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Inflation Still Expected To Decline This

Year

 

Investor sentiment tends to be fickle. Markets started the year on expectations that inflation would decline this year, economies would most likely suffer a recession, and central banks would need to cut interest rates. Since the beginning of February, a slew of stronger than expected economic data started to create a shift in market perceptions about economic growth, inflation, and monetary policy.

Markets paid particular attention to the overshoot in January inflation data. Inflation data had been showing signs of softening during the third and fourth quarters of 2022 and markets were expecting this to continue into January as well. Though inflation data for January 2023 showed strength, one month of stronger than expected data does not make a trend. The reactions, particularly in the bond and precious metals markets, to the January inflation reports were essentially a correction of the excessive optimism about cooling inflation and lower federal funds rates during the last quarter of this year, which was being observed in the markets over the past few months. Inflation is expected to soften over the course of 2023. The decline will be gradual and volatile, however.

Inflation is expected to soften during 2023 based on:
– The Fed maintaining a restrictive monetary policy.
– Tighter financial conditions than those observed over the past several months, as markets align their federal fund rate expectations with those of the Fed.
– An easing of supply chain bottlenecks that had developed due to covid.
– Potential softening in demand for goods and services by businesses and consumers as the year progresses.
– A reduction in some cyclical inflationary pressures.
– And some actual softness or at least concerns of softness in labor markets that should help dampen demand.

There are risks to higher inflation as well:
– The Russia-Ukraine war.
– Covid.
– Supply constraints, e.g. poultry and eggs due to bird flu.
– Inflation in the services sector.
– Resilient labor market.

What Is Expected To Weigh On Inflation

Monetary policy typically takes several quarters to fully work its way through the economic system. The sharp increase in interest rates across major central banks in 2022, particularly the Fed, are expected to have a more pronounced effect on inflation and economic growth over the next few quarters of 2023. Additionally, the Fed is expected to keep monetary policy restrictive, possibly raising rates even more than it suggested during its December 2022 meeting, at least through the end of this year to try and cool the labor market which has been fueling services inflation.

Furthermore, and probably more importantly, as the gap between the market’s expectation of monetary policy and the Fed’s projections of monetary policy narrows, the more effective monetary policy will be in combating inflation. In recent months markets had been pricing in multiple cuts to the Federal funds rates toward the end of this year. The Fed was projecting no reversal in interest rates for this year, but the markets were factoring in up to a 50 basis points (bps) reduction in rates during the fourth quarter of 2023. The consequent loosening of financial conditions was exactly the opposite of what the Fed was looking to accomplish with the raising of its federal funds rates.

In recent days a new divergence has begun to form between the Fed’s last released projections and market’s expectations of monetary policy in 2023. Now the markets are pricing in an additional 25 bps in interest rate increases more than what the Fed had put out in its December economic projections and there are no reductions in rates for 2023 being priced in at the time of this writing. If market expectations of interest rates are in line with or tighter than what the Fed is projecting, the opposite of what was being observed over the past several months, it will have the effect of tightening financial conditions and more effectively controlling inflation.

As mentioned before, while inflation is expected to soften over the course of the year, the path is expected to be bumpy, with stronger than expected inflation figures being reported from time to time. This should keep markets from expecting further interest rate cuts later this year.

Another factor that is expected to weigh on inflation is the easing of supply chain bottlenecks which had developed in 2020 and worsened over the following two years due to the war between Russia and Ukraine and China’s zero-covid policy. Some of the chokepoints resulting from the war have eased and the suspension of China’s zero-covid policy toward the end of last year has permitted further loosening of the supply chain bottlenecks. Additionally, a shift in demand from goods to services over the past year have further helped to reduce the backlog created by supply chain bottlenecks.

Jerome Powell has been vocal about focusing on reducing services inflation. This inflation is more sensitive to wages and labor market conditions. Bringing this inflation down will require some loosening of the tight labor market conditions. One of the objectives of raising rates is to have a healthier labor market rather than the super tight conditions that have been observed over the past several quarters. How successful the Fed is in cooling the labor market is up for debate, but the possibility of job loss could have a dampening impact on demand. Already there are some cracks being observed in the labor market with some industries like finance and information technology, which were aggressively hiring over the past couple of years, experiencing some job losses.

