Many times in your life, you have probably observed or experienced the accuracy of the saying that while two dogs are fighting for a bone, a third runs away with it.
It can be said that gold is taking advantage of a similar situation, and while the market, economy, and world of politics are slightly in turmoil, the yellow metal is slowly climbing.
As the dollar continued its consolidation on Feb. 1, gold proudly hovered above the $1,800 mark. As you know, as long as the precious metals don’t space out, they can use the falling USDX to improve their performance.
It so happened that, thanks to mixed signals from European and US financial authorities, which investors interpreted in their own way, the dollar basket suffered some losses. Yesterday I wrote:
Although the ECB seems extremely dovish, especially compared to the Fed, and inflation figures remain relatively low, the Eurozone’s currency enthusiasts are counting on some bold moves. The fervor of the euro bulls fazed the greenback, which, interestingly, was also the case in almost all similar situations last year.
Another demotivating factor for the USDX may have been the somewhat shy tone some Fed officials took on Monday about the withdrawal of economic aid in the face of rampant inflation. The general plans of the US federal reserve to raise interest rates in March have not changed though, so it turns out that some investors interpreted the signals in their own way and the optimism regarding both precious metals and the EUR/USD pair is temporary.
In fact, while the ECB will still have a chance to comment, so far, despite its dovish approach, the bank did not have to say or do anything special to strengthen the European currency in the EUR/USD pair, because the Fed got it covered. To the delight of the euro—and probably gold—bulls, the Federal Reserve’s officials did not speak in unison on Monday, when commenting on monetary policy plans.
Of course, it is known that the Fed continues its hawkish tactic and intends to fight inflation with a heavy weapon, which will be raising interest rates. The fact that the first step in monetary tightening will be taken in March is already taken for granted. However, when the Federal Reserve announced a week ago that it was planning to raise interest rates earlier—and possibly more aggressively—than expected just several months ago, now the choir began to sing unevenly.
Some of the Fed’s members suggested that future rate hikes were likely to be data-driven and not necessarily automatic. In addition, apart from the fact that it is not known how much the first raise will be, the pursuit of neutrality was mentioned. Some views on what the Fed should do after the initial rate hike, shared on Monday, became a source of volatility. Among other things, the interpretation of such uncertain statements helped raise the price of gold.
In addition to the above, there is another factor supporting yellow metal stocks.
Russia Breaks the Silence
After several weeks of absence from public life, during which fears were mounting in Western capitals that Russia was preparing an invasion of Ukraine, President Vladimir Putin broke his silence.
During a press conference in the Kremlin, Putin told reporters that he was not satisfied with the US response to Russian demands. Previously, Russia demanded that NATO withdraw its troops and infrastructure from Eastern Europe, claiming that the alliance would never accept Ukraine. He also presented a potential scenario suggesting that if Ukraine is admitted to NATO, there may be a conflict over the Crimea.
In his first public comments on the crisis in Ukraine that has worsened since December, the Russian leader accused the US of ignoring Russian security proposals and of using Ukraine as a tool to obstruct Russia's actions.
Although Putin has said he is ready to enter into dialogue with the West, at the same time, Russia continues to deploy thousands of troops and weapons on the border with Ukraine, according to the world's media.
Both President Joe Biden and US Secretary of State Antony Blinken consider Putin to be unpredictable. As Blinken told the press, the authorities are not sure whether the Russian leader has already made a decision about his next move and what it is, so they must be prepared for different results.
Ukraine does not remain indebted. The country has announced that it intends to increase its armed forces, as many European leaders have pledged to support it in the current stalemate with Russia. According to the media, tensions between Ukraine and Russia have not subsided.
The improvement in gold's position was due to similar news in mid-January. However, at the time, I wrote that such rallies were insignificant, and that it was specific military actions, rather than rumors of tension and deterioration in the geopolitical situation, that could lead to a real breakthrough in the market.
Later in the text, I will also explain other reasons why the optimism of precious metals is likely to turn out to be temporary and turn into pessimism in the medium term.
