Gold Rally Poised to Continue Amid Rising Inflation Expectations

Inflation bets are on the rise as Bernanke left the door wide open for a possible QE3 stimulus and also stated the inflation may not be so temporary and he had previously said before.

16 July 2011 02:38 GMT
By Ilya Spivak, Currency Strategist
DAILY FX

The path of least resistance appears to lead higher for gold prices as mounting inflation expectations drive demand for the metal as an alternative store of value. The two-year breakeven rate, a measure of investors’ bets on future price growth as reflected in bond yields, appears to have overturned the down trend in place since late April with a break above its 20-day moving average. The correlation between the breakeven rate and gold prices stands at the highest in three months, suggesting that if inflation expectations rise then so too will the yellow metal.

Inflation bets are on the rise following a pair of Congressional testimony outings from Federal Reserve Chairman Ben Bernanke. In the first sit-down with the House of Representatives, Bernanke conspicuously left the door open for a “QE3” stimulus program if the recovery remains anemic. In the second, he qualified that no such thing was on the immediate agenda because inflationary pressures thought to be temporary (such as those from the spike in oil prices earlier in the year) may not dissipate as quickly as expected, while the recovery was thought to be finding its footing.

Taken together, this amounts to two possible scenarios. If the recovery stumbles – either on its own or because the failure to reach consensus on raising debt ceiling sends borrowing costs higherin the absence of a QE2 program, snuffing what little growth there is – then the Fed will step in with more stimulus. If the central bank is right and growth picks up, prices will find natural upward pressure from accelerating economic activity. In either case, inflation expectations over a 2-year time horizon (the aforementioned breakeven rate) have scope to drift higher.

Lingering uncertainty in the Euro Zone is wildcard. The results of European bank stress tests published Friday proved suspect as expected. As with last year’s outing, the key thing not tested was the likely impact of a sovereign default within the Euro Zone on lenders’ balance sheets, seemingly defeating the point of the exercise. The Economist newspaper put it best, drawing a parallel between the test outcome and a doctor who declares a patient complaining of chest pain to be healthy, as long as he’s not having cardiac arrest. If this paves the way for an upswing in sovereign risk concerns, the safe-haven US Dollar is likely to advance, which may pressure gold lower considering the metal is denominated in terms of the greenback on global markets.

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