The October statement from the Fed made one thing very clear; December is a live meeting and Fed is ready to hike rates if it sees fit. Yellen was more hawkish than the market was expecting, sending gold prices lower and bond yields higher. The critical focal point from here will be if the Fed’s hawkish stance will be validated by the upcoming economic data, most importantly the two employment releases we get between now and the December FOMC.
Employment data had been solid for the last few years, indeed the Fed shifted its focus from employment to inflation, reflecting that their mandate of achieving full employment was nearly accomplished. However the last two prints of +136k and +142k have put a spanner in the works. Are these one off points like the +119k we got earlier this year? Or is this a change in the health of the economy which could see the first rate hike delayed?
As mentioned above, we read the statement as a clear attempt by the Fed to keep a December hike on the table. Given that market pricing had been leaning towards only a 20-30% chance of a December hike following the NFP data, if the Fed had been any less hawkish they would likely have pushed December out of consideration. Since this is the first hike in such a long time, and part of unwinding the biggest easing of monetary policy the world has ever seen, the Fed would likely be hesitant to raise rates with very low market implied probabilities of policy action. The market is now pricing much closer to a 50% chance of a December hike, giving the Fed flexibility to raise rates if they wish. If the markets are still only pricing 20-30%, the Fed would likely not hike for fear of causing instability.
50% is probably fair pricing for December, given the uncertainty over data. If the next two payrolls figures are solid (+200k), the Fed will increase rates in December. If they are weak (+100K) then the Fed will delay hiking, and rightly so, as they will be cautious and concerned that the employment market is seriously softening. Those are the two easy solutions, but the grey area will come if the employment prints are mediocre.
What If Data Prints Grey
If the data is simply average from now until December, in our view the Fed will hike rates. Our reasoning for this is due to creditability and stability.
On credibility, the Fed has been saying all year that they plan the raise interest rates in 2015. Every dot plot has shown this, and the Fed has delayed and delayed again for a number of reasons over the past few years. In the absence of a smoking gun reason not to hike, the Fed would lose credibility if they remained on hold. The market would doubt that the Fed will ever be able to get off zero. Even if the Fed stressed that they could hike in early 2016, the market would not believe it.
On stability, the Fed would prefer a meeting with a press conference and projection materials to deliver their first hike. December is such a meeting, but January is simply a statement with the next press conference being in March. Whilst Yellen has stated that they could hold an impromptu press conference, it is highly unlikely that after a record time on zero, the first hike would be delivered with an impromptu tone. This would risk causing unnecessary volatility in markets. In addition to this January meeting on the 27th would only give the Fed a minor amount of additional data compared to December, for example there is just one more employment print between the meetings.
Therefore if the Fed does not go in December, they will have to wait until March to hike. That could be too long. In our view, if Fed is this close to hiking, then they are best to execute the first hike in December, with minimal surprise to markets.
Fed speakers between now and the December meeting will be key. The Fed will want to ensure the market is fully prepared. Therefore expect pricing to drift towards 75% if the data is solid, encouraged by hawkish Fed speakers.
What does this all mean for gold?
The simple answer is that a hike is bearish for gold prices, as it will reduce the need to hold gold as a financial asset and the USD strength resulting from a hike will see gold fall in USD terms. To demonstrate this the chart below shows the price of the front Eurodollar futures contract (Currently December) and gold prices. The futures price is quoted as 100 minus the 3mth Libor rate. Therefore a lower price means a higher expected 3mth yield. So as the chance of a Fed hike increases, the Eurodollar price falls. It is clear that generally gold has been falling and rising with the Eurodollar price, indicating its sensitivity to Fed policy.
If market pricing increases past 50% and towards 75% as we expect it to, as a result of solid employment data and Fed speakers talking up the chance of a December hike, the Eurodollar price will fall to new lows. Therefore we would expect gold to also fall to fresh lows.
Technically on the downside $1125 is the next support, and should that break we would expect gold to fall swiftly towards $1080. A catalyst will be needed for this to break and that catalyst will likely be the NFP data this Friday.
Trading Gold on the First Rate
We currently have short position in gold, via a few different option strategies. However we are not aggressively short the yellow metal here, and have not been since the start of 2013, when we turned our long term bullish stance to a bearish one, reflecting that the easing of monetary policy in the US had come to an end.
The reason we are not aggressively short gold at this stage is due to the data risk. Monetary policy and therefore gold prices are massively leveraged to the next few data prints. Employment data is a lottery and therefore having too large a position is similar to taking a coin flip. That is not a prudent way to manage capital and take risk.
Our current position will lose us a small amount of money if we are wrong, but could pay off considerably should we be correct. If this payrolls print is strong, we will add to gold shorts. Any kind of positive backward revisions would see us shorting gold aggressively with $1030 (the pre QE2 resistance that is now a major support level), as an initial target.
Holders of gold mining stocks are unfortunately in for yet more of the same under this scenario. Whilst we are without a position in gold stocks at present, we are looking for opportunities to establish short positions. Despite October being the best month since 2009 for equities, gold stocks barely outperformed the S&P 500, even though gold gained 2.25% over the month. We are concerned that a pullback in stocks, combined will a fall in gold prices in a December hike situation would see gold stocks fall to yet another low, even though the HUI index is already down 25% in 2015.
For now the next stop is this US Employment data this Friday. Following that we will reassess the situation, but as things stand a December hike by the Fed is more likely than not, which is bearish for gold prices in the short term. Our full trading record is available on our website, and if you wish to subscribe you may do so using either of the buttons below.
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