Are gold's headwinds gaining strength?

Gold enters a key week for markets, as it faces the familiar problem of higher interest rates along with higher bond yields. Only a month ago, markets were increasingly convinced that another US interest-rate hike could be avoided, with a rate hike priced at a 32% likelihood at one point. A flurry of softer employment and retail data had helped keep the probability of a September hike down significantly.

However, since Kevin Warsh's hawkish speech at Jackson Hole, economic data released has pointed strongly towards a more inflationary US economy. August non-farm payrolls increased unexpectedly by 162,000, whilst Friday's Consumer Price Index (CPI) showed prices rising 0.4% during August and 3.4% over the past year, which was much hotter than expected.

As you would expect, energy is becoming an increasingly important part of that inflationary picture, with US gasoline prices alone rising 3.9% in August. This accounts for more than a third of the monthly increase in US inflation. This rise follows continued disruption around the Strait of Hormuz, which has already restricted global energy supplies and created these price shocks. However, things have escalated further with Saudi Arabia's East-West pipeline – a crucial alternative route that bypasses the Strait – being forced offline following drone attacks. The pipeline had been carrying around four million barrels per day, equivalent to roughly 4% of global supply. Brent crude has subsequently climbed beyond $108 per barrel.

This backdrop sees markets pricing around a 90% chance of the Federal Reserve raising rates on Wednesday, which is a dramatic reversal from the 32% only 4 weeks ago. For gold, that presents a significant short-term headwind, with higher interest rates increasing the appeal of yield-paying assets, which gold is not.

But as we have mentioned before, interest rates and oil are only half of the story. US government bond yields have also been climbing sharply, with the 10-year Treasury yield moving above 5% – ominously this is its highest level since 2007. Ordinarily, higher bond yields represent another challenge for gold as investors can earn a greater return from holding government debt, increasing the opportunity cost of owning a non-yielding asset. Yet those same yields also expose another problem, which is fundamentally that the US government has to pay them.

With government debt already elevated, higher borrowing costs make servicing that debt increasingly expensive. The US Treasury has attempted to ease pressure at the longer end of the bond market through increased buybacks, but bonds haven't listened and yields have continued to climb.

Around the same time of the buyback operation getting started, and perhaps rather unhelpfully, President Trump came out with an eyebrow-raising announcement. He proposed paying every American adult $5,000 if Republicans retain control of Congress in November's midterm elections. The proposal would require Congressional approval and has been estimated to cost more than $1 trillion if implemented.

So, despite a strong environment of significant headwinds for gold, with higher interest rates and bond yields, gold remains almost 20% higher than it was this time last year.

One thought behind this may be that the higher those yields climb, the more expensive government debt becomes to service. Concerns over government debt, deficits and the long-term purchasing power of currencies continue to support what has become known as the "debasement trade" – investors looking towards assets such as gold which sit outside the system as governments contend with increasingly large debt burdens.

It leaves gold caught between two powerful forces. In the short term, Wednesday's expected Federal Reserve rate increase could keep pressure on the precious metal for a little while, whilst higher rates and higher bond yields remain formidable headwinds.

But whilst bonds may be competing with gold today, the question is what happens if governments increasingly struggle to afford them tomorrow. That, perhaps more than Wednesday's rate decision itself, is the longer-term battle worth watching.