Inflation Expectations Are Next

If inflation expectations surge higher, gold & silver prices should surge too…

 by Craig Hemke via Sprott Money News

Inflation in the U.S. is at 40-year highs, and the latest report on consumer prices revealed an annualized inflation rate of over nine percent. But that news was not unexpected, and the key metric to watch going forward will be longer-term inflation expectations.

Why are inflation expectations so important? Because gold prices are most influenced by inflation-adjusted or “real” interest rates. And how do you determine an inflation-adjusted interest rate? You subtract the inflation rate from the nominal interest rate you will be receiving on your U.S. treasury bond or note.

For example:

  • Current U.S 10-year note yield: 3.0%
  • Current U.S. inflation rate: 9.1%
  • Your inflation-adjusted “real” interest rate is -6.1%

This means that, as of this moment, you will see your purchasing power decline by 6.1% by holding and owning this investment.

However, that simple calculation fails to take into account that the inflation rate will change over the 10-year life of your investment. So, for market purposes, real interest rates are actually calculated using the current 10-year inflation expectations.

Of course, these expectations are notoriously inaccurate—think of Powell’s 2021 “inflation is transitory” argument. But that hardly matters to metals traders and their HFT machines. What matters is today’s nominal interest rate and today’s inflation expectation. This is what is used to determine your expected real interest rate over the life of your investment:

  • Current U.S. 10-year note yield: 3.0%
  • Current U.S. 10-year inflation expectation: 2.4%
  • Your expected real interest rate is +0.6%

As you can see, that’s a pretty big difference, and it’s based upon rejecting the reality of current inflation and basing your decision upon the expectation and forecast of lower future inflation.

Inflation expectations have fallen sharply since April, and so with real interest rates now measured in positive territory, COMEX gold prices have fallen too.

Putting this all together, you can begin to see that the key to turning the COMEX gold price around in the second half of this year and beyond will be:

  1. a) A drop in nominal interest rates
    b) A rebound in inflation expectations
    c) Both

And this is where Wednesday’s CPI report was crucial. Price inflation has been steadily rising for over a year, and it is now understood that it is not “transitory”. With human nature being rather fickle and short-sighted, it’s only natural to expect that the longer inflation rates remain elevated, the higher projected future inflation will become. So with each passing month the likelihood that inflation expectations become “sticky” increases. The likelihood of higher inflation expectations will grow too.

The U.S. gross domestic product contracted by 1.6% in Q1 of this year. Current projections are for a continued contraction in the just-completed Q2. The textbook definition of “recession” is two consecutive quarters of economic contraction, so here we are.

So what will Powell and his FOMC do next? They claim that they intend to continue hiking the fed funds rate with another 75 basis point boost expected at the next meeting in two weeks. But the U.S. economy is already in recession, so how much higher can the Fed force interest rates without deepening the recession toward something even worse?

With this in mind, the fed funds futures market (yes, there is such a thing) is already pricing in a fed funds rate CUT as soon as Q1 2023! When forced to make a choice between combating inflation or “saving the economy”, you can be certain that Powell will choose the latter.

Now let’s refer back to that real interest rate calculation in order to project where gold prices will head from here. Let’s make these assumptions for the end of this year:

  1. a) The nominal yield on the 10-year note: 2.50%
    b) The updated 10-year inflation expectation: 3.50%
    c) The 10-year real interest rate: -1.00%

The last time real interest rates were that sharply negative was the summer of 2020. And where was the COMEX gold price back then? Near $2100/ounce. As recently as March of this year, just after the Ukraine War began, real interest rates were again near -1.00%. And where was the COMEX gold price then? Again, near $2100/ounce.

So watch inflation expectations very closely in the months ahead. The next major update will come this Friday with the latest University of Michigan consumer sentiment numbers. Within this report will be updated inflation expectations, and if they surge higher, you should expect COMEX precious metal prices to surge too.

Whether or not this next bounce will finally mark the end of what has been a rather nasty grind lower in prices since April is something we can discuss in the weeks ahead. For now, though, just be sure to monitor inflation expectations and real interest rates, as nothing is more important in driving the demand for COMEX gold futures and price.