If the Fed hikes dovishly, gold is likely to benefit

After a pause in June, it is expected that the Federal Reserve hikes by 25bps on Wednesday, 26 July. This is because although inflation is moderating, it is well above target, and the job market is still tight. The CME FedWatch tool has the probability of the rate increase at close to 100%.

There is a fair delay between the meeting on 26 July and the next policy announcement on 20 September. During this period, the Fed will get a further two job and inflation reports, as well as more information on the tightness of credit in the economy. It will also give the central banks some time to assess the effects of the previous hikes as they come through the transmission mechanism.

Source: www.tradingview.com

The dot plot projections have indicated one more hike after this one. However, the market is of the opinion that this will be the last rate increase for the year. To this end, keeping an eye on the US 2-year yield will be helpful. It suggests resistance or a yield cap around the 5% level (red shaded horizontal).

The 2-year yield is a good reference for Federal Reserve monetary policy. This is because the short-end of the yield curve adjusts relatively quickly to changes in the cost of capital. Moreover, if the Federal Reserve announces a dovish increase, suggesting that the July hike may, in fact, be the last for the year, it will have ramifications for other financial instruments.

Consider XAUUSD (middle candlestick chart). It has a negative 82% correlation (bottom indicator) with the US 2-year yield. This is a robust inverse relationship between the note and the precious metal. This suggests to us that if the 2-year reacts off the 5% resistance area due to a dovish hike, gold is likely to benefit.

Determining the Tone of the Announcement

- As we get closer to the rate announcement, keeping an eye on gold's channels and RSI will help us assess the tonality of the rate hike.
- XAUUSD's candlesticks are trading in their daily bullish channel, between the upper blue and red bands.
- The daily RSI is above 50 (blue rectangle).
- This is the bullish side of 50 and the longer it maintains on this side, the greater the support for the gold price.
- A dovish hike should keep the precious metal in its bullish channel.
- However, if it falls into the neutral channel between the blue bands and the RSI dips below 50, it may be off the back of a hawkish tone from the Fed Chair, during his press conference following the FOMC statement.