A Golden Inflation Conundrum

Last week, SPDR Gold Shares (GLD) rallied on weak inflation news and pulled back on strong inflation news. The gap up in GLD followed by a gap down created the dreaded “abandoned baby top.” This technical pattern typically signals the end of a rally. What gives with this golden inflation conundrum?

SPDR Gold Shares (GLD) printed a technical topping pattern amid mixed inflation news, but it is trying to hold uptrending support at the 20-day moving average (DMA)

The Conundrum

The current inflationary cycle could be ending, at least in North America. For example, the Bank of Canada (BoC) showed inflation data with a steeply descending trend ending with a near perfect landing at the Bank’s 2% target in late 2024.

Here in the U.S. plenty of pundits have declared inflation a non-threat ever since the Federal Reserve finally got serious about it. Cathie Wood has been one popular critic of the Fed’s inflation concerns. The disbelievers received more confirming evidence when the latest producer price index told a disinflationary story. A slightly weaker than expected inflation reading from the March Producer Price Index (PPI) generated cheer in stocks given the implication for looser monetary policy. Since producer prices sit upstream from final goods prices, PPI can be a leading indicator of future prices.

Gold also celebrated the soft inflation numbers; GLD gained 1.4%. This reaction represents the upside of the golden inflation conundrum. Gold bugs suspect that the seeds of inflationary pressures remain well-grounded in the economy. I agree with them. A relaxed Fed is a potential catalyst for rewatering the garden of growing prices, especially if labor markets remain tight. Thus, the prospect of a relaxed Fed supports higher gold prices.

The downside of the golden inflation conundrum can come on stronger inflation signals because they support an aggressive, inflation-fighting Fed. GLD went into retreat in the wake of a surprising surge in consumer expectations for inflation next year from 3.6% in March to 4.6% in April. This reading from the University of Michigan’s surveys of consumers was last this high in November, 2022. Even if this move coincided with the jump in gas prices, surges in inflation expectations are sure to encourage the Fed to stay on message. As it happened, the market got a timely dose of messaging from Governor Christopher J. Waller the same day.

The Fed Stays On Message

In the wake of the economic data, Governor Christopher J. Waller spoke at the Graybar National Training Conference in San Antonio, Texas. Waller reiterated the all too familiar refrain “inflation remains much too high.” He provided the following cautionary assessment of inflation (emphasis mine):

“Inflation moderated in the second half of 2022, but that progress more or less stalled toward the end of the year…On April 12, we got consumer price index (CPI) inflation data for March, and it was another month of mixed news…Core inflation, which strips out food and energy prices, is a good guide to future inflation, and that measure came in at around 0.4 percent in March, which translates to an annual rate of 4.6 percent if it were to persist. It was the fourth month in a row with core inflation at 0.4 percent or higher. Since December of 2021, core inflation has basically moved sideways with no apparent downward movement. So, despite some encouraging news on a slowing in housing costs, core inflation does not show much improvement and remains far above our 2 percent inflation target.

Whether you measure inflation using the CPI or the Fed’s preferred measure of personal consumption expenditures, it is still much too high and so my job is not done. I interpret these data as indicating that we haven’t made much progress on our inflation goal, which leaves me at about the same place on the economic outlook that I was at the last FOMC meeting, and on the same path for monetary policy. Because financial conditions have not significantly tightened, the labor market continues to be strong and quite tight, and inflation is far above target, so monetary policy needs to be tightened further. How much further will depend on incoming data on inflation, the real economy, and the extent of tightening credit conditions.”

With the Fed’s next decision on monetary policy just two weeks away, Waller’s words suggest that the Fed could raise rates yet again. The odds are low of getting a disinflationary signal strong enough to counter Waller’s observations. Thus, I think GLD will struggle to invalidate the technical topping pattern for the time-being.

The Trade

The golden inflation conundrum leaves GLD in a contrary place. In the short-term, GLD’s best chances lie with soft inflation numbers. Indeed, GLD bottomed shortly after the market bottomed in October when market participants concluded that inflation had finally peaked. Inflation’s peak does not equal the Fed’s inflation target; the Fed has gone to great lengths to issue these reminders. Yet, beyond day-to-day volatility, the market has overall chosen to fight the Fed’s hawkishness ever since October. Volatility is even back to levels last seen at the start of trading in 2022 despite the linger crisis in regional banking.

Where volatility is poorly positioned, GLD is well-positioned. From the looming battle over the U.S. debt ceiling to the prospect of the Fed standing down later this year to geo-political risks, there are enough reasons to stay bullish on GLD. I am back to trading around my core position. I took profits on half my call spreads last week. My remaining half is set to expire in September. I want plenty of runway for the gold-positive catalysts to work their way through the golden inflation conundrum.

Be careful out there!

Full disclosure: long GLD shares and call spread

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