Banking crisis impact: Rate cut in US prerequisite for sustained gold rally

The current surge in prices of yellow metal, sparked by the banking crisis, may be followed by a period of volatility

With a banking crisis unfolding across the United States (US) and Europe, investors have turned to gold, the classic safe-haven asset, sparking a 4.6 per cent rally over the past week. However, the continuance of this rally remains uncertain and will be determined by a host of factors.

Triggered by banking crisis

When interest rates rise by such a large quantum (450 basis points in the US) within a short span of time, there is always the possibility of some pocket of the economy taking a hit. In this instance, it is the start-up space that has borne the brunt, with funding drying up.

Silicon Valley Bank, which catered to start-ups, faced a run on its deposits due to an asset-liability mismatch. The problem then spread to other regional banks and even to Europe. However, with central banks like the US Federal Reserve (Fed) and the European Central Bank (ECB) stepping in, the problem is likely to be contained.

“Market participants are, however, wondering about the magnitude of the problem. This return to uncertainty has caused risky assets to decline and gold, the classic safe-haven asset, to rally,” says Chirag Mehta, chief investment officer, Quantum Asset Management Company.

The Fed had, in recent months, adopted a very hawkish stance as its efforts to rein in inflation failed to produce the desired result. “The banking crisis is, however, expected to lead to a moderation in the US Fed’s stance,” says Pritam Patnaik, head-commodities and HNI (high net worth individual), NRI (non-resident Indian) acquisition, Axis Securities.

It may be forced to reconsider both the pace and quantum of hikes. Fed Fund Futures are already reflecting a significant reduction in rate-hike expectations. The market has even begun to anticipate rate cuts in the second half of the year.

Positive and negative scenario

If the current uncertainty continues, the Fed may have to pivot from controlling inflation to containing this crisis by offering monetary support. Such a scenario would be positive for gold.

The dollar’s strength in the recent past has been owing to the Fed’s more aggressive stance compared to other central banks. “If this changes, the dollar may decline and that will also be positive for gold,” says Mehta.

On the other hand, the banking crisis could be contained with just some liquidity support, leaving the Fed free to continue with rate hikes. “If the Fed’s hawkish stance continues, that would be negative for gold,” says Ajay Kedia, director, Kedia Advisory.

In such a scenario, the dollar would continue to strengthen and that would be negative for gold.

Slowdown would be game changer

Central banks have not been able to bring inflation down to their level of comfort yet. More steps in that direction could cause volatility in the price of gold in the near term.

However, when interest rates were low and there was ample liquidity, poor-quality investments may have been made. Many such investments could unravel amid the current high interest-rate scenario. The ongoing banking crisis is just one manifestation.

“High interest rates may even begin to impact economic growth, forcing the Fed to cut rates and provide liquidity support,” says Mehta. Such a scenario would lead to gold prices rallying decisively.

Kedia is of the view that any hint by the Fed that the rate hike cycle has ended would spark a big rally.

Patnaik believes that the Fed is likely to stop raising interest rates and may even consider cutting them towards the end of this calendar year. He expects these developments to boost gold prices significantly.

Build allocation

The banking crisis and the ensuing rally have once again reiterated the need to include gold in one’s portfolio. Maintain a 10 per cent allocation to the yellow metal at all times as a hedge against inflation, equity market volatility, and economic slowdown. If you don’t have that allocation yet, use the volatility expected over the next few months to build it.

Avoid lump sum purchases after the recent rally. “Invest in tranches whenever there is a dip in price or buy gold via a systematic investment plan,” says Patnaik.