US interest rate-cut expectations have yellow metal shining bright

Mild recession, low inflationary pressures in the US and a stronger rupee would act as headwinds

Gold closed at Rs 56,655 per 10 grams on Monday, an all-time high in the domestic market. In the international market, the yellow metal closed at $1,918 per ounce, up 16.6 per cent over the past three months.

Rate cut expectations driving gold up

Gold faced a couple of headwinds last year. The US Federal Reserve (Fed) was hiking interest rates and tightening liquidity aggressively. The dollar was strengthening. Now, the market anticipates that the end of the rate hike cycle is near. “The Fed funds futures implied rate, a market-driven rate, is indicating that the Fed will reach peak rate by the middle of 2023, and then start cutting rates. It is this anticipation of rates coming down that has caused the rally in gold,” says Chirag Mehta, chief investment officer, Quantum Asset Management Company.

Another factor, correlated to the expectation of rate cuts, is the weakening of the dollar index. “From the peak of 114.11 (on September 27, 2022) the dollar index is now at 102.2,” says Pritam Patnaik, head-commodities and HNI (high net worth individual), NRI (non-resident Indian) acquisition, Axis Securities. Gold is priced in dollars in the international market. Its weakening pushes the price of gold up.

Recession, inflation concerns are supportive

Experts differ in their near-term view of gold prices. “In the near term, the Fed is expected to hike interest rates further. That could produce some correction in the price of gold,” says Mehta.

Patnaik, on the other hand, believes the rally in gold prices has begun. “Only if the Fed makes a very hawkish statement will gold prices come off,” he says.

Over a slightly longer horizon, two scenarios would be positive for gold. “If there is a deep recession in the West, which compels central banks to cut interest rates aggressively and inject liquidity, that would be positive,” says Mehta.

Low or negative real interest rates provide a fillip to gold since money moves out of interest-bearing instruments like bonds and into gold. After the beating cryptos have taken, not many may want to use them as a hedge (as happened in the past).

If interest rates are cut, the dollar may continue to weaken. That will also be positive for gold.

Gold would also do well in a scenario where inflation remains elevated above the US central bank’s comfort level.

According to Ajay Kedia, director, Kedia Advisory, “Continued gold purchases by central banks, geopolitical tensions, and purchases by end-users in China (before the Chinese New Year) and in India will also support gold prices.”

Soft landing could act as headwind

It is also possible that the US economy witnesses a shallow recession and the Fed is not required to undertake deep rate cuts. Inflation is tamed and comes down from current levels. Both these scenarios would be negative for the yellow metal.

The rupee’s decline against the dollar had enabled gold to earn a double-digit return in the domestic market in 2022. From a (end-of-day) low of Rs 83 against the dollar on October 19, 2022, it is now at Rs 81.6. Any further strengthening will be negative for gold.

What should investors do?

Mehta is of the view that the US economy will find it difficult to achieve a soft landing. “The 450-basis-point rate hikes and liquidity tightening will have a repercussion on economic activity. A soft landing is a low-probability scenario,” he says.

The market may have run ahead in anticipating interest rate cuts. If the Fed hikes rate before ending the current hiking cycle, that will cause some volatility in the price of gold during the first half of 2023.

Investors should ideally have a 10-15 per cent allocation to gold in their portfolios. If they don’t have this allocation, they should use price corrections to build it.

Those who have an investment horizon of eight years should invest in sovereign gold bonds (SGBs). Those who have a shorter investment horizon or require liquidity, should go for gold exchange-traded funds.