What’s Likely To Boost Inflation

While risks from the Russia-Ukraine war and covid are reduced compared to before, there still are risks to rising inflation from these factors. In fact, the Russia-Ukraine war is not only a threat to renewed strength in inflation but also is playing an important role in the deterioration of relations between the West and Russia and also the West and China. This deterioration of cross border relations is an extremely important factor in providing support to gold and silver prices due to the function of these metals as portfolio diversifiers. From an inflation point of view the war could still become a source of concern, with Russia planning to scale back on oil production in retaliation for price caps on its exports. Sanctions and retaliations between the West and Russia are likely to continue in some shape or form until the war continues, which is expected to be a constant support to inflation. Covid too remains an ongoing threat to inflation, with possible mutations causing renewed spikes in cases, which could sporadically grind manufacturing and supply chains to a halt.

Inflation for goods has declined over the past several months as a result of an opening up and smoother functioning of supply chains and also a transition in consumer demand from goods to services. This deflation in goods inflation has been one of the primary reasons for softening inflation figures during the last few months of 2022. The impact of this transition should be expected to fade with time, which would act as a tailwind to inflation in 2023. Services inflation has historically been harder to reduce. It has a close relation with employment and wages. So far, tightening monetary policy has had a limited impact on the labor market. This could start to change as the year progresses, but it seems at this time like it would be a slow process.

A tug-of-war between the aforementioned headwinds and tailwinds to inflation should create a bumpy trajectory for future inflation. The factors expected to reduce inflation are more likely to win over the factors expected to push inflation higher, however, which should lower inflation in a slow and uneven fashion.

What Does This Mean For Precious Metals Prices

Precious metals prices have taken a beating since the start of February. There could be some more downside to prices in the coming months, as seasonal patterns change and broader markets, including the precious metals, continue to price in tighter monetary policy than previously expected. The downside for precious metals is likely to be limited, however. There are numerous factors that are expected to both support as well as push precious metals, especially gold and silver, prices higher. The weakness in gold and silver prices in the next few months could present a good buying opportunity for longer-term investors. While gold and silver prices are expected to soften in the coming few months, they are expected to rise in the next few years possibly to fresh record highs.

In the near term, precious metals prices may struggle with weakness as these markets continue to fully price in tighter monetary policy. But beyond a certain point this restrictive monetary policy could start to provide downside support to precious metals, as these markets begin to price in a future economic slowdown due to tighter monetary conditions now. Other factors like the debt ceiling discussions, which should be expected to come with an abundance of drama and brinkmanship, and strong inflation in Europe which is expected to boost European bond yields and the euro should also provide some support to precious metals prices over the next few months.

Over the medium to longer term, weaker economic growth due to current restrictive monetary policy and the scaling back of fiscal stimuli coupled with ongoing political hostilities both domestically and internationally are expected to push gold and silver prices higher for their asset diversification attributes.

Markets In Summary

Gold Market

At the end of February gold prices were essentially back to levels seen at the end of 2022. Gold prices are likely to see some further declines in the coming months, but the declines in gold prices are not expected to be as sharp as they were from April through October last year. Prices could slip to $1,800 or even fall toward $1,750. Prices could struggle to fall beyond these levels, however.

Three Month Gold Projection - March 2023

One of the biggest headwinds for gold prices at this time is the market adjusting to higher bond yield expectations. While this adjustment is still in the process, at least a part of this adjustment has already occurred over the course of February. This limits further downside potential for gold prices as a consequence of this adjustment to higher bond yields.

That said, if economic growth and inflation continue to show strength in the face of tighter monetary policy another readjustment to higher bond yield expectations could occur which could sink asset prices further. While this is not the base case scenario, it should not be entirely surprising to see such strength.

Central banks around the world, especially the Fed, have been relatively aggressive in raising rates since last year. While the increases have been sharp the levels for rates still are very low by historic standards, which could help to explain some of the resilience in both economic growth and inflation. But as mentioned before, monetary policy takes time to filter through the economic system. It could be well into summer or even fall 2023 before the full impact of the rate hikes that have already been put in place start to have a fuller impact on slowing economic growth and inflation. As the year progresses, seasonal strength in gold prices also typically fades as the market heads toward spring and summer, which could add some downward pressure on prices as well.

