Why is gold price down as markets price in a pause after 10 consecutive rate hikes?

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(Kitco News) The gold market extended its weekly losses ahead of the Federal Reserve's interest rate decision as markets re-priced expectations for a rate skip on Wednesday, followed by a rate hike in July.

The highly anticipated inflation report revealed a contradictory outlook for the U.S. On the surface, inflation cooled to a 4% annual rate, marking the lowest level in more than two years. However, the core CPI number, which the Fed pays closer attention to because it strips out volatile food and energy prices, ran at a pace of 5.3%, down from 5.5% but slightly hotter than market consensus calls.

Analysts remain cautious despite cooling inflation, which unlocks a pause option for the Fed.

"Today's data should lock in a pause at the June FOMC meeting, i.e. no rate hike," said Wells Fargo's economists Sarah House and Michael Pugliese. "However, we expect Chair Powell's press conference and the latest Summary of Economic Projections to signal that one more rate hike is still in the cards."

And if the Fed is still dealing with core inflation between 3% and 3.5% at the end of the year, markets won't be expecting rate cuts any time soon either.

"Directional progress should not be confused with mission accomplished," House and Pugliese added. "There is a lot of ground to cover between the 5.0% run rate of core inflation today and the FOMC's 2% goal."

After the CPI data on Tuesday, markets were projecting a 92% chance of a pause on Wednesday and a 60% chance of a 25-basis-point hike in July, according to the CME FedWatch Tool.

"A June hold is done deal, and the July FOMC decision should be a coin flip as the disinflation process will likely continue, but signs of stickiness remain," said OANDA senior market analyst Edward Moya.

The focus for the gold market will be the updated economic forecasts, the dot plot, and Fed Chair Jerome Powell's press conference.

"For gold to rally, it needs Wall Street to become confident that the Fed is done raising rates. This inflation report was in-line, but some Fed members might be concerned that core pricing pressures are looking sticky," added Moya. "The Fed will remain data-driven, but optimism should be high that the end of tightening is near."

Tuesday, gold saw double-digit losses, with August Comex gold futures last trading at $1,956.30 an ounce, down $13.40.

Analysts warn that if there is a surprise rate hike on Wednesday, gold is at risk of an extensive selloff.

"A surprise rate hike has the potential to trigger an aggressive selloff towards levels not touched since mid-March at $1,900," said FXTM senior market analyst Lukman Otunuga. "In the meantime, prices remain trapped within a range with support at $1,935 and resistance at $1,983."

The outlook for the Fed depends on how much the economy cools from here, said Comerica Bank chief economist Bill Adams.

"The most likely path for the economy is further softening of activity and the job market, passing through to lower inflation and eventually lower interest rates," said Adams. "But economic growth and the job market have been more resilient than expected; if that trend holds up, inflation could surprise to the upside too, forcing the Fed to keep rates high for longer than expected."

The updated dot plot, which will be released along with the rate decision on Wednesday, will clarify how high the Fed is willing to raise rates in this tightening cycle.

At the May meeting, the Fed raised rates for the tenth consecutive time, bringing the federal funds rate to a 5-5.25% range – the highest since mid-2007. But the statement included a "meaningful" change — a decision to take out the reference to "some additional policy firming may be appropriate."

Risk of a July hike

The Fed is likely to describe its June decision as a 'pause' rather than a 'hold' to appease the more hawkish members of the FOMC, Adams added. "Reflecting the FOMC's lean toward more hikes, financial markets price in greater than 50-50 odds that the Fed raises its policy rate by a quarter percentage point at either the July or September decision after holding rates steady next week," he said.

Markets are keeping a close eye on the scenario where the Fed pauses in June only to hike again in July, a similar path taken by other central banks, including Canada and Australia.

"The core debate is between 1) a hawkish pause based on guidance from top Fed officials & market expectations that the Fed will 'skip' (the new term) with an inclination to resume hikes at the July meeting, similar to what Canada & Australia did (EG: RBA was a hike/hike/pause/hike/hike cycle) vs 2) a dovish 25bp hike (recent U.S. labor & inflation data favors a hike for the Fed who has repeatedly insist they're 'data dependent')," said MKS PAMP head of metals strategy Nicky Shiels.

At the June meeting, the Bank of Canada raised its key interest rate by 25 basis points to 4.75% — the highest since 2001 — after pausing for two consecutive meetings. The move was a surprise as market consensus calls projected for rates to remain on hold.