De-escalation in geopolitical tensions coupled with a strengthing US dollar and rising bond yields ensured a decline in gold prices in April. The US Dollar Index is trading to the highest level since March and 10-year treasury yields is at the highest level since 2014. It is the dollar story which received a boost mainly because of the Euro.
The US Federal Reserve in its recently held monetary policy left benchmark interest rates unchanged and maintained their projected pace to raise rates two more times this year. The statement said that inflation on a 12-month basis is expected to run near the committee’s symmetric 2% objective over the medium term. The committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate. These statements suggested that the Federal Reserve continues to be accommodative.
The Federal Reserve is on course to shrink its balance sheet by $420 billion or 9.4% this year and by $600 billion next year as a result of the policy known as quantitative tightening. Meanwhile, G7 balance sheets are still expanding in aggregate though the rate of expansion will slow sharply this year. The aggregate size of the balance sheets of the Fed, the Bank of Japan, the ECB and the Bank of England increased 17% to $15.2 trillion at the end of 2017. Based on the stated central bank policies, the aggregate balance sheet is projected to rise by 6.8% to $16.3 trillion by the end of this year. The impact of lesser money will be over time felt by equity markets and the euphoria on tax cut optimism, liquidity and higher asset prices will likely come to an end this year.
The trade war dispute between the two superpowers (the US and China) is far from over. It is hard to imagine that either of the two will back down immediately which suggests that this dispute will continue for some time. A trade war could affect demand for US assets just as the budget deficit swells, leaving the dollar vulnerable should international buyers shun US debt. The aggregate federal, state and local debt in the US, both on balance sheet and entitlements, relative to levels of savings and investments in the economy, will contribute to worries over the longer-term purchasing power of the dollar, particularly in view of low current yields.
Should there be a “deep trade war,” with complications for global growth, industrial commodities such as base metals, energy will be negatively affected, but that scenario would benefit gold. The world continues to remain in a state of great disequilibrium, both with respect to the global economy and geopolitics. Given the macroeconomic picture, gold will be a useful portfolio diversification tool and thereby help you to reduce overall portfolio risk.
The writer is senior fund manager, Quantum AMC