Gold was trading flat on Wednesday. Investors are likely to take a wait-and-see attitude before the release of the Federal Reserve's meeting minutes, because they can provide clarity on the central bank's further plans on the interest rate.
As of 6:10 p.m. London time, spot gold prices remain at $1832 an ounce. Gold futures on the COMEX were trading near the flat line, at $1841.30 an ounce.
The Federal Reserve raised interest rates by 25 basis points at the end of its last meeting. This time, the market expects the central bank to raise the rate above 5% by May and it has every chance of peaking at 5.35% in July.
US economic data was released the day before, which turned out to be quite encouraging and as a result strengthened the expectations of analysts, who are confident in several interest rate hikes of the Fed. This was bound to put pressure on gold quotations, which managed to decline by 4.7% over the past three and a half weeks.
The Fed would do well to put the nation's inflation back on a steady decline this year. If it fails to do so, it could repeat the pattern that occurred in the U.S. in the 1970's when the central bank had to continually raise interest rates.
Generally speaking, gold prices and the Fed's behavior are even more connected than they appear at first glance. When investors invest in gold, they are clearly betting that the Fed will exploit its monetary policy to the fullest extent possible to move the economy away from default.
So, since 2008 the debt of the US government has grown twice as much as the GDP. The same picture can be seen with individual and corporate debt. Total debt in the U.S. economy is more than $70 trillion, which is on top of the annual GDP. And that is without the present value of future obligations, without social security - everything that can easily double the debt burden of the U.S. Treasury.
The government can borrow as much money as it wants. It issues debt securities to cover current expenses, to pay interest on existing debts, or to pay off debts with an upcoming maturity. This scheme can be considered perfectly workable, but only if the debts are in demand. This is where help from the Fed comes into play.
It is a mistake to think that the central bank prints money to finance the government. Money is printed to manage interest rates and to purchase Treasury debt (the same quantitative easing).
Monetary policy is able to influence the supply of bonds on the open market and the yields at which they are traded. This is how the Fed is able to determine how much the Treasury Department spends on interest payments on its debt.
And what about gold? Investors in the gold market clearly understand that the Fed is using aggressive monetary policy to alter yields. The central bank has been doing a great job so far, but one can't help but admit that its actions are bringing the dollar closer to depreciation.
Thus, the chart shows a close correlation between gold and real yields, which has been held for 20 years.
But the dot plot shows the same data, but in a different format. And it is obvious that the correlation is high.
Lately, the correlation has become more vertical (dots in orange). Gold has stopped rising and falling as much as real returns, which is what we've seen over the past 20 years. This is because the relationship between gold and real returns weakens when returns are positive.
So, what follows from all this? Gold prices show a close relationship to real returns when we see zero or negative real returns. This correlation is as follows: when real returns decline, gold prices rise. Or to put it another way, gold prices go up when the Fed uses a policy that is too stimulative for today's conditions. Leaving last year aside, that has been the case for the last 15 years.
Real yields are now at record highs for the last ten years. And that's why gold is showing such weak dynamics. The situation is tense, because it is absolutely unclear how long the economy will be able to sustain such high real yields.
At some point, the economy might crash, financial markets might get stormy, and the Treasury Department might finally start to oppose high interest costs. And that's when that key moment will come, when the Fed will come to the rescue. The central bank, of course, would cut rates sharply so that real yields would return to lower levels, perhaps even to zero. The realization of such a scenario would be extremely favorable to gold prices.
But if the Fed takes a hawkish approach and real yields remain positive, gold prices will continue to be under pressure.
