Gold and Silver likely to sink further, but inflation data should help us find the bottom

[MongiIG]

The gold rebound seems to be some way off, but traders should watch inflation data for signs of the next precious metals bull market

Source: Bloomberg

 

 Joshua Mahony | Senior Market Analyst, London | Publication date: Friday 28 October 2022 

Gold could get worse before it gets better

Gold has been hit hard over the course of 2022, with the precious metal currently trading 20% below its March peak. A combination of rising interest rates and a strengthening dollar has held back this historically heralded haven asset at a time of economic concern.
Will we see the bulls come back into play before long or are we due another strong move lower over the coming months?
It is important to note that rising interest rates are a cause for concern for gold bulls, with rising yields signalling the potential to generate a respectable return for holding US denominated bonds. Gold obviously pays no dividend. It is also worthwhile noting that any rise in commodity prices will typically result in higher dollar demand as they are paid for with US dollars. In any case, the price of gold often does well in times of distress when central banks react by slashing interest rates. The chart below highlights the relationship between the dollar and Gold, with the recent surge into the greenback coming at the expense of gold demand.

Source: Eikon

That dollar strength has much to do with central bank policy, with gold patiently waiting for a Fed pivot to signal the potential beginning of the next bull run. In an ideal scenario for gold bulls, economic data declines to the point where the Fed need to reverse course and loosen monetary policy. That would provide the benefit of seeing future rates on a downward trajectory, but without the widespread selling pressure that Gold can often get caught up in as traders liquidate assets across the board. For now, that does not seem likely. US economic data is holding up relatively well, and inflation shows little sign of rolling over to a degree that would bring confidence in a more dovish central bank stance.

The amount of time this selloff last for will likely come down to when we start to see the inflation picture reverse. There are some calls for a swift reversal thanks to base effects as year-on-year comparatives eradicate the previous surge in prices. However, the chart below refutes that story, with the one-year moving average for the month-on-month figure standing around 0.4%. Comparing that to the pre-pandemic levels around 0.15%, and it is clear that the US continues to exhibit rapid monthly price growth according to the core PCE metric. The lower section highlights this in a different way. The overall price of goods in the US according to the core PCE measure has shifted its rate of ascent since the pandemic. The red line highlights the previous rate of price growth, which has also been overlaid on the 2021/22 period. It is evident that the current rate of advance is much steeper, with little sign of a reversal beyond the one blip in July. Until we see price growth shift away from the current rate (highlighted by the black line), core inflation looks set to continue tracking well above target.

Source: Eikon

Thus, there is a strong chance that while markets are celebrating the gradual end of the tightening cycle, we could continue to see elevated prices that leave central banks having to maintain elevated rates for longer than hoped. Gold bulls should keep a close eye out for the moment that the inflation trajectory changes to bring hope that the monetary policy outlook could reverse. Until then, further downside looks likely.

Taking that same approach from the headline CPI indicator, we can see that the decline in energy prices has helped drive down the rate towards that same pre-Covid trajectory (red line). To some extent this is simply a reflection of the heat being taken out of the headline figure as we see those base effects come into play from energy.

Source: Eikon

Wrapping up those two, we can see below that it is energy which has made significant steps to driving the top end of inflation away. However, the likes of shelter (accounts for over 30% of CPI), food, and core inflation remain a problem that is yet to be solved. The three-month breakdown of those factors in the bottom section does show that we are seeing the likes of core and food growth slow somewhat, but they remain well above normal levels. It is also worthwhile noting that any major uptick in energy inflation could undermine any near-term declines in inflation as it would drive up costs of goods thanks to higher transport costs.

Source: Eikon

The monthly chart below highlights how we appear to be exiting a topping pattern similar to that seen back in 2011/12. The move below $1684 signals the possibility of a bearish continuation as inflation finds its feet.

Source: ProRealTime

All in all, it is worthwhile that until inflation shows signs of being brought under control, or the Federal Reserve reverses their outlook if economic troubles become too troublesome, the dollar is likely to maintain strength to the detriment of gold. No central bank wants to hurt growth in the process of normalizing inflation, and thus it is likely that they will ultimately ease once again once inflation allows. The moment markets realise we could be gearing up for that new easing phase will likely drive another bull market for gold. Until then, further downside looks likely for the precious metal.

The daily gold chart highlights how price is reversing lower after a rebound into the $1677 resistance level (historical resistance). A break up through the $1729 resistance level would be required to negate the current downtrend playing out over the course of this year. Until then, further downside looks likely.

Source: ProRealTime

Finally, it is worthwhile keeping an eye out for Silver as an alternate investment opportunity. The Silver/Gold ratio has been heading lower since the February 2021 peak. Interestingly, we can see that the ratio is highly correlated with the price of Silver and gold. That means we are likely to see Silver underperform as long as this sell-off continues. However, it also means we could see a more substantial rebound for Silver once we do bottom out and head higher.

Source: Eikon

[Murikbro]

I understand that many people are already building charts comparing the price of gold and the dollar.