Gold is going to "counterattack"?

On January 5, 2022, US time, the Federal Reserve released the minutes of the December 2021 meeting, which was more hawkish than the interest rate statement, proposed the possibility of an early interest rate hike and mentioned the balance sheet reduction for the first time. After the release of the minutes, the market's concerns about the Fed's further tightening of monetary policy increased, US Treasury yields rose rapidly, and US stocks adjusted sharply. Affected by the expected balance sheet reduction, the 10-year US Treasury yield rose sharply, from 1.66% after the close of trading on January 4 to 1.78% after the close of trading on January 10. U.S. stocks fell rapidly, closing on Jan. 5, with the S&P 500 falling 1.94 percent, while the more interest-rate-sensitive NASDAQ fell 3.34 percent. On Jan. 10, Fed Chairman Jerome Powell, who has been nominated for four years for re-election, said at a confirmation hearing that the U.S. economy is growing rapidly and the labor market is strong, and the Fed will prevent high inflation from continuing. Affected by this, the three major U.S. stock indexes collectively opened low, and then the decline was further expanded, and the NASDAQ plunged 2.7% at one point during the session. During this period, gold did not fall sharply, but still maintained a high oscillation, reflecting its hedging ability to hedge against inflation and US stock volatility. Recently, the Fed's official and voting governors have frequently issued early interest rate hikes and balance sheet reduction signals, and global market volatility has intensified. This article briefly reviews the last Fed balance sheet reduction, combs the background of this balance sheet reduction, and helps investors understand the trend of gold prices.

After the outbreak of the financial crisis in 2008, the Fed adopted a QE policy for the first time, and by 2013, a total of three rounds of QE had been implemented, and its balance sheet size had expanded from $900 billion to $4.5 trillion. With the subsequent recovery of the US economy, the Federal Reserve announced in December 2013 that it began to reduce the scale of bond purchases, and in December 2015, it announced a rate hike, embarking on the path of normalization of monetary policy. In comparison, the Fed's balance sheet expanded from $4.2 trillion to nearly $9 trillion after the outbreak of the new crown epidemic in 2020; the Fed announced in November 2021 that it began to reduce the size of its bond purchases and expected to start raising interest rates for the first time in 2022. As can be seen from here, the background of the two scale reductions is similar.

The final plan for the last scale reduction was proposed in June 2017, following the principles of passivity, gradualness and predictability. The passive principle means that the Fed does not actively sell assets, but instead reduces its balance sheet by stopping the reinvestment of some of the matured assets, which has the advantage of having less impact on liquidity. The progressive principle refers to the scale reduction of the stride from small to large, initially only $10 billion per month, and then gradually increasing to $50 billion per month over a year's time. The principle of predictability refers to early and full communication with the market, and the reduction of the balance sheet is basically carried out in the case of market expectations, and the impact on the market is minimized.

The Fed slowed its balance sheet reduction in May 2019 and officially ended its balance sheet reduction at the end of September 2019. Minutes from the January 2019 interest rate meeting showed Fed officials agreeing on the end of the contraction during the year. At its march 2019 interest rate meeting, the Fed officially announced a plan to gradually slow down its balance sheet reduction, from $30 billion to $15 billion per month from May, and stopped shrinking its balance sheet at the end of September; however, from October, the MBS was reduced to purchase Treasury bonds, up to $20 billion per month.

From October 2017 to September 2019, the size of the Fed's balance sheet shrank from $4.5 trillion to $3.8 trillion. Nearly $700 billion was reduced in two years, or 15.6 percent of pre-balance sheet reduction.

The background and time node of the Fed's balance sheet reduction are deduced

On January 5, 2022, the Fed released the minutes of its December 2021 interest rate meeting. In terms of employment, the minutes of this meeting show that the United States is facing a serious labor shortage and excessive wage growth, the job vacancy and voluntary turnover rate continue to be at a historical high, the labor market recovery trend is relatively clear, gradually approaching the Fed's maximum employment target, and even some officials believe that full employment has been achieved. In terms of interest rate hikes, the minutes of the meeting raised the need to raise the federal funds rate earlier; participants generally pointed out the need to raise the federal funds rate earlier and faster than previously expected, based on the economic, labor market and inflation conditions; and even some participants even believed that it was appropriate for the Fed to raise the target range of the federal funds rate before the maximum employment rate was fully achieved. In terms of balance sheet reduction, this is the first time that the Fed has talked about this issue in the minutes of its meeting, and the vast majority of participants believe that it is appropriate to start a balance sheet reduction at some point after the first increase in the target range of the federal funds rate. In terms of the epidemic, the minutes of this meeting pointed out that the Mutation strain of Omikejong or the exacerbation of frictions such as labor shortages and supply-side restrictions will continue to pose downside risks to economic activities and upward risks to inflation, but will not change the recovery trend of the US economy.

