US inflation is at the highest level since the early 1980s, when Ronald Reagan was in the White House and the Cold War was at its peak. With signs that inflation may now be starting to cool, we look at the prospects for precious metals in a world of “higher, longer, slower” interest rate rises.
US inflation on the Consumer Price Index (CPI) measure hit 9.1% in June 2022, the highest since late 1981. Food and energy prices remain high owing to disruptions stemming from the Russian war in Ukraine. Supply chain bottlenecks and a broad post-pandemic recovery in demand have continued to exert upwards pressure on inflation in 2022, and though there have been four successive months of declining inflation to the end of October, CPI remains at a still -40-year high of 7.7%. In an effort to bring inflation under control, US interest rates have risen at the fastest pace since 1981 – with the Federal Reserve lifting rates by fully 3% between June and November, and signalling that it will continue to raise rates into 2023.
Though gold and precious metals tend to shine as havens in a high inflation environment, this has been more difficult in 2022 as bullion and its sister metals have faced the twin headwinds of rising US government bond yields and a stronger US dollar. Yields on 10-year US Treasuries have surged and, adjusting for longer-term inflation expectations, have moved into positive territory this year for the first time since the initial COVID wave in March 2020. Higher yields of course make non-yielding precious metals look less attractive, and this has contributed to a trimming of physical gold longs in the ETF market and a reduction in speculative length on COMEX.
IN AN EFFORT TO BRING INFLATION UNDER CONTROL, US INTEREST RATES HAVE RISEN AT THE FASTEST PACE SINCE 1981
The US dollar for its part has surged to 20-year highs against a basket of major currencies on the back of investment inflows in response to the aggressive interest rate hikes in the US, which has left the US with by far the highest benchmark interest rate of major developed markets. The strong dollar has left USD-denominated gold under the weather, while gold in euros and sterling has fared somewhat better. The dollar has also arguably reverted to its traditional safe haven role as geopolitical risks, from Ukraine to Taiwan, remain elevated and the combination of rising rates and the impact of high inflation across many economies brings the risk of recession.
With an increasingly gloomy and uncertain outlook, the IMF has downgraded its GDP forecasts and now expects the world economy to grow by 2.7% in 2023, down from the 3.8% it forecast at the beginning of 2022. Eurozone GDP growth is expected to also slow down next year, while China’s growth is expected to accelerate, though the country’s zero tolerance COVID policies and periodic lockdowns could threaten this rise.
This slowdown in growth is not especially positive for the demand side of the precious metals markets, implying reduced offtake in the manufacturing of jewellery and industrial products. Turnover of bullion on the Shanghai Gold Exchange, much of it destined for the jewellery market, has been impacted by the periodic lockdowns in China this year and lower consumer spending as the cost-of-living squeeze is felt around the world.
While demand for high-grade gold and silver has been decent in the electronics sector despite wider supply chain challenges, consumer pull in the consumer electronics space is ultimately at risk from rising inflation and squeezed household budgets. In the automotive sector, where gold and silver are used in speciality electronics and PGMs are used in emissions control, the supply of vehicles continues to be impacted by ongoing supply chain disruption and demand for new cars is constrained by rising auto financing costs and lower consumer confidence. This is also resulting in a buoyant used-car market and fewer end-of-life vehicles available for recycling in the near term.
THE US DOLLAR HAS SURGED TO 20-YEAR HIGHS AGAINST A BASKET OF MAJOR CURRENCIES ON THE BACK OF INVESTMENT INFLOWS IN RESPONSE TO THE AGGRESSIVE INTEREST RATE HIKES IN THE US
Given that inflation remains consistently higher than interest rates in many markets, a period of major interest rate tightening is likely to continue over the next year or more. Wary of triggering a recession, central banks and governments may vary in their appetite for squeezing inflation out of the system and we are likely to see a greater degree of speculation over rate decisions manifest in higher market volatility. As inflation-adjusted yields remain low to negative, gold and its sister metals may continue to benefit from a degree of risk hedging, perhaps augmented by worryingly high levels of inflation in certain markets.
Europe in particular is at risk of a long and difficult winter as sanctions on Russian energy supplies and possibly supply interruptions weaken industrial output, add to higher costs and redouble inflationary woes, contributing to negative economic sentiment. Though this may weigh on the more industrial-facing white metals, it will likely create some further investor interest in bullion. With little room for the ECB to raise rates without creating further economic pain, the Euro may continue to slide, giving a lift to EUR-denominated precious metal prices.
If the Fed continues to raise rates, which it is likely to do given persistently high inflation and few signs of a slowing labour market, the dollar is likely to continue its bull run and temper the gains in USD-priced precious metals. However, ongoing aggressive rate hikes are likely to eventually slow the economy and result in a landscape of high inflation and weaker growth – one in which precious metals can provide portfolio diversification and help manage downside risks.
As we take stock of the past year and look towards 2023, we contemplate a combination of high inflation and rising rates last seen a generation ago. While this may be challenging from an industrial demand point of view, for those brave enough to navigate the inevitable volatility, it contains opportunities for hedging and risk mitigation not seen for many years.