Gold prices retreated again after market sentiment turned more cautious following renewed tensions in the Middle East and a hawkish Federal Reserve stance. The combination of rising US bond yields, higher interest rate expectations and inflation risks are now the main pressures on XAU/USD.
However, gold's latest decline has not yet erased the positive trend built throughout August. Bullion is still up around 10% this month, heading for its best monthly performance since January.
Hawkish Fed Back Pressures Gold
The biggest pressure on gold right now comes from changing expectations for US monetary policy.
Fed Chairman Kevin Warsh's speech at Jackson Hole last week sent a strong message that the central bank still prioritizes efforts to control inflation. The statement led the market to increase bets that the Fed might raise interest rates at its September meeting, with the probability of a hike now exceeding 60%.
This change in expectations is negative for gold because higher interest rates increase the opportunity cost of holding non-yielding assets like gold.
Rising Treasury yields have also added to the pressure. As yields on yield-bearing assets rise, some investors have more reason to reduce exposure to gold.
Middle East Conflict Again Disrupts Markets
Meanwhile, geopolitical risks have risen again after the United States and Iran exchanged direct attacks for the first time in about a month.
The United States launched an attack on an island in the Strait of Hormuz, before Iran responded with attacks on the United Arab Emirates and Jordan.
The development has renewed concerns about the stability of energy supplies and global trade routes.
US crude oil prices have returned to above US$85 a barrel. If energy prices remain high, inflationary pressures could become more prolonged.
This creates a somewhat peculiar situation for gold. Geopolitical tensions usually increase demand for safe-haven assets like gold, but if the conflict causes energy prices to surge and inflation to rise, markets can expect the Fed to maintain tighter policy.
In such circumstances, the positive safe-haven effect on gold could clash with pressure from interest rates.
Gold Still Supported by US Fiscal Concerns
While the Fed is now a drag on gold, there is another big theme that continues to support bullion demand: concerns over the US fiscal position.
In mid-August, the Treasury’s decision to increase its repurchase of long-term government bonds helped ease pressure in the bond market and rekindled what is known as the debasement trade.
Investors are concerned that rising government debt and fiscal deficits over the long term could weigh on the currency and increase the need to hold hard assets like gold.
This makes the outlook for gold more complex.
On the one hand, the Fed is increasingly hawkish and higher rates are putting pressure on XAU/USD. On the other hand, concerns about government debt, fiscal policy and the potential for currency depreciation continue to give investors a reason to hold gold.
Gold Market Now Facing a Clash of Two Sentiments
The current situation can be seen as a clash between two superpowers.
Bearish sentiment: a more hawkish Fed, rising Treasury yields and expectations of a rate hike in September.
Bullish sentiment: Geopolitical tensions, concerns over US government debt and demand for gold as a safe haven and hedge against currency risk.
As long as the market continues to believe that the Fed needs to raise rates to control inflation, gold will face pressure to maintain its upward momentum.
However, if geopolitical risks worsen, US fiscal pressures return to focus or interest rate expectations begin to change, demand for gold could rebound.
What Should Traders Watch?
The gold market is now focused not just on bullion price movements, but on the relationship between inflation, Fed rates, Treasury yields and geopolitical risks.
If oil prices continue to rise due to the Middle East conflict, the market will watch to see if inflationary pressures force the Fed to take a more hawkish stance.
Conversely, if geopolitical tensions escalate without a major increase in interest rate expectations, gold could potentially regain support from safe haven demand.
Currently, gold appears to be retracing after a big rally throughout August. However, the decline does not necessarily signal a larger trend change.
The market is currently in a tug of war between an increasingly hawkish Fed and concerns over geopolitical risks and the US fiscal position.
The next direction of XAU/USD will depend largely on which sentiment ultimately dominates the market.
