Gold and equities shine bright in thin trading

Gold rides higher on Fed bets

Global markets continue to trade on the notion that major central banks, spearheaded by the Fed, will launch a powerful easing cycle next year. This theme has dominated trading activity in recent weeks as investors ramped up bets that interest rates will be slashed rapidly come Spring, against the backdrop of slowing economic growth and fading inflationary pressures.

With speculation for Fed rate cuts running wild, yields on US government bonds have been slammed lower and the dollar has taken collateral damage. This has been a bullish cocktail for zero-yielding assets such as gold, which is also priced in dollars.

The yellow metal closed at $2,077 per ounce yesterday, its highest closing price on record and a level it failed to hold earlier this month, when it briefly went through the roof. Beyond the sharp retreat in real yields and the dollar, gold has also been boosted from geopolitical instability as well as direct purchases from central banks diversifying their reserves, most notably in China. 

Heading into next year, gold’s performance will be decided mostly by how the economic landscape evolves and whether the rate cuts that have been priced in are delivered on time. Geopolitics will play a role too, and in fact might be the biggest downside risk for gold in an otherwise favorable macro environment, considering recent reports that Russia is quietly angling for a ceasefire in Ukraine.

Wall Street continues to party

Stock markets have performed well this entire year, but the rally has gone into overdrive lately with the Dow Jones and the Nasdaq 100 cruising to fresh record highs. The S&P 500 is less than 1% away from its own record peak.

Even though the latest melt-up in equity prices can be attributed to seasonal factors, like underperforming investment managers chasing the year-end rally in an environment of scarce liquidity, the bigger story is that the US recession everyone feared got canceled, or at least postponed.

Many investors came into this year positioned for a recession, and when that never materialized, they were forced to raise their risk exposure. The problem is that the tables have turned and US equities are now pricing in the dream scenario for next year - no recession, a sharp acceleration in corporate earnings growth, and a series of Fed rate cuts. 

In other words, equity markets are currently priced for perfection. With valuations already stretched, that is a recipe for turbulence, particularly if earnings growth undershoots as the global economy loses momentum.

Dollar retreats, euro and yen capitalize

The US dollar has been on the ropes this month, as markets shifted to price in a Fed rate cut in March next year. The Fed is now expected to slash rates before the ECB does, even though the European economy is on the brink of a technical recession.

The euro has naturally capitalized on this shift, with euro/dollar pushing above the $1.11 region on Wednesday. Another beneficiary has been the Japanese yen, which touched its highest levels in five months against the US dollar, as the intensity of Fed rate-cut bets overpowered signals from the Bank of Japan that there is no rush to raise rates.

Of course, the undisputed winner in the FX arena this year has been the Swiss franc, which climbed to eight-year highs against both the euro and the dollar. The Swiss National Bank’s exit from negative rates and its FX interventions to prop up the franc were major factors, alongside a quiet flight to safety as the Eurozone economy lost steam.