A Value Trap
While the USD Index declined again on Feb. 1, the pullback was more of a corrective downswing within a medium-term uptrend. For example, stock market optimism often results in bids for 'risk-on' currencies. With the dollar outperforming in recent weeks, investors' see 'value' in currencies like the euro and the CAD.
However, they're more of a value trap. The USD Index, at time of writing, remains in an uptrend, and the dollar basket also rallied after approaching its 50-day moving average on Feb. 1. As a result, the recent consolidation is a normal occurrence, and there isn't much cause for concern.
Similarly, while mining stocks attempt to retrace some of their recent losses, the general stock market has helped uplift their performance. However, their idiosyncratic technical and fundamental outlooks remain bearish. As such, the short-term support from the S&P 500 should dissipate sooner rather than later. For context, I wrote previously:
"Once one realizes that GDXJ is more correlated with the general stock market than GDX is, GDXJ should be showing strength here. If stocks don’t decline, GDXJ is likely to underperform by just a bit, but when (not if) stocks slide, GDXJ is likely to plunge visibly more than GDX."
Having said that, let's take a look at the situation from a fundamental point of view.
Digging A Deeper Hole
While the PMs remain relatively upbeat, their fundamental outlooks continue to worsen. For example, with the Fed now fighting inflation, rate hikes should commence in the coming months. However, in the meantime, the ground is already shifting beneath the PMs’ feet. 
To explain, the blue line above tracks the Goldman Sachs' Financial Conditions Index (FCI). For context, the index is calculated as a "weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP." In a nutshell: when interest rates increase alongside credit spreads, it's more expensive to borrow money and financial conditions tighten.
To that point, if you analyze the right side of the chart, you can see that the FCI has surpassed its pre-COVID-19 high (January 2020). Moreover, the FCI bottomed in January 2021 and has been seeking higher ground ever since. In the process, it's no coincidence that the PMs have suffered mightily since January 2021. To that point, with the Fed poised to raise interest rates at its March monetary policy meeting, the FCI should continue its ascent. As a result, the PMs' relief rallies should fall flat, like in 2021.
Likewise, while the USD Index has come down from its recent high, it's no coincidence that the dollar basket bottomed with the FCI in January 2021 and hit a new high with the FCI in January 2022. Thus, while the recent consolidation may seem troubling, the medium-term fundamentals supporting the greenback remain robust.
Furthermore, Fed hawks remain focused on inflation, and while investors' positioning may seem contradictory, Fed officials' transition from hawkish rhetoric to hawkish policy should help the USD Index surpass 98 in the coming months.
To explain, Philadelphia Fed President Patrick Harker told Bloomberg on Feb. 1 that a 50 basis point rate hike in March shouldn't be expected. For context, the prospect was always unrealistic. However, investors seemed to buy into the notion for a short time. He said:
“I would be supportive of a 25 basis-point increase in March. Could we do 50? Yeah. Should we? Well, I’m a little less convinced of that right now. But we’ll see how the data turn out in the next couple of weeks.”
However, Harker still expects four rate hikes for 2022, as long as inflation remains elevated.
Source: Bloomberg
Moreover, it’s important to remember that Fed Chairman Jerome Powell uses his deputies to deliver monetary messages. For example, during his Dec. 15 press conference, Powell was asked if he postponed his “hawkish policy stance” until after he was reappointed for a second term. I wrote about his response on Dec. 16:
"As one of the most important quotes of the press conference, Powell admitted:
'“My colleagues were out talking about a faster taper and that doesn’t happen by accident. They were out talking about a faster taper before the president made his decision. So it’s a decision that effectively was more than entrained.”'
"And while Powell sounded a little rattled during the exchange, his slip highlights the importance of Fed officials’ hawkish rhetoric. Essentially, when Clarida, Waller, Bostic, Bullard, etc., are making the hawkish rounds, “that doesn’t happen by accident.” As such, it’s an admission that his understudies serve as messengers for pre-determined policy decisions."
