Threats of escalation, drone strikes, calls for condemnation and restraint surrounding the Israeli-Iranian conflict all contributed to choppy trading conditions in gold markets over the weekend. Last Friday saw yet another record high for the precious metal, briefly reaching above $2,430 an ounce before a heavy retrace hammered prices back down to close the day 1.2% in the red. If a continuation of the downward pressure was expected this week, then so far it hasn’t materialised, as gold yet again continued to rise in early trading in Asia.

Markets at large appear to have accepted the fact that the Federal Reserve is not going to implement an interest rate cut any time soon, as evidenced by the continued strength of the Dollar. The DXY did just enough to earn a close above 106 on Friday, a level not seen since November last year. Higher than expected inflation numbers continued to be a lingering cause for concern last week, as did a stronger than expected labour market. The initial uptick in prices observed early in the year can no longer be safely attributed to seasonal deviations, as was originally hoped.

Looking forward to the week ahead, Monday will be dominated by American retail sales, followed on Tuesday by a variety of Chinese metrics, including retail sales of their own, industrial production, unemployment rate and GDP figures. Later on we have US jobless claims on Thursday, followed by more retail sales on Friday, this time from the UK. Economic calendar aside, barring any real moves to deescalate tensions in the Middle East, market participants may have to expect the unexpected again this coming week.

The fear surrounding the latest release of US inflation data turned out to be fully justified. We mentioned previously that many traders would be hoping the numbers would not beat expectations, but that is exactly what happened. The month-on-month and year-on-year core figures came in hotter than anticipated at 0.4% and 3.8% respectively. The data release preceded the FOMC minutes, which once again emphasised the need to tame inflation before any serious talk of monetary easing. Markets are now pricing in only two rate cuts this year as opposed to three.

The news sent the DXY flying straight over 105, up over one percent in its best day in a year. The move pushed USDJPY over 153 Yen, an exchange rate not seen since 1990. Other currencies also took a hammering versus the greenback, as did stocks. Adding confusion to the narrative, PPI figures dropped a day later on Thursday, which actually revealed lower than expected price rises, in direct opposition to the inflation data.

If American inflation figures came in too hot, then Chinese figures came in too cold. In a report on Thursday, inflation numbers for the world’s second largest economy came in far lower than expected at just 0.1%. Coupled with factory-gate prices continuing to decline, the release will no doubt contribute to growing concerns of deflationary pressure in the RMB.

Strength in the Dollar may have tempered the meteoric rise in gold on Wednesday, which saw bullion prices lose $18 an ounce, but the pullback did not last. Thursday saw yet another record high for the precious metal, this time reaching over $2,370 an ounce. By the looks of things, early Asian trading is pushing it higher still. Silver too, recently finding its footing, edged up to just under $29 an ounce during this morning’s trading session.

Part II: How does the central bank change the interest rate?

In part I, we explained how central banks used interest rates to influence the strength of their respective currencies. But how do they do this? Changing interest rates is not quite as simple as fiddling with a dial to achieve the desired outcome, it requires a little more finesse than that. The exact mechanisms differ slightly from country to country, and are often tediously technical, so we’ll stick to basic principles whenever possible.

Let us first return to supply and demand. We mentioned previously that a lower interest rate is tied to a weaker currency and a higher money supply. If we exploit this correlation, then by changing the money supply we can manipulate the interest rate. As per the chart below, by moving the supply to the left or right of the demand curve, we decrease or increase rates.

Traditionally, modifying the money supply has been a major tool in a central bank’s arsenal for controlling interest rates. It does so via the buying and selling of government bonds. The exact nature of a bond falls outside of the scope of this article, but in the simplest terms, it is an IOU from the government. When the central bank buys a government bond, it takes that bond and pays cash into the system, increasing the available supply of money. Conversely, by selling that bond, it takes that cash back, reducing the available supply. The buying and selling of bonds therefore has a direct impact on the money supply.

