Gold remains an attractive long-term asset as inflation takes its toll

In the last two days, investors have had to digest two significant inflation reports. Tuesday, the U.S. Labor Department reported headline consumer prices rose last month by 3.8% in the last year. At the same time, core inflation, which strips out volatile food and energy prices, rose more than expected at 2.8%. Inflation has pushed further from the Federal Reserve’s 2% target.

Following on the heels of the disappointing consumer numbers, the Labor Department said on Wednesday that its Producer Price Index surged in April. Wholesale inflation increased 6.0% over the last 12 months, the report said, the largest 12-month advance since December 2022, when prices rose 6.4%.

Meanwhile, core producer prices rose 4.4%, their largest 12-month increase since it jumped 4.5% in February 2023.

With the combined two inflation reports, markets now see a more than 30% chance that the Federal Reserve will have to raise interest rates by the end of the year.

This would create a difficult environment for gold, as potential rate hikes will raise the opportunity costs of holding the precious metal. However, despite the substantial rise in inflation, the gold market has held neutral territory with prices trading just below $4,700 an ounce, which has become an important short-term technical level. Spot gold last traded at $4,687 an ounce, down 0.5% on the day.

Fawad Razaqzada, Market Analyst at FOREX.com, said that gold could be finding some support as he highlights the risk that the growing inflation threat could weigh on the economy.

“High inflation and rising yields are not good news for risk assets. Gold has been treated as a risk asset over the past several years, with a strong positive correlation with the S&P 500. On the other hand, there is now even more reason for investors to seek inflation hedge. So short-term I think it is negative for gold, long-term positive,” he said in a comment to Kitco News.

In a note on Wednesday, Razaqzada wrote that inflation could start taking a toll on economic activity, creating a low-growth, high-inflation, stagflationary environment.

“Just one day after a hotter-than-expected CPI report rattled investors momentarily, the latest Producer Price Index data delivered an even bigger shock. Wholesale inflation exploded higher in April, reinforcing fears that the world’s largest economy may be drifting towards a stagflationary environment — where growth slows while inflation remains high,” he said.

He added that the concern is that higher energy prices, driven by the ongoing war in Iran, are becoming embedded in the broader economy.

“Yes, energy remains the dominant catalyst, driven largely by the earlier oil spike, but this is no longer just an oil story. Services inflation is now accelerating as higher input costs gradually seep into broader areas of the economy. That “pipeline effect” is exactly what investors feared would happen if elevated energy prices persisted long enough,” he said.

Analysts have said that a stagflationary environment is positive for gold as it will force the Federal Reserve to maintain low interest rates even as inflation pressures rise. This environment should push real yields lower, reducing gold’s opportunity costs as a non-yielding asset.

Analysts are now looking to Thursday’s retail sales numbers, which could be an important piece of the evolving economic puzzle. Markets will be anxious to see if consumer activity remains healthy in the face of elevated gasoline prices and embedded inflation.