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Why is gold down nearly $100 after Fed shakes up markets?

Kitco News

(Kitco News) In just 24 hours, gold managed to lose nearly $100 after the Federal Reserve signaled higher inflation and updated its dot plot projections, showing a possibility of two rate hikes as soon as 2023.

The news triggered a surge in the U.S. dollar and a rise in the 10-year U.S. Treasury yield, which weighed heavily on gold. The precious metal's plunge was intensified by technical selling as gold tumbled below the $1,800 and came close to testing critical support at $1,770-60.

The market zeroed in on the upward revision to the PCE inflation forecast for 2021, which was raised a full percentage point – from 2.4% in March to 3.4%. This comes after very strong inflation readings in April and May.

During the press conference, which followed the Fed statement on Wednesday, Fed Chair Jerome Powell tried to reassure the markets that the central banks' dot plot, which showed that two rate hikes are possible as early as 2023, should be taken with a "big grain of salt."

He stated: "We did not have a discussion whether a lift-off is appropriate at any particular year. It is too early to talk about that. The dot plot is not a great forecaster of future rate moves."

Powell also reiterated that the Fed does view the spike in inflation as transitory, making comparisons to the surge in lumber prices, which are now settling down.

"Over time, these things driving up inflation will be temporary … The experience with lumber prices is illustrative of this. Prices that have moved up really quickly because of the shortages and bottlenecks should stop going up. And in some cases should actually go down. And we did see that in the case of lumber," he said. "Our expectation is that these high inflation readings that we're seeing now will start to abate. And it'll be like the lumber experience."

However, the market has already made up its mind, viewing the Fed's June announcement as surprisingly hawkish, which is why gold suffered.

"The biggest surprise was that the median Dot Plot now sees two hikes in 2023 vs. none before," said BBH global head of currency strategy Win Thin. "We also got a shift for 2022 but not enough to change the median, with seven now seeing a hike next year vs. four in March."

For gold, the market's reaction spelled out bad news.

"'Transitory' and 'hikes' don't mix," said strategists at TD Securities. "Yet, the Fed's dot plot provided a clear signal of a change in tone with the median showing 50bp of tightening by end-23. The FOMC showed its hand: while the Fed has continued to reiterate that the strength in inflation is 'transitory,' the officials' formal assessments of risks tilted strongly to the upside, with participants' uncertainty assessments for core PCE inflation rising notably, alongside their risk weightings for core PCE."

Gold's significant pullback has room to run as speculative and physical flows slow, TD Securities added.

"If inflation turns out to be truly transitory, the Fed should be happy to walk the hiking signals back," they said. "Unfortunately for gold bugs, underlying inflation trends will remain distorted for months — which removes the immediate impetus for buying the yellow metal," they stated.

Some analysts, however, view the drop in gold as excessive, especially considering that the precious metal already walked back some of its price gains in the days before the Fed's announcement.

"Admittedly, the combination of a noticeably firmer U.S. dollar and higher yields poses quite a burden for gold. Whether it justifies a price slide on this scale is another matter, however. After all, gold had already fallen in recent days in anticipation of a possible change in direction on the part of the Fed," said Commerzbank analyst Carsten Fritsch. "Rate hikes in two years' time are too far off to warrant any such slump in price, especially as yields are well below the expected rate of inflation."

At the time of writing, the U.S. dollar index was trading at 91.85, the 10-year U.S. Treasury yield was fetching 1.506%, and August Comex gold futures were at $1,780, down 4.37% on the day.

Live 24 hours gold chart [Kitco Inc.]

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