Gold Risks A Correction Amid Shifting Fed Policy Outlook

While central bank demand remains the key driver for gold markets, Fed policy outlook is also an important catalyst. Gold, which pays no interest, is sensitive to the changes in Treasury yields.

Fed policy outlook has recently become more hawkish as traders reacted to the strong Non Farm Payrolls report, which showed that the U.S. economy created jobs at a robust pace. The labor market is strong, so Fed would not be in a hurry to start cutting rates.

According to FedWatch Tool, the market expects that Fed will start the rate cut cycle in November by cutting the federal funds rate by 25 bps. There is a 40.0% probability that Fed will finish the year with just one rate cut.

The recent changes in Fed policy outlook may provide additional support to the U.S. dollar. Importantly, the ECB has already cut the interest rate, which means that the American currency has become more attractive compared to the euro. Strong dollar is bearish for dollar-denominated commodities, including gold.

A combination of higher Treasury yields and stronger dollar may put material pressure on gold markets in the near term. The price of gold has enjoyed strong support near the $2300 level. In case gold settles below this level, some traders would rush to close their long positions, pushing gold towards the next material support near the $2200 level.

The potential pullback would be a gift to central banks that want to increase their exposure to gold. In the long-term, central bank demand would remain the key bullish catalyst for gold markets. Ultimately, this demand would push gold prices to new highs. In the near term, central banks would like to buy gold at lower prices, so it remains to be seen whether they would defend the key $2300 level.

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