Why Lower Crude Oil Prices Could Drive Gold Higher

By: Bob_Kirtley

We view gold as monetary asset; therefore our directional views on the yellow metal are primarily a function of our expectations of monetary policy. After being very bullish on gold in the years following the global financial crisis as the Fed pursued highly accommodative monetary policy and quantitative easing, we turned bearish on gold at the end of 2012 as the period of easing monetary policy appeared to be coming to an end. We have maintained our bearish stance as the Fed has moved towards tightening monetary policy, however the recent fall in oil prices has caused us to question our view, and whilst we remain bearish over the longer term, we now think that gold prices could bounce from current levels.

Lower Oil Would Harm The Economy

Whilst minor declines in energy costs can be a positive for the economy, the drop in oil prices has been so dramatic that it arguably hampers economic growth. This is due to the ripple effects of a slowdown in the oil sector, seeing job cuts not just in the energy industry, but in the related areas of the economy.

We potentially have yet to see the full impact of low oil prices on the US economy and if oil falls further the damage accelerates. A drop of 20% from here would be more damaging than the last 20% fall as more oil production projects would become unviable. If this impact begins to shift the momentum of the US economy, the Fed could delay its tightening and this move to a more accommodative stance would be bullish for gold.

Disinflationary Impact

Potential economic damage of very low oil prices aside, the larger risk is the disinflationary impact of falling energy costs. The decline in oil prices saw interest rates fall as the market was concerned that lower oil prices would see less inflation, reducing the amount the Fed would need to hike. Once oil bounced, yields moved higher again. However oil prices are now testing recent lows, and therefore we could see bond yields decline and gold prices rise as the market becomes concerned that the disinflationary impact of lower energy costs will see the Fed delay tightening monetary policy.

Transitory

After the GFC when commodity prices were soaring, including oil, the Federal Reserve was under pressure to stop its QE programs and increase interest rates to combat coming inflation from rising prices. However the Fed looked through rising food and energy costs, with the key word “transitory” popping up again and again in their statements. What the Fed means by this is that they see moves in volatile commodities such as oil as temporary price shocks, and therefore they do not have much weight in their monetary policy decisions.

We believe that it is likely the Fed does this again, and will continue on its plan to normalize interest rates with the view that once energy costs return to a more long run average level, inflation will be a threat so they wish to be ahead of this issue by tightening monetary policy this year. If the Fed moved interest rates based on commodities there would be significant financial instability and it would work against the Fed’s medium term goals by overly focusing on short term factors.

No Inflation Globally

Australia, South Korea, Canada, China, Denmark, India, Indonesia, Israel, Poland, Russia, Sweden, Switzerland, Turkey; What do these countries have in common?

Their central banks have all cut interest rates in 2015.

Missing from that list is of course, Japan, the Eurozone and the United Kingdom, who cannot reduce their rates any further and are still doing quantitative easing. Then there is the USA, with the Fed possibly going to raise interest rates in June.

If there is no inflation globally and the disinflationary pressure is so strong that many countries are cutting interest rates, how can the US be so different to begin to hike a few months time?

The Fed Could Go Alone

Whilst it will be tough to tighten monetary policy when much of the world is easing, the Fed can certainly go it alone. One must remember that over recent years the Fed has eased policy faster and more aggressively than its peers. Europe announced QE programs when the Fed was bringing its own QE3 to an end. The US economic data has been far stronger than European or Japanese data and the US economy is not as leveraged on the price of oil as countries such as Canada.

Therefore the fact that other central banks are cutting will not stop the Fed hiking, but global disinflationary pressures could decrease the extent to which it increases the Fed Funds Rate. The US economy is linked to every other in the world, so if there is a lack of inflation globally this will dampen the inflation outlook in the US.

Conclusion

The precarious price action in oil has created an asymmetric risk profile where a 20% rise in oil prices will maintain the status quo but a 20% drop would trigger the market to reassess the outlook for the US economy and monetary policy. Given that a further decline in oil would see the market question the likelihood of imminent Fed tightening, gold prices are ripe for a bounce off this key support level around $1150.

However over the longer term we are still bearish on gold as the Fed will ultimately consider the drop in oil prices as transitory and focus on tightening policy ahead of the future inflationary pressures that will arise once energy costs return to a more normal level. This will send gold prices down below $1000 and therefore we favour being square at these levels, looking to initiate short positions on the yellow metal on this bounce higher. To find out what trades we are making and how are positioning ourselves in other markets, visit www.skoptionstrading.com to subscribe.

Go gently.

Bob Kirtley

Email:bob@gold-prices.biz

URL: www.silver-prices.net

URL: www.skoptionstrading.com

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