The central bank has another tool at its disposal: it can tell regular banks how much money they must hold in reserve. This means that every bank has to hold a certain percentage of its deposits with the central bank. This limits the amount of money the bank has to lend out to its customers. Imagine a reserve rate of 10%. The bank has customer deposits worth one thousand Dollars. This means the bank is required to keep $100 with the central bank, while having $900 to use however it wishes, typically lending it out. Increasing or decreasing the reserve requirement therefore reduces or increases the amount of money in the system.

Finally, a central bank dictates the rate at which regular banks can borrow money from it. Although during normal operations banks usually borrow from each other, the central bank can act as a lender of last resort, setting a form of baseline interest rate for inter-bank lending. This in turn affects the rate at which those banks can profitably lend money to their clients, and to each other, once again indirectly affecting the money supply.

The above is important to understand from a historical perspective, but unfortunately, it explains economic conditions that have long since departed us. The tools previously described work in an environment of restricted monetary liquidity, or more concretely, they work when banks are forced to borrow money to cover their normal operations. This is no longer the case.

The financial crisis of 2008 changed everything. Following the crash, governments the world over enacted measures to inject liquidity into their economies in order to stimulate growth. Interest rates went straight to zero and central banks began injecting vast amounts of cash into their banking systems and mass purchasing assets - a process known as quantitative easing - hugely increasing the money supply. Supply and demand have flown out of the window because the fact of the matter is that the supply is now so large that manipulating it is utterly futile. Mathematically one may as well operate under the assumption that it is in fact infinite.

A new monetary era requires new monetary tools. How to influence banks when they don’t need to worry about limited reserves? The answer is to incentivise them. For the United States’ Federal Reserve, this is called interest on reserves. For the European Central Bank, it is called the deposit facility rate. The Bank of England simply calls it the bank rate, which previously meant something else. Different names but the purpose is the same: the central bank pays regular banks to deposit their cash reserves with them. For clarity, we will use the term “interest on reserves” from here on.

By earning interest on deposits held at the central bank, regular banks now have an extra option for their excess cash reserves. The bank can now lend money out to borrowers, earning interest payments from customers, or it can deposit that money at the central bank, earning interest on reserves. This creates a type of money marketplace where the various interest rates charged and offered by the bank never deviate too far from the rate fixed by the interest on reserves. The effective interest rate of a given currency therefore ties in closely with the interest on reserves awarded by the central bank.

One might expect the effective interest rate to be higher than the interest on reserves. After all, if a bank can earn more money from the central bank than it can by lending it out, then why bother taking the risk? The key here is that only banks can deposit their reserves at the central bank; nonbanks are not eligible for such a system. These nonbank lenders, lacking such an option, have an incentive to lend at any rate above zero, thereby lowering the overall effective interest rate. Banks are all too happy to borrow this money because they can arbitrage the spread between the lower interest repayments and the higher interest on reserves.

The 2008 crash prompted drastic changes in the way our monetary system works. Up until that point, banks operated within a framework of limited liquidity, forcing them to shore up their reserves and borrow enough to remain solvent. Following the crisis, the framework changed to one of extreme abundance, a completely different game. As recent as these changes are, whispers of another system of monetary governance are already emerging. How it will function is anyone’s guess, so let us once again anchor ourselves to the most fundamental definition of an interest rate: it is the price of using money. For as long as we retain any kind of debt-based monetary system, interest rates will remain the cornerstone of our financial world.

No brakes on the gold train. Despite an early dip on Monday morning, gold continued to push higher this week, climbing up to $2,352 an ounce by Tuesday’s close. The safe-haven narrative remains one of the main drivers behind the momentum in the precious metal, as does the continued purchasing of gold by central banks across the globe. Tensions in the Middle East and Ukraine also continue to worry many market participants.