The minutes of the Fed's December 2021 interest rate meeting show that officials have engaged in a rich discussion around the issue of balance sheet reduction, exacerbating market fears of a further turn of the Fed. The minutes repeatedly mentioned the keywords of "balance sheet" or "balance sheet reduction", and revealed that the current round of balance sheet reduction may be earlier and faster, mainly due to the rapid recovery of the US economy after the epidemic, strong demand in the labor market, and inflation levels continue to rise above expectations.

On January 7, the U.S. Bureau of Statistics released non-farm payrolls for December 2021, and the overall performance was mixed. New non-farm payrolls increased by 199,000, underperforming the expected value of 400,000 and the previous value of 249,000, the smallest increase since January 2021. The unemployment and wages were strong, with the unemployment rate recording 3.9% in December 2021, outperforming the 4.1% expected value and the 4.2% previous value, continuing the new low since February 2020; wages rose 4.7% year-on-year, exceeding the expected value of 4.2%. Strong unemployment and a rapid rise in wages highlight the trend towards better employment and still strong inflation.

The U.S. unemployment rate fell to 3.9 percent in December 2021, outperforming the 4.1 percent expected and 4.2 percent previous values, the lowest level since the outbreak and very close to the Fed's 3.5 percent unemployment forecast for the end of 2022. The performance of the unemployment rate shows that the US job market is infinitely close to full employment, having met and exceeded the Fed's estimate of full employment (the Fed fixed it at 4.0%), while offsetting the negative impact of non-farm payrolls new jobs being less than expected. The U.S. labor force participation rate rose to 61.9 in December 2021, stronger than the previous value of 61.8. The decline in the unemployment rate in the context of the increase in the employment participation rate indicates that some of the labor markets have recovered better than the current situation shown in the data, and the decline in the unemployment rate can be directly understood as the result of the increase in the number of employed people. Average hourly earnings in December 2021 rose 4.7% year-on-year, better than the 4.2% forecast, indicating on the one hand that the labor market is tight and that wages are rising on the other, and that inflation will remain strong.

The strong unemployment rate and wage growth in the United States in December 2021 have heated up expectations for an early interest rate hike by the Federal Reserve. After the non-farm payrolls data, the swap market is currently expecting a 25BP rate hike in March with a probability of about 88%, and the first rate hike in May is more likely; the trend of federal funds rate futures shows that the Probability of the Fed raising interest rates in March is 90%, up from 80% on January 5. Moreover, from the Fed's perspective, the current labor market is not its main focus, but has been replaced by a sharp rise in inflation; the US CPI rose 6.8% year-on-year in November 2021, a 40-year high. In order to curb the continued rise in inflation, the Fed will inevitably move towards interest rate hikes or even balance sheet reductions in 2022.

For the Fed's monetary policy, the end of QE in March is basically certain. In terms of interest rate hike policy, the possibility of the Fed starting to raise interest rates in March has increased significantly, and the interest rate hike cycle will be opened in June at the latest, and the trend of inflation is the core influencing factor of the Fed's interest rate hike time point in the case of the continuous improvement of the job market and the unemployment rate basically meets the Fed's expectations. In terms of balance sheet reduction policy, the minutes of the Fed meeting have clearly discussed the necessity and feasibility of balance sheet reduction, Fed officials have also constantly emphasized the necessity of balance sheet reduction, and the market expects that the Fed will put the balance sheet reduction on the agenda after raising interest rates 1-2 times, and begin to release signals and implement the balance sheet reduction policy in the second half of the year.

Gold prices are more volatile and could hit 2020 highs

The overall trend of gold prices in 2021 weakened and did not come out of the obvious trend market, mainly because the US economy is in the recovery stage, but due to the imbalance of global economic recovery, increased energy price fluctuations and structural problems in the US domestic supply chain into "chaos", the Merrill Lynch clock of the US economy swings between "recovery" and "stagflation". The contradiction between the regulation of the US government and the Federal Reserve and the current state of the economy has made the precious metal not out of the smooth downward trend.

Affected by the epidemic, the global supply chain continued to be disrupted and market liquidity flooded, and inflation in major economies continued to rise and hit a record high. The Fed has opened taper in November 2021 and expects to end QE in March 2022, and expectations of interest rate hikes and balance sheet reductions have also been significantly advanced. Under this premise, the global liquidity inflection point has emerged, which will have a huge impact on global risk assets in 2022; the US dollar index will continue to remain strong and suppress gold. But after the recent release of hawkish expectations by the Federal Reserve, gold did not fall sharply, but fluctuated slightly around $1800 / ounce, and gold's safe-haven properties provided support for its price. At present, the main US stock index is still at a historical high, but the volatility has increased significantly, and in 2022, under the expectation of the Fed's balance sheet reduction, it will fluctuate greatly, and gold will become an ideal hedge against inflation and risk assets such as US stocks. We expect that in 2022, in the case of the Fed's tightening expectations of the bearish gradually exhausted, gold's safe-haven properties will appear, the volatile center of gravity of gold prices will rise, volatility will increase, and may hit the 2020 highs. (Author Affilications:Soochow Futures)

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This article originated from Futures Daily