While higher bond yields and seasonal weakness could weigh on gold prices over the next few months, there are multiple factors that are expected to provide support to prices. Some of these factors like the U.S. debt ceiling debate and strained and deteriorating political relations around the world that have been mentioned before are expected to play an important role in supporting gold prices both in the short as well long term. but in addition to this gold prices could find support from higher than expected inflation and economic growth data from Europe. Any upside surprises in European data are expected to be supportive of higher European bond yields and a stronger euro. While a lot of the higher bond yields have been priced into the dollar, there is still a lot of upside potential for the euro. Given the interdependent nature of currency values and the importance of the euro’s value to the dollar’s value in the trade-weighted dollar index, a stronger euro could act as a meaningful headwind to the U.S. dollar, which could act as a tailwind to all U.S. dollar denominated assets like gold but also other precious metals as well.

Another factor that could prevent a sharp decline in gold prices is demand for gold from central banks. These entities have shown both an interest in adding gold to their holdings as well as a sensitivity to gold prices. The weakness in gold prices from levels earlier this year could be used as an opportunity by these banks to add to their holdings.

Official Transactions

Central banks were net buyers of gold during 2022. These entities added 9.6 million ounces of gold to their holdings during the year. While gold demand from central banks during 2022 was off to a slow start, with central banks being net sellers of the metal during January, momentum picked up as the year progressed. Central bank net purchases picked up starting the second quarter of 2022, which also happened to be the time when gold prices had started to soften. This is not surprising, with central banks historically showing a tendency to be price sensitive.

Some gold market commentators are saying that central banks are rushing into gold, but this is not the case. Of the 21 central banks that added gold to their monetary reserves, only eight of them added more than 600,000 ounces. And, of those eight central banks, six of them were in Islamic states. India, which has a Muslim minority that is heavily involved in the Indian gold market, was the seventh, and China the eighth. In other words, only a handful of central banks were major gold acquirers in 2022, and most of those were Islamic central banks. That hardly represents a broad rush by central banks into gold.

It should be pointed out that central banks as a group also were not wholesale dumping their U.S. dollar holdings, which basically have held steady not for the past few years along, but for decades.

Indeed, with the exception of 2020 when central banks were more focused on addressing the economic fallout from the pandemic than they were on diversifying and building their reserves, net purchases of gold in 2022 were the lowest since 2016, when central banks made net purchases of 7.9 million ounces. Central bank gold additions to their reserves were not at a record level of the post-Bretton Woods era.

These statistics, based on actual reported transactions and holdings by central banks, are distinctly at variance from reports of historically high central bank purchases in 2022 based on ‘unreported’ and presumed purchases by unnamed central banks. Those purchases appear to have been central banks handling metal being sold by domestic jewelers, investors, and refiners during the seven months in 2022 when gold prices were dropping from $2,040 to $1,624. They were not central banks adding that gold to their monetary reserves, although perhaps a third of it was bought by central banks in the three months after prices bottomed out in early November.

The relative softness in total central bank demand during 2022 could be attributed to a slow start to 2022.

The largest net buyer of gold during 2022, was the Central bank of Turkey, which added 2.5 million ounces of gold to its holdings during the year. The People’s Bank Of China (PBOC) also returned as a buyer to the market in November 2022, for the first time since October 2019. Other large buyers of gold during 2022, included the central banks of Egypt, Qatar, Iraq, Uzbekistan, India, and the United Arab Emirates. These eight central banks made up 38% of the total central banks that were net buyers of gold during 2022, but accounted for 91% of total gross gold purchases made during the year.

The largest seller of gold during 2022 was the central bank of Kazakhstan, which reduced its holdings by 1.63 million ounce or 66% of total gross gold sales during the year. Kazakhstan had been a consistent buyer of gold from domestic production for several years prior to 2022. It was hit with an attempt to overthrow the government in January 2022 that precipitated Russia sending troops into the country to crush the attempted revolution. This plus economic stress within Kazakhstan over the entire year led the bank to sell some of its gold to raise foreign exchange to finance imports.

Central banks turned net sellers of gold during January 2023, with net sales totaling 131,000 ounces. This should not be entirely surprising given the price sensitive nature of these entities and the high and sharply rising price of gold.

The central banks of Turkey and Uzbekistan saw holdings decline by 373,000 ounces and 370,000 ounces, respectively. Both these central banks were large buyers of gold during 2022.

