Are gold prices about to fly? Gold is a hedge against a policy mistake, says Pepperstone

New York (Jan 20)  The recent trading pattern in gold shows signs that a bull market could be just around the corner, with investors starting to price in a possible policy mistake as central banks worldwide begin to raise rates.

Gold hit 2-month highs this week as prices surged above $1,845 an ounce level. But what's surprising is the environment in which the yellow metal is able to make new gains — a hawkish central banks backdrop and rising U.S. Treasury yields.

"We are not just talking about the rise in nominal Treasury rates, we are talking about the rise in real Treasury rates. And these are Treasuries adjusted for inflation expectations. Usually, gold and yields move in a close inverse relationship. If real rates go higher, then gold goes lower," said Pepperstone head of research Chris Weston.

Gold doesn't have a yield. This is why when yields on a real basis climb, gold becomes less attractive. "Since the start of the year, we are seeing a really interesting dynamic where real rates are moving sharply higher, but gold price is holding in really well," Weston said on Thursday.

This is a major development that cannot go unnoticed. The markets are already pricing in at least four rate hikes this year as the Federal Reserve is gearing up to fight four-decade high inflation in the U.S. But the gold market seems to be getting ready for something else — a policy mistake.

"Gold is not an inflation hedge at the moment. It is a hedge against a policy mistake," Weston said. "Markets are saying we will see four or five rate hikes this year, with passive balance sheet runoff. Does that mean we are closer to a policy mistake? I think this is what you are seeing in a gold market — if central banks have to backtrack, gold will absolutely fly. It is a hedge you have in your portfolio against this policy mistake."

A surge in crude oil prices is also contributing to this argument as higher oil is helping to support gold.

"That's going to be another nail in the coffin for the consumer. And as demand ramps up, we will be talking about $100 oil. This will feed into the gold situation due to rates pricing. If central banks raise by the projected amount, do we want a 10% allocation to gold and silver? That's exactly what you're seeing in the market. That's why it has broken away from nominal and real rates, and people are saying let's have a hedge against a policy mistake."

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