(Kitco News) Precious metals are caving under the strength of the U.S. dollar and rising Treasury yields ahead of the critical interest rate decision by the Federal Reserve.
Some analysts fear the $1,600 an ounce level is in the cards as the Fed looks to remain hawkish despite some worrying economic signs.
"Thirteen central banks are meeting this week, and most are expected to hike rates aggressively, [but] it’s the FOMC meeting that is the marquee event of the week," said Pepperstone's head of research Chris Weston.
Markets stand ready to comb through the rate hike decision, updated economic projections, and the language Fed Chair Jerome Powell uses at the press conference following Wednesday's announcement.
And with less than 24 hours to go until the big September event, gold's positioning could still worsen despite last week’s heavy losses. December Comex gold futures were last trading at $1,674.10, following a drop from last week's high of $1,740 an ounce.
Here's why gold price could drop to $1,600 next
It all comes down to whether the Fed blinks in the face of rising recessionary concerns and doubts over a soft landing, according to analysts. One such sign is an "extreme (near 50bp) inversion in the U.S. 2-10 Treasury curve," described ING's global head of markets Chris Turner.
This is why the tone Powell chooses is so important. "Fed Chair Powell's messaging will likely determine if gold gets crushed here. Gold will be in trouble if Powell is able to convince markets that not only will they remain aggressive with tightening, but that they will hold rates even as the economic downturn worsens," OANDA's senior market analyst Edward Moya said.
The predominant trend weighing on gold has been the expectations of an oversized 75-basis-point hike Wednesday, another 75 bps at the November meeting, and 50 bps at the December meeting.
"The Fed made it clear that it is leaning toward doing too much tightening rather than too little. With inflation stubbornly high, interest rate hikes will be aggressive," said ANZ's senior commodity strategist Daniel Hynes. "The precious metal remains vulnerable to further moves lower amid a challenging macro backdrop. Expectations of another aggressive rate hike are likely to lead to continued strength in the USD."
At the end of the day, the U.S. dollar is the big winner, which is what makes this environment so difficult for gold.
"We now think USD strength will last longer than we had thought. Labour resilience means the Fed will have to hike further than the market is expecting. Deteriorating liquidity conditions and higher U.S. yields will feed haven flows and add risk premium," Hynes explained. "Europe faces a serious energy crisis, which is a headwind for EUR and support for the USD. This makes us thinks the USD will peak in Q1 2023. In the face of sustained dollar strength, we see gold continuing to underperform."
In the short term, the risk for gold is a drop to $1,600 an ounce as demand for the precious metals continues to wane.
"Haven demand remains subdued despite the rising geopolitical risks and worsening economic backdrop. Technically, the bearish trend is likely to continue. The break below USD1,675/oz suggests the price could fall to USD1,600/oz," Hynes noted.
Volatility in gold is not going anywhere, added Moya. "Prices will likely have a strong case for either a move towards $1,600 or above the $1,700 level," he said.
And even though most economists expect the Fed to raise rates by 75 basis points on Wednesday, there is still a 16% chance of a full percentage point increase, according to the CME FedWatch Tool.
"While prices are certainly weak, precious metals' price action could still have further to fall as the restrictive rates regime is set to last for longer. Indeed, gold and silver prices have tended to display a systematic underperformance when markets expect the real level of the Fed funds rate to rise above the neutral rate," said commodity strategists at TD Securities.
What to expect from the Fed aside from an aggressive rate hike
Another essential element of the Fed monetary policy meeting will be the updated economic projections and the dot plot, which could reveal new information on when the Fed's hiking cycle might pause or even end.
"The swaps market is starting to price in a terminal rate of 4.75% over the next 12 months, up sharply in recent days and making new highs for this cycle. Indeed, we expect a hawkish shift in the Dot Plots, with the expected policy rate moving up to 4.0% in 2022 and up to 4.25-4.5% in 2023," said BBH Global Currency Strategy global head Win Thin. "For 2024, the expected rate is likely to remain steady in order to underscore that any sort of pivot is not foreseen, at least for now."
On the economic front, analysts are projecting the Fed to lower growth estimates and raise inflation forecasts.
"It wouldn't shock at all to see its core PCE inflation forecasts lift for 2022 from 4.3% to 4.5%, but will there be any change to the call of 2.7% for 2023?" asked Weston. "In June, the Fed forecasted GDP at 1.7% for both 2022 and 2023 – we should see the 2022 GDP forecast cut in half, but will we see forecasts of 1.7% GDP for 2023 revised lower?"
