(Kitco News) – While the U.S. Federal Reserve believes inflation won’t return to target before 2025 and rates must be kept higher for longer, a new research report from WisdomTree argues that inflation has already been tamed and the risk of recession is still rising.
According to Nitesh Shah, Head of Commodities and Macroeconomic Research for Europe at WisdomTree, the Fed’s current path could far overshoot their inflation target and take the U.S. economy into recession.
“US inflation is arguably falling hard,” Shah wrote in the latest Gold Outlook report. “However, the stale shelter data in the Consumer Price Index (CPI) calculation masks the reality. An alternative inflation metric, calculated by WisdomTree (that substitutes real time housing metrics for shelter inflation), reads at 1.4% instead of the 4.1% official Bureau of Labor Statistics (BLS) headline inflation, with core inflation using real time metrics running at 2.1% – almost exactly the Federal Reserve’s (Fed) target inflation.”
Shah notes that the shelter inflation metric used in the official BLS reports is currently at 8% over the last 12 months. “However, our alternate metric puts the shelter price increase at 0.5%,” he said. “This single variable change would dramatically alter the Fed’s inflation narrative and shows the Fed should be done hiking.”
He references the Fed’s latest dot plots, which show that Federal Open Market Committee (FOMC) members still expect to hike rates further. “That could potentially overdo it and raises the risk of recession,” he said. “The rapid pace of rate hikes could have an outsized impact once the lag is accounted for.”
When recession risk is measured based on yield curve inversions, Shah sees a 70% chance that the U.S. economy will be in recession by mid-2024.
“The Federal Reserve Bank of New York model has had a fairly good track record of pinning down past recessions, and so it’s hard to ignore this warning sign,” he said, adding that with recession risks rising, investors should consider gold as a “defensive asset.”
Shah points out that gold has a history of performing well in times of economic stress. “As Figure 2 below shows, when composite leading indicators (Figure 3) turn strongly negative, gold performs positively while equities tend to be negative,” he writes. “Gold also outperforms Treasuries, which are seen as competing defensive assets.”
Shah uses WisdomTree’s quantitative gold model to look at what has been driving gold prices of late. “[W]e can see that inflation is moderating, thus providing less support for gold prices than last year,” he said. “The recovery in investor sentiment towards gold (measured by speculative positioning) has largely plateaued. The extension of the debt ceiling, and the passing of the mini banking crisis without any major systemic impacts (yet), has softened investor demand for the metal.”
He adds, however, that the decline of the U.S. dollar compared to 2022 is acting as a support for gold.
Shah then uses the same model to generate gold forecasts “consistent with several macroeconomic scenarios.”
“Our consensus scenario takes Bloomberg Survey of Professional Economists’ average views on inflation, US dollar and Treasury yield forecasts,” he writes. “Consensus is looking for inflation to continue to decline (although above central bank target), the US dollar to depreciate, and bond yields to continue to fall. Without a consensus forecast on gold sentiment we reduce speculative positioning to a conservative 100k, which is close the long-term average, from the elevated level of close to 180k in June 2023. The risk is clearly to the upside this year if a recession or financial dislocation materialises.”
Shah writes that a recession could drive demand for the yellow metal even higher. “In the consensus case scenario, gold reaches US$2,225/oz by Q2 2024, piercing through previous all-time nominal highs (US$2,061/oz on 7 August 2020) by Q4 2023 at $2139/oz,” he says. “However, in real terms, this does not reach an all-time high, which was reached in January 1980. In fact, it would be 34% below that level. And, in real terms, it is still 10% below the 2020 high.”
WisdomTree’s bullish scenario assumes that the Federal Reserve gets worried about signs of recession and pivots to cutting rates faster. “If the Fed begins monetary expansion by autumn 2023, bond yields will be falling and, assuming it moves before the European Central Bank and other major central banks, we could see the US dollar depreciate at a faster rate,” he said. “We assume inflation will be stronger than in the consensus scenario as a result of the Fed loosening monetary conditions.”
Shah writes that if these recession fears do become reality, gold futures will remain elevated. “In this scenario, gold could reach US$2490/oz,” he said. “That would be 22% higher than the all-time nominal high (reached in August 2020) and about the same level as that in real terms. However, it would be 28% below the all-time real high reached in 1980.”
In Shah’s bearish scenario, the Fed overdoes the tightening and CPI falls below its target to 1.8%. “Bond yields rise and the US dollar appreciates as an overzealous Fed outpaces other central banks,” he says. “Although we acknowledge that such a scenario increases recession risk and, therefore, could be gold positive drawing more investors to the yellow metal as a hedge, for the sake of building a negative scenario, we cut speculative positioning in gold futures down to 50k.
He says that in WisdomTree’s most pessimistic scenario, “gold could reach US$1710/oz, retracing prices back to November 2022 levels.”
Posted by:
Jack Dempsey, President
401 Gold Consultants LLC
jdemp2003@gmail.com