violence in Iraq could add support
Gold’s intriguing market reaction continues
The behaviour of gold prices has not been that straightforward recently. Since the ECB monetary policy decision on 5 June, gold prices have become more sensitive to market expectations about inflation in the US. However, when these stabilised, another driver took over. For example, the violence in Iraq. We experienced this at the end of last week and at the start of this week. The violence in Iraq has increased caution among investors. Therefore, gold prices have received support. But the sentiment changed on Tuesday as the FOMC meeting approached, because part of the market considered it likely that the FOMC may sound less dovish. Therefore, gold prices came under some pressure. The higher than expected US headline and core inflation initially pushed gold prices lower for the same reason. However, this proved to be temporary. Soon thereafter, gold prices bounced higher again driven by an increase in inflation expectations. This reaction signals that a part of the market is of the view that the Fed is behind the curve. To conclude, inflation expectations remain a dominant force for gold prices at the moment, but other drivers could temporary take over.
Will the Fed manage inflation expectations?
It is likely that there will be an upward revision of members’ view of the appropriate level of federal funds rate for 2015 and 2016 in the so called dots plot (see our Global Daily Insight of 18 June). Currently, this is not entirely reflected in market expectations. As a result, the market would consider this as the Fed having a less dovish stance. In general, a less dovish stance by the Fed, would be a negative force for gold and precious metal prices. However, this time around it will be more important how inflation expectations behave. If the Fed is not able to cool these, gold prices could go higher.
Don’t underestimate the impact of oil prices
Due to the Iraq crisis, tensions in the oil market have risen. Iraq is the second-largest OPEC oil producer after Saudi Arabia, and the sixth-largest worldwide. Fears that oil production will be affected by advancing ISIS (Islamic State in Iraq and the Levant) rebels has pushed up the oil spot price. Despite the widespread media coverage of the ISIS threat, the increase so far is only 2-3%. This limited impact on the oil price is due to several reasons. 1) The largest oil fields and export ports are located in the south of Iraq, while the epicentre of the unrest is in the north. 2) Any decrease in oil exports from Iraq will be absorbed by increased deliveries from other OPEC countries (mainly Saudi Arabia) or the release of strategic reserves by the International Energy Agency (IEA) members. 3) The global increase in demand for oil can be largely absorbed by higher oil production in the US and Canada in the coming months. Moreover, it is by no means clear whether ISIS is targeting the oil production and export facilities in the south of Iraq. If the risk premium were to rise further, resulting in higher oil prices, gold prices will most likely rally as well. Indeed, not only is it likely that higher oil prices will support gold prices because of the market’s upwards adjustment in inflation expectations, but more importantly, more violence in Iraq and fears of possible supply disruption could result in investors becoming more risk averse. In such environment, gold prices usually do well.