Gold price jumps ahead of Fed

On Wednesday an inflation surprise which makes a US interest rate hike next month a bit more unlikely  lifted the gold price more than $20 an ounce giving it more breathing space above the psychologically important $1,100 an ounce level.

In solid volumes, gold for delivery in December – the most active futures contract – raced higher nearly 2% to $1,123.70 an ounce before giving back some of the gains to end the day at $1,119.00. It was the best one-day performance for gold in more than a month.

According to figures from the Department of Labor CPI dipped 0.1% in August, the first deflationary number since January this year.  Subdued inflation should give pause to hawks on the Fed's decision making committee who want to announce an increase in interest rates at the end of its current meeting on Thursday.

What has now almost become a rule of thumb is that rising real interest rates raises the opportunity costs of holding gold because the metal provides no yield and therefore the price should decline. Higher rates also boost the value of the dollar – up 14% in a year – which usually move in the opposite direction of the gold price.

Since the global financial crisis the relationship between interest rate expectations and the gold price has only become tighter with some analysts believing the metal can serve as an early warning system of both the direction and magnitude of the move in rates.

In a recent note from Capital Economics the independent research house that while the negative relationship between rates and gold is real "this link can be overdone":

"Note first that it is a question of degree. An eventual rise in annual US interest rates to, say, 4%, would not have a huge impact on the relative attractiveness of holding gold, given its value as insurance against extreme events and the scope for prices to move by significantly more than 4% in a relatively short period.

"Suppose, for example, that the Fed is tightening policy because US inflation is picking up. In this case there may actually be increased demand for gold as an inflation hedge. Alternatively, suppose that Fed tightening triggers a sell-off in other asset markets, including equities as well as bonds. This may well increase demand for gold as a safe haven."

When the Fed does indeed decide to pull the trigger it would be the first US rate hike since June 29, 2006 (incidentally a day the gold price jumped 3%).

A 25 basis point hike from zero is not exactly a high interest rate environment either. Anything approaching 4% rates remain a long way off, if the Fed gets there at all – consensus forecast for US short term interest is a climb to 3%. And only by the end of 2017.