To that point, a chorus of Fed officials reiterated their hawkish expectations over the last two days, and, as Powell said, “that doesn’t happen by accident.”
San Francisco Fed President Mary Daly said:
“We definitely are poised for a March increase. But after that, I want to see what the data brings us.”
Richmond Fed President Thomas Barkin said:
“I'd like us to be better positioned. Better positioned is somewhere closer to neutral, certainly, than we are now and I think the pace of that just depends on the pace of inflation."
Atlanta Fed President Raphael Bostic said:
“When I started looking at this year, I had three moves or three rate increases in mind. And March increasingly was looking like it's the right time to do that.”
Kansas City Fed President Esther George said:
“It is in no one's interest to try to upset the economy with unexpected adjustments. I do think the Federal Reserve is going to have to move deliberately in its decisions to begin to withdraw accommodation."
St. Louis Fed President James Bullard said:
“We are cognizant of the inflation issue, we’re moving on the policy rate, but we’re also going to move on the balance sheet so we’re not that far from reaching neutral if you are willing to consider both of those.”
Thus, it’s clear that the Fed is on autopilot. In contrast, the ECB hasn’t achieved its rate hike criteria. Thus, while the EUR/USD’s recent rally hurts the USD Index, should we be concerned? To explain, I wrote on Feb. 1:
"While the USD Index may come under pressure this week, it’s the same old story: euro bulls bid up the EUR/USD in hopes that the ECB will say or do something hawkish. And in the process, dollar weakness spreads to other currency pairs, and the USD Index suffers. However, once the short-term sentiment highs dissipate, the fundamentals reign supreme. And with the Fed all but certain to raise interest rates in March and the ECB poised to disappoint once again, the EUR/USD’s downtrend should continue over the medium term."
All in all, it’s important not to overreact to short-term fluctuations. While it seems like the USD Index has fallen out of favor and the PMs are back in investors’ good graces, the reality is that other currencies bounced off of relatively oversold levels, and positioning shifts occurred. However, the USD Index suffered several countertrend declines in 2021. As a result, the recent weakness is far from a regime change, and its robust fundamentals should rule the day over the medium term.
Finally, since Fed officials’ hawkish forecasts depend on the direction of inflation and the U.S. economy, the outlook for both remains resilient. For context, the Omicron variant will likely depress Q1 GDP growth. However, I noted on Jan. 31 that warmer weather should shift the narrative. I wrote:
"The U.S. economy is growing well ahead of its pre-pandemic trend. Moreover, while disruptions from the Omicron variant will likely slow growth in Q1, the outbreak should calm down when warmer weather arrives. With the season also allowing for patio dining, camping trips, and other outdoor activities that support economic growth, Q1’s weakness should be short-lived."
Supporting the thesis, the U.S. Bureau of Labor Statistics (BLS) revealed on Feb. 1 that U.S. job openings came in at 10.925 million, well ahead of the 10.300 million expected. Moreover, there are now 4.606 million more job openings in the U.S. than unemployed citizens.
To explain, the green line above subtracts the number of unemployed U.S. citizens from the number of U.S. job openings. If you analyze the right side of the chart, you can see that the epic collapse has completely reversed and the green line is now at an all-time high. Thus, with more jobs available than people looking for work, the economic environment supports normalization by the Fed.
The bottom line? While short-term price moves may seem material, false narratives are built on foundations of sand. While several castles crumbled in 2021, prophecies of the dollar’s demise have risen once again. However, with the fundamentals signaling more dollar strength over the medium term, it’s likely only a matter of time before the USD Index’s bullish ascent continues.
In conclusion, the PMs rallied on Feb. 1 and the USD Index continued its consolidation. However, with financial conditions already tight and poised to tighten further, the pullback lacks fundamental credibility. Moreover, with the U.S. economy still on solid ground, the Fed has little reason to perform a dovish 180. As a result, the PMs’ optimism should turn to pessimism over the medium term.