Gold Rally: Flash in the Pan or Sustainable?

  • 17 Feb 2016
  • By Erik Norland
  • Topics: Metals

In the highly unlikely scenario that the markets ever price in strong expectations of negative rates from the Fed, however, gold would be off to the races.Gold prices jumped nearly 20% from their mid-December 2015 lows into mid-February this year before backing off a little.  This move included a $59-an-ounce spike on February 11 to the highest close in over a year.  The surge in gold begs the question: what’s driving the rally and can it be sustained?

Gold hitting bottom on December 17 was not a random act.  It was the day after the Federal Reserve (Fed) hiked rates for the first time since 2006.  Higher rates are depressing news for gold investors since gold is a store of value that does not pay any rate of interest.

At the time of the Fed rate hike, the Federal Open Market Committee (FOMC) indicated that it was considering hiking rates four times over the course of the next 12 months.  The market never believed that the Fed would be able to tighten policy to such an extent in quick succession, with the Fed Funds Futures on December 17 pricing just two rate hikes for 2016, and another two for 2017. Since then, there has been a sea change in expectations: amid collapsing oil prices, falling equity markets, and roiled credit markets, Fed Funds Futures by February 11 were pricing a small chance that the Fed might even cut rates.  Another round of policy tightening was not priced until 2018 (Figure 1).  And, in response to actions by the European Central Bank (ECB), the Swedish Riksbank, Swiss National Bank, and Bank of Japan, Fed Chair Janet Yellen indicated that the Fed would study the negative rate policies being adopted by their peers. 

Figure 1: No Rate Hike Expectations Left to De-Price (February 12, 2016).

On a daily basis, from January 1, 2015 to December 16, 2015, gold correlated at -0.30 with the daily change in the Fed Fund Futures rate (100 minus the price) as shown on Figure 2.  Since the Fed’s December 16 rate hike, the correlation has become even stronger: -0.57 (Figure 3).  When expectations for Fed rate increases rise, gold tends to fall; and when expectations for Fed rate moves diminish, gold tends to rise.   And, while we do not think the Fed would adopt a negative rate target for federal funds, as it would be punishing for bank earnings, even thinking about negative rates in the U.S., gives gold prices a boost. 

Figure 2: January 1, 2015 to December 16, 2015.

Figure 3: December 17, 2015 to February 12, 2016.

Thus, it appears that gold prices have been driven higher largely by diminished expectations for further rate hikes in the United States and the contemplation of the possibility of negative U.S. rates, even if the probability of such action is exceedingly low.  While the likelihood of a very slow pace of future Fed tightening is indeed good news for gold investors, the bad news is that the change in expectations that drove the rally may have largely run their course.  Basically, there isn’t much of a rate hike expectation left to de-price.  Unless markets really come to expect that the Fed will reverse course and take back its recent rate hike, which seems unlikely, the gold rally is likely to lose a major source of support.

From our perspective, the Fed wouldn’t dream of taking back its recent rate hike unless there is a significant and sustained deterioration in the U.S. labor market, something that has not happened.  Employment growth continues at around 2% per year and average hourly earnings are up by 2.5% year on year.  Net of a slight decrease in the average number of hours worked, total labor income has risen by 4.1% in the year to January (Figure 4).  Moreover, with inflation still low, the real growth in labor income is over 3%.  This should support consumer spending and continued economic growth. 

Figure 4:

The fact of higher gold prices is in some ways bad news for gold investors, at least to those who intend to hold the metal over the long term, because they will incentivize more gold mining production.  In addition to being highly sensitive to short-term changes in U.S. rate-hike expectations, gold prices show a strong long-term sensitivity to mining production (Figure 5). In 2014, the all-in cost of gold mining was below $1,000 an ounce and the cash flow cost was below $700 (Figure 6).

Figure 5: Increased Mine Production Typically Drives Gold Prices Lower.

Figure 6: With Gold Near $1,250/Ounce Running Gold Mine Should Still be Highly Profitable.

What’s more is that gold production costs have probably fallen substantially since the end of 2014, both in terms of all-in sustaining costs as well as cash costs. Three factors likely drove it lower:

  1. Lower energy prices:  Mining and refining gold is highly energy intensive, and lower oil, natural gas and coal prices will reduce the cost of doing business (Figure 7).
  2. Efficiency gains: From 2002 to 2014, mining companies focused mainly on expanding production.  Now, the focus will turn to squeezing more value out of existing production by cutting costs.
  3. Weaker non-U.S. Dollar currencies: Most gold isn’t produced by workers earning in U.S. dollars, (Figure 8) and a weaker Russian ruble, South African rand, Canadian and Australian dollar etc. should also reduce labor costs from a U.S. dollar perspective.  This will also reduce mining costs, roughly half of which are typically denominated in the local currency.  It will be even more so if China allows the Renminbi to fall versus USD as most other currencies already have.

Figure 7: Gold Versus Oil.

Figure 8: Very Little Gold is Produced by Workers Earning U.S. Dollars.

Overall, the interest rate market having de-priced almost all of its Fed rate hike expectations may limit gold’s ability to rally in the short term while higher gold prices will discourage mining companies from cutting back supply, which may limit further upside in the long run.  There is always the possibility that concerns over slowing growth in China, and financial instability resulting from the collapse in commodity prices could continue to encourage bids in gold.  Count us as skeptical, though.  Gold, historically, has been mainly successful as an inflation hedge.  For the moment, however, the world’s main concern appears to be the opposite: inflation will persist at levels that are too low or even decline further.  So far, the Fed and its counterparts like the Bank of England, Bank of Japan, European Central Bank, Swiss National Bank and Sweden’s Riksbank, have shown very little success at boosting inflation despite round after round of quantitative easing and year after year of low, and in some cases, even negative interest rates.  In the highly unlikely scenario that the markets ever price in strong expectations of negative rates from the Fed, however, gold would be off to the races. 


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

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