A better backdrop, not an easy one

Gold does not need a perfect macro backdrop to perform well. What it needs is for the forces working against it to become less powerful. That is increasingly what is happening.

July's US inflation report gave the market another reason to believe that the next move from the Federal Reserve may not be another rate increase. Headline CPI rose just 0.1% during the month and eased to 3.4% from a year earlier. Core CPI, which strips out food and energy, rose 0.2% and slowed to 2.5% year on year from 2.6% in June. Inflation is still above the Fed's 2% objective and the central bank's preferred PCE measure remains hotter, with June headline PCE at 3.7% and core PCE at 3.3%. This is disinflation, not victory.

That distinction matters. The Fed itself has not turned dovish. At its July meeting it left the federal funds rate at 3.50% to 3.75%, while three voting members actually favoured a 25-basis point increase. The change has instead taken place in the market's view of what the Fed is likely to do next.

The first big shift came after July payrolls unexpectedly fell by 23,000. Rate markets sharply reduced the probability of a September increase, and the two-year Treasury yield fell. The softer CPI report has reinforced that message. After the inflation data, the two-year yield slipped towards 4.18%, while market pricing tilted further towards the Fed leaving rates unchanged in September.

For gold, that is an important change. The debate is no longer simply about how high rates may have to go. It is increasingly about whether the Fed can afford to sit still.

The pressure point is shifting

This is where the gold story becomes more interesting. Gold pays no coupon and produces no cash flow, so rising interest rates increase the opportunity cost of owning it. When markets begin to question the need for further Fed tightening, that headwind starts to fade. The opposite dynamic was painfully visible in June, when rising rate expectations and a stronger dollar helped drive gold below $4,000 an ounce.

The clearest evidence can be seen at the short end of the Treasury curve. The two-year yield, which is particularly sensitive to expectations for monetary policy, stood at 4.22% on 11 August and dipped towards 4.18% after the CPI release. That move is not dramatic by itself, but it fits with the broader repricing that began after the weak employment report.

Real yields offer a second, more tentative source of support. The five-year real Treasury yield was 2.19% at the end of July and 2.16% on 11 August. That is only a small decline, and it would be wrong to call it a confirmed downtrend. Still, the earlier upward pressure has eased. If real yields begin to fall more decisively, the opportunity cost of holding gold would decline further.

The relationship is not as simple as it once appeared. World Gold Council research notes that gold's inverse relationship with real yields has been less reliable since 2022 because central-bank purchases, geopolitical risk and other forces have sometimes overwhelmed the rates effect. That makes real yields an important indicator, but not the only one.

The dollar may be the cleaner signal.

A weaker dollar gives gold room to breathe

The US dollar weakened after both the jobs report and the latest CPI release. FXCM's USDOLLAR basket fell after the inflation data as investors reduced expectations for another near-term Fed hike. That feeds directly into one of gold's most persistent macro relationships.

Gold is priced globally in dollars. When the dollar weakens, bullion becomes cheaper for buyers using other currencies, while the relative attraction of holding dollars also diminishes. World Gold Council analysis finds that gold's relationship with the US dollar has been consistently negative over recent decades, and more consistently so than its relationship with bond yields.

That does not mean gold rises every time the dollar falls. Correlations are never fixed and gold is being driven by more than one story. Geopolitical tension remains elevated and investment demand is showing signs of life again. Global gold ETFs attracted $3 billion of net inflows in July after two consecutive months of outflows, reversing some of the weakness seen earlier in the summer.

The price response has been notable. Gold fell below $4,000 an ounce in late June but has since recovered to around $4,400. The rebound has coincided with weaker labour data, reduced expectations for Fed tightening and a softer dollar. That does not prove causation, but the pieces increasingly fit together.

There is still an obvious risk. Inflation remains above target and energy prices could keep the Fed cautious. If inflation reaccelerates, rate-hike expectations could return, dragging the two-year yield, real yields and the dollar higher. That would rebuild the very headwinds that are now beginning to ease. The Fed's July statement itself made clear that inflation remains elevated, partly because of supply shocks including energy.

For the moment, however, gold has something it lacked earlier in the year. The macro backdrop is no longer becoming steadily more hostile. Core inflation is cooling, the labour market has weakened, markets are pricing a less aggressive Fed path, front-end yields are easing and the dollar is softer. Real yields have not yet confirmed the move, but they are no longer pushing decisively higher.

Gold does not need the Fed to cut rates for this setup to work. It may be enough for the market to believe that the tightening cycle is close to finished. If that belief strengthens and the five-year real yield finally rolls over, gold's macro tailwind could become considerably stronger.