The rise comes ahead of the latest US inflation figures, set to be published later today courtesy of the Bureau of Labor Statistics. Expectations for the core inflation rate currently stand at 0.3% for the month-on-month and 3.7% for the year-on-year. Many traders will have their fingers crossed that the numbers do not come in any higher than that, fearing that the Fed may have to postpone any potential rate cuts until things calm down. Speaking of the Fed, we also have FOMC minutes to look forward to later in the day, which will no doubt offer some clues as to just how worried the Federal Reserve board members are about rising prices.

Although content to remain in gold’s shadow for the time being, silver is also part of the emerging picture. Prices continued to increase yesterday, breaching $28 an ounce for the first time since 2021. Easy to forget that despite gold establishing new all-time highs every other day, silver is nowhere close to breaking its own record, currently standing just shy of $50.

Last week ended with yet another new all-time high for gold, gaining a commendable 1.7% on Friday to close at a record $2,330 an ounce. The precious metal gained $100 over the course of the week, seemingly immune to everything else going on in the world of finance. Threats of delayed interest rate cuts have had no real dampening effect on gold, instead the safe-haven asset narrative is leading the price action. Just as on Friday, early trading in Asia is pushing gold to the downside this morning, whether or not the selling pressure will survive the opening bells in Europe and America remains to be seen.

Speaking of early morning trading, oil prices are taking a big hit today as Israel takes a more reconciliatory tone, withdrawing troops from Gaza and committing to fresh talks. Brent Crude and WTI already down 2% at the time of writing.

Friday also saw the publication of Non-Farm Payrolls figures, and they did not disappoint. The US economy added 303k jobs in March, beating the consensus of 200k jobs by 50%. The unemployment rate also fell from the previous month, down to 3.8% versus 3.9% in February. The data will do nothing to pressure the Fed into implementing a rate cut, but as Chairman Jerome Powell has stated, a strong jobs market is not necessarily a barrier to monetary easing as long as inflation remains under control. Speaking of which, wage growth slipped to 4.1% YoY in March, easing such inflationary fears.

Stocks were predictably thrilled with the news, recouping at least some of the losses from Thursday. The DJI clawed back 0.8% on Friday, beaten out by the S&P 500 and Nasdaq Comp, up 1.1% and 1.24% respectively.

Looking forward to the week ahead, there is very little to get excited about on the economic calendar today and tomorrow. Wednesday will see the publication of a slew of US inflation data, followed by FOMC minutes. We have the Chinese inflation rate early morning on Thursday, followed by the ECB’s interest rate decision, markets currently pricing in no change from the current 4.5%.

Confidence in the Federal Reserve’s commitment to lowering interest rates continued to erode yesterday after several of its members questioned whether the cuts were justified in light of recent economic data. In an interview on Thursday, Minneapolis Fed President Neel Kashkari voiced the opinion that interest rate cuts may not happen this year at all if inflation continues to move sideways. The statement echoes a growing sentiment that the US economy has not yet cooled off enough to justify any form of monetary easing.

The reaction in stocks was not pretty. All three major indices continued to tumble in what is shaping up to be a dismal start to the second quarter. The Dow Jones Industrial Average fell over 500 points, or 1.35% during yesterday’s session, the Nasdaq Comp following in lockstep with a 1.4% loss and the S&P 500 faring marginally better with a 1.23% drop. All the while Non-Farm Payrolls loom in the background, the official job figures set to be released mere hours from now. Current expectations are of 200k new jobs and a maintaining of the previous 3.9% unemployment rate. Although the figures often undergo significant revisions after publication, a too hot labour market will further dampen optimism of imminent rate cuts.

The recent rally in gold finally lost some momentum after reaching $2,300 an ounce in the mid-week, possibly due to public holiday market closures in China. The precious metal lost around 0.4% on Thursday and early morning trading in Asia looks even worse, down almost 1% at the time of writing. Interestingly, silver has also performed well this week, peaking its head above $27 for the first time since 2021.

No such faltering in the oil rally as of yet, with Brent crude prices breaking above $90 a barrel yesterday for the first time since October last year; WTI up to $86. Political tensions continue to be the main fuel behind the move, in both Ukraine and the Middle East.