The central bank of Kazakhstan, which was a net seller of gold during 2022, turned a net buyer during January, adding 127,000 ounces of metal to its holdings during the month. The PBOC continued to add gold to its holdings during January but had reduced the pace of its purchase by more than half the monthly pace seen in the preceding two months. The PBOC added 480,000 ounces of gold to its holdings during January.

Central banks are expected to remain net buyers of gold during 2023, and the weakness in prices during February coupled with projected softness in prices over the next few months is likely to being these price sensitive buyers back into the market.

Silver Market

After performing better than gold during the last quarter of 2022, silver prices had been underperforming gold during the first two months of 2023. The gold:silver price ratio that helps to illustrate the relative price performance of these two metals had fallen to 75.7 on a monthly average basis during December 2022, which was the lowest level this ratio had reached since October 2021. In February, this ratio had risen to 88.9, which was the highest level since August 2022.

Silver prices are likely to face downside pressure in the near term. Tighter monetary policy expectations are expected to be the primary headwind to silver prices in the near term. Silver prices appear somewhat oversold at this time, however, which could limit the near-term downside. Silver prices have some support at the $20.40 level. Prices could break below this level and could potentially retest $19.50 or even the $19.30 level over the next few months.

There is still potential for prices to soften further in the near term, driven lower by weakness in gold prices and strength in the bond yields and the dollar. There have been signs of strength in the economy, which should provide some support to silver fabrication demand. Most of the strength being observed in economies around the world is coming from the services sector, however, which is not particularly stimulative of silver fabrication demand. One area of silver fabrication demand which is expected to be relatively unaffected by consumer demand or by broader economic conditions is the metal’s use is solar panels. This should help to provide a floor to silver prices.

Silver Statistical Projection Table March 2023

Platinum Market

Platinum prices have had a rough start to 2023, falling back to levels seen in early November 2022 by the end of February 2023. Prices seem to have found some support above the $900 level, for now. As in the case of silver, a lot of the negative fundamentals for platinum already seem to be priced in. That said, there is potential for platinum prices to soften further, with next support for prices around $880.

South Africa alone accounts for around 72% of global platinum mine supply. Given the concentration of mine supply from South Africa markets tend to be sensitive to mine supply disruptions from the country. So far only small disruptions have occurred due to the power issue in South Africa. This has helped support platinum prices, but weak fabrication demand fundamentals have overpowered the positive impact of lost platinum supply due to electricity shortfalls. If there were to be a large disruption to platinum mine supply from South Africa due to the electricity shortfall it has the potential to push platinum prices sharply higher.

Three Month Platinum - March 2023
Platinum Mine Supply - March 2023

Palladium Market

Palladium has had an even more challenging year than platinum so far in 2023. Toward the end of February palladium prices were testing the lows that were seen at the height of the covid related sell-off during 2020. Weak palladium fabrication demand fundamentals are the primary culprit for the current weakness in prices. While concerns around Russian mine supply disruptions, following Russia’s invasion of Ukraine, had helped to drive palladium prices up sharply in 2022, those concerns, while still alive, have been placed on the backburner.

Three Month Palladium Price Projections - March 2023

Markets are now more focused on the future of palladium fabrication demand. While the Chinese economy is expected to revive this year, following a tough 2022 due to its zero-covid policy, the positive impact on passenger vehicle sales is likely to be limited as sales from 2023 were brought forward into 2022 due to the tax incentives. Tax incentives do remain in place for electric vehicles, but sales of electric vehicles are a negative for palladium fabrication demand from the auto sector.

Soft passenger vehicle demand in other major auto markets and the ongoing loss in internal combustion engine market share to electric vehicles added a further headwind to palladium fabrication demand from the auto sector.

While palladium prices have already seen a substantial decline in prices over the past several months, there is still potential for more downside. It would not be surprising to see palladium prices slip toward $1,300 or even lower as the year progresses.

Palladium prices, like platinum, will have to rely on a supply side shock to see any meaningful increase in prices. There is potential for such a shock for palladium mine supply from both South Africa as well as Russia. Both countries account for meaningful percentages of global palladium mine supply at roughly 40% for Russia and 37% from South Africa. It is also worth noting that some major mining companies are scaling back on their future production plans in light of the deteriorating fabrication demand fundamentals. For the planned reduction in mine supply to have a meaningful impact on prices will take several quarters, however, depending on the pace at which any such reductions are instituted.

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