After a week of market confusion over policy signals from Federal Reserve Chair Kevin Warsh, gold appears to be finding a new direction. On Wednesday, the precious metal surged over 4%, marking its third-largest single-day gain of the year and its strongest performance since February. This rally in the traditional safe-haven asset reflects growing investor concern about the Fed's ability to combat inflation, even as multiple Fed officials recently indicated they are prepared to support rate hikes if price pressures do not ease.
Markets are now recalibrating their expectations for the Fed's future path, following unclear signals from Warsh. Investors are increasingly concluding that the central bank's willingness to tighten policy may fall short of what current inflation levels demand. Meanwhile, progress in reopening the Strait of Hormuz has alleviated fears of energy supply disruptions. With Brent crude oil futures falling below $80 per barrel, expectations for a September rate hike have declined, and the 10-year US Treasury yield has dropped from 4.75% to around 4.60%.
Weakening Dollar Emerges as New Catalyst for Gold
Previously, gold's trajectory was largely driven by US interest rate expectations and market perceptions of Fed policy. Since gold generates no yield, investors typically reduce their allocation when real yields rise. Since the outbreak of the Iran conflict, real yields have risen rapidly, weighing on gold's performance. However, Wednesday's sharp rally suggests that a weakening dollar is replacing real yields as the primary near-term driver for gold prices. Aakash Doshi, global head of gold and metals strategy at State Street Global Advisors, noted, "Today's gold move is less about rates and more about the dollar falling to its weakest level since early June."
Markets are now debating whether gold has passed its most challenging phase. Roukaya Ibrahim of BCA Research believes that as the dollar weakens and geopolitical risks subside, gold may enter a new upward phase. "Our base case is that the most significant headwind from real yields for gold is behind us," she said. "Looking ahead, unless there is a complete diplomatic breakdown and oil prices surge, our US bond strategists expect real yields to remain roughly range-bound over the coming months. This would help form a floor for gold prices." Beyond macroeconomic factors, central bank gold purchases remain a key support. The World Gold Council reports that central banks and sovereign wealth funds bought a record 289 tonnes of gold net in the second quarter, a 62% increase year-on-year. Safe-haven demand from the Iran conflict has also driven investors to increase gold allocations, even as markets continued to anticipate potential US rate hikes.
Long-Term Gold Targets Rise, but Rate Hike Risk Remains
Arun Sai, an analyst at Pictet Asset Management, argues that while gold remains relatively expensive compared to its 20-year history, its risk-adjusted appeal is improving. "In this context, we are upgrading gold from neutral to overweight," he said. "As real rates gradually ease, the opportunity cost of holding non-yielding assets declines, and with geopolitical uncertainty remaining high, we see room for upside in precious metals." Doshi views $4,000 per ounce as a base-case scenario for gold, with a six-month target of $5,000. Kevin Smith of Krescat Capital presents a more aggressive long-term scenario. He suggests that in two scenarios, gold prices could reach $20,000 per ounce over the next four years. The first scenario is based on the relationship between global money supply and above-ground gold stocks. "With precious metals now being continuously accumulated by global central banks... extrapolating the trend line points to a gold price target of $20,000 in about four years," Smith said. He also believes current fiscal imbalances and the geopolitical environment could accelerate the expansion of global M2 money supply, shortening this timeline. The second scenario is based on a model of the gold-to-S&P 500 ratio, assuming a 50% stock market decline and a weaker dollar. Smith notes that historically, peaks in the gold-to-S&P 500 ratio have coincided with market crashes following periods of high large-cap valuations and significant dollar depreciation. He states that if the S&P 500 falls 50% and the gold-to-S&P 500 ratio reaches 5.25 times—below the 1980 peak of 7.58 times but above the 1933 peak of 4.76 times—gold could also reach $20,000. While this prediction is far from current levels, Smith argues it is not without historical precedent, as the S&P 500 fell 50.4% and 57.4% during the dot-com bust and the global financial crisis, respectively. However, there are clear risks to gold's rise. If the Fed unexpectedly delivers three consecutive rate hikes, recent gold gains could be quickly reversed. Doshi notes that this policy shift is not yet fully priced into the yield curve. The market's ultimate focus remains on whether inflation expectations are truly under control.
Warsh Pushes Policy Review, Fed's Inflation Framework Under Scrutiny
Despite lingering policy uncertainty under Warsh's leadership, financial markets still believe long-term inflation expectations are broadly stable. The "five-year, five-year forward breakeven inflation rate," a key Fed focus, has remained steady since its post-pandemic rise and is near the 2% target. In contrast, consumer inflation expectations are more pessimistic. The New York Fed's survey shows three-year inflation expectations have risen to their highest level since 2022, also above most of the nine years before the pandemic inflation surge. The Institute for Supply Management's latest survey also indicates that service sector managers still see high price pressures, and services make up the majority of the Consumer Price Index. Meanwhile, five working groups appointed by Warsh are evaluating the Fed's policy framework, including a data working group and an inflation framework working group. Warsh has previously hinted that the Fed may focus on a "broader data set" rather than just the Personal Consumption Expenditures (PCE) deflator, which is the basis for the current 2% target. Tiffany Wilding, an economist at PIMCO, notes that core PCE has recently diverged from other inflation measures, partly due to prices for software and portfolio management services. She believes this could create a policy dilemma for the Fed: whether the investment boom from AI infrastructure construction will push inflation higher in the short term. Some market participants speculate that Warsh might try to ease policy pressure by adjusting the inflation measure, but this could damage the central bank's credibility. Bernard Yaros, an economist at Oxford Economics, stated, "Changing the inflation gauge behind the 2% target would damage the Fed's credibility, as it would be seen as moving the goalposts while inflation remains above target." He believes that adjusting the PCE as a policy target metric will not be a major topic of discussion for the Federal Open Market Committee until the Fed consistently achieves the 2% inflation target. Justin Weidner, an analyst at Deutsche Bank, believes the Fed's working groups may attempt to downplay the traditional Phillips Curve framework, shifting more attention to money supply or government spending. This direction could lead to more hawkish policy recommendations, as it might imply the Fed needs to resist inflationary pressures from fiscal stimulus. However, whether such recommendations translate into actual policy will require support from other FOMC members. Dario Perkins, an analyst at TS Lombard, argues that truly changing the Fed's policy constraints would require adjusting the central bank's mandate, which can only be done by the US Congress. As Warsh pushes forward with the policy review, the divergence between market and consumer inflation perceptions will likely persist. This uncertainty may continue to be a key factor supporting gold demand. For gold prices, the worst may be over, but whether the best is yet to come depends on how the Fed under Warsh answers the unanswered question: how to view inflation.
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