Recent troubles in the U.S. and Swiss banking systems have led to a sharp, downward revision of Federal Reserve (Fed) rate expectations. Within the space of a few weeks, traders have gone from pricing a strong likelihood of four additional rate hikes to wondering if the Fed might continue to increase rates at all, or perhaps even begin cutting rates as soon as this summer (Figure 1).
Figure 1: Interest rate expectations have changed sharply in the past couple of weeks
The abrupt change in interest rate expectations has been a boon for gold. Gold remains a de facto currency that still features prominently in the reserves of nearly every major central bank. However, gold is a currency that pays zero interest. As such, when expectations form for interest rate increases, gold prices tend to falter. Indeed, the rapid shift in investor expectations towards higher short-term interest rates that began in late 2021 prevented gold from rallying (Figure 2) even as inflation rates surged in the U.S., Europe, Latin America, South Korea and Japan.
Figure 2: Expectations for Fed rates and gold prices tend to move in opposite directions
Gold’s failure to rally confounded many investors who view gold as an inflation hedge. In this case, however, inflation and rate expectations were pulling in opposite directions, and with the Fed conducting the fastest rate hikes since 1981, the downward pull of higher rates proved to be temporarily stronger than the upward push of inflation on gold prices.
One could argue that gold’s 2018-2020 rally from $1,200 to $2,000 per ounce anticipated the surge in inflation that the world is currently experiencing. That rally was trigged by expectations that began to form in late 2018, that the Fed would have to lower rates in 2019, which it did with three 25-basis-point (bps) cuts. When the Fed cut a further 150 bps early in the pandemic period and expanded its balance sheet by $1 trillion per month between March and May 2020, gold prices rallied further. However, gold prices peaked in July 2020 just as interest rate expectations in the U.S. hit their lowest point.
Gold has a long-standing negative correlation with day-to-day changes in interest rate expectations. On days when investors expect a steeper pace of Fed tightening, gold prices tend to fall, and on days when expectations are for a lesser degree of Fed tightening (or a greater degree of Fed cuts), gold tends to rally. This correlation has been particularly pronounced over the past year (Figure 3).
Figure 3: Gold prices have a negative correlation with day-to-day changes in Fed rate expectations
When it comes to the Fed and expectations for monetary policy, it’s clear that the central bank is in a bind. For the moment, it has two problems to deal with: inflation is too high at 6% (Fed’s target is 2%), and the banking system is under pressure. Dealing with higher inflation calls for higher rates. However, further increases in rates could trigger increased uncertainty among regional banks.
These depository institutions are seeing their profit margins come under pressure from two related phenomena. First, higher long-term bond yields have caused some of them to lose money in their longer-term loan portfolios, and in cases like Silicon Valley Bank, on their Treasury holdings. Also, an inverted yield curve makes banks inherently less profitable. Higher short-term rates mean that they must pay depositors more money in order to borrow funds. By contrast, with longer term interest rates below short-term interest rates, they don’t make the same margins when they lend out those deposits. Finally, tighter monetary policy can also translate into higher loan default rates.
Taken by itself, the Fed might consider cutting rates given these lenders’ distress. However, the Fed is still facing high rates of core inflation that have not really begun to abate in any substantial way, and the Fed’s rates are still 75 bps below core CPI (Figure 4). In Europe, the situation is even more dramatic, where the European Central Bank and the Bank of England have policy rates at more than 200 bps below the rate of core inflation. Moreover, the U.S. labor market remains tight despite some layoffs in the tech industry and the recent problems experienced by certain regional banks (Figure 5).
Figure 4: Despite all the Fed rate hikes, Fed funds still 75 bps below core inflation
Figure 5: U.S. employers are still looking to hire nearly 11 million new workers, 4.5 million more than pre-pandemic
If labor market tensions ease and if the U.S. economy experiences a recession and/or lower rates of core inflation, this could pave the way for deeper rate cuts than currently priced into the forward curve and a sustained gold rally. By contrast, if growth remains resilient and/or inflation remains above the Fed’s target, the Fed may wind up hiking rates more than the forward curve currently suggests. If so, this could subject gold to renewed downward pressures.
Faced with this uncertainty, options traders price around 20% implied volatility on gold options according to CME’s CVOL tool, which looks at a range of options strike prices. This is close to the market’s long-term average and far from highs experienced in 2020 and early 2022 (Figure 6).
Figure 6: Gold’s CVOL is running close to historical averages and well below peaks
That said, gold traders price substantially more extreme upside risk than extreme downside risk for gold. CVOL’s up vol (for options with strikes above the current gold spot price) is running at around 22%, whereas CVOL’s down vol is trading at around 18% (for options with strike prices below the current gold spot price). This means that traders price about 4% skew – or 4% greater upside volatility than downside volatility (Figure 7).
Figure 7: Gold CVOL has a sharp upward skew but that doesn’t imply positive returns going forward
One should be cautious, however, about interpreting such information. In the past when traders price more up vol than down vol, gold tended to underperform over the next few months (Figure 8). The opposite happened when traders price more downside risk than upside risk: gold tended to achieve higher than usual returns. So, traders’ bullishness about gold upside risk might translate into bearish price action. Afterall, with the forward pricing 200 bps of Fed rate cuts, much of this optimism for lower rates might already be incorporated into the price of gold.
Figure 8: Gold has tended to underperform in the three months after positive CVOL Skews
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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.