• Until recently gold was trading in an increasingly narrow range
  • Gold failed to rally during the recent surge in inflation
  • Gold may have broken to the upside on doubts about the pace of Fed rate hikes
  • Gold options remain historically inexpensive, especially compared with equity options

Gold, traditionally considered a hedge against inflation, doesn’t appear to have benefited from the recent surge in U.S. consumer prices that have gone from 2% to 7.5% year on year as much as one might have expected. Between the summer of 2020 and early February 2022, gold has not only moved sideways, it traded in an increasingly narrow range that technical traders sometimes refer to as a “flag formation.” However, beginning in mid-February it broke to the sharply to the upside before correcting in mid-March (Figure 1).

Figure 1: Has gold broken out of its “flag formation” of increasingly narrowing trading ranges?

Gold’s recent behavior leads to two questions:

  1. Why did gold not rally between April 2021 and January 2022 as inflation surged?
  2. Why did gold suddenly begin to move upwards in mid-February only to correct in mid-March? 

What Held Gold Back from Rallying?

While perhaps rising inflation should have theoretically boosted gold, reality proved to be more complex. The sharp increase in U.S. consumer prices produced an enormous change in investor beliefs about the future of U.S. monetary policy. As recently as early October 2021, Fed Funds futures did not price even one rate hike for the following 12 months. By early February, traders had come to expect around seven rate hikes in the next 12 months followed by two more in the subsequent 12 months (Figure 2).

Figure 2: Since early October there has been a sea change in investor expectations for the Fed

Higher interest rates are anathema to gold. Gold can be seen as a quasi-currency, but one that does not pay interest on deposits. As such, when investors anticipate central banks’ easing monetary policy, the price of gold tends to react positively. The opposite tends to happen when investors come to expect tighter central bank policy: the prospect of higher interest rates on fiat currency deposits can make them seem more attractive compared to gold. This is apparent when looking at the price of gold in a chart alongside expectations for Fed Funds two years out (Figure 3).

Figure 3: Gold prices often move the oppositive direction of Fed rate expectations

When one correlates the day-to-day movements in gold prices with the day-to-day changes in Fed rates expectations, one finds that gold almost always displays a negative correlation with changes in expectations for Fed rates two years from the present (Figure 4).

Figure 4: Daily changes in gold prices correlate negatively to daily changes in Fed policy expectations

As such, it seems likely that the trend towards expecting higher Fed rates held gold back from rallying up until mid-February. Then, when the Russia-Ukraine conflict began, expectations for rate hikes fall sharply for a few weeks, sending gold prices soaring. After the conflict dragged on into the third week, however, the reality of much higher commodity prices along with continued strength in the U.S. jobs and inflation data, led investors to price in even more rate hikes than they had in mid-February, leading to a correction in the price of gold.

As of this writing gold prices are still below their summer 2020 peak. Given the sea change in expectations for the Fed rate hikes, its impressive that gold prices held up as well as they did, suggesting that gold may have benefitted from rising inflation after all: the rise in inflation appeared to cancel out the impact of expectations of higher Fed rates.

It is also worth pointing out that the price of gold soared from early 2019 to mid-2020 as expectations for the level of Fed rates began falling even before the pandemic began.

The rise in gold option volatility and outlook

Gold’s narrow trading range and lack of realized volatility may also explain why the implied volatility on gold options fell to such low levels going into mid-February, even as the cost of options on other markets, such as equities, had already begun to rise. Gold’s upside break from mid-February into early March coincided with a substantial rise in risk perceptions as measured by implied volatility (Figure 5).

Figure 5: Gold option implied volatility lags the rise in equity index options implied volatility

Perhaps the most striking feature of the global economy is the combination of soaring inflation, supply chain disruptions and extremely low bond yields in the U.S., Europe, Japan and Australia. Across the curve, real rates are still steeply negative. While some central banks, such as the BoE and the Fed, have begun to tighten policy, many others including the European Central Bank, the Bank of Japan and the People’s Bank of China are keeping policy easy. Simultaneously, equity markets, though off their highs, remain historically expensive in many markets. As such, many investors may be looking for safe havens and some might look towards gold as a safe harbor in an uncertain and inflationary environment, especially since gold has underperformed most other metals and financial assets since the beginning of the pandemic.

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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 author 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.

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