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The year 2022 was a challenging one for the global economy in all aspects from the RussiaUkraine war to four-decade-high inflation in the developed world leading to heightened volatility in financial markets. International gold prices also underwent significant push and pull due to the confluence of factors that affected all asset classes. Gold prices approached an alltime high of around $2,070 in March on the back of risk aversion triggered by the RussiaUkraine war. But later, as the geopolitical risk premium waned coupled with the Federal Reserve’s tightening spree to combat sky-high inflation, prices faced heavy downside pressure.

Chart 1: Rising US real yields impacted gold prices in 2022

Past performance may or may not be sustained in the future.

The Central bank started hiking rates in March and took rates from 0.25% in March to 4.5% by December. The Fed also initiated the unwinding of its $9 trillion balance sheet by $95 billion a month since October. This rapid pace of tightening resulted in the flight of money from risky assets to the US dollar as the real interest rates (indicated by US 10Y Treasury Inflation Protected Securities) turned positive for the first time in two years in May 2022. This led to a sell-off in gold taking prices down to a two-and-a-half-year low of $1,614. However, as inflation started to moderate sequentially in Q42022, investors started anticipating a less aggressive Fed in 2023, and the dollar came under pressurehelping gold prices to scale back up.Risk assets too saw a relief rally.

Stepping into 2023, we can’t be sure if this reaction is justified given that inflation in the US remains well above the Fed’s 2% target, and the Fed has made it clear that while the pace of rate hikes could slow down from hereon, but the slower pace does not mean lower rates which the markets had started anticipating. The terminal rate is expected to be higher than previously expected at above 5% as per the dot plot after the FOMC meeting in December. This translates into another 50-75 basis points of hikes in 1H 2023, which could result in bouts of volatility in both risk assets and gold as real rates rise in an environment of cooling inflation and higher nominal rates.

Complicating the inflation trajectory is the Russia-Ukraine war, which is in its 10th month and shows no signs of easing, and the potential opening of China after three years of strict Covid-19 restrictions which could ignite its economy. A combination of this could further fan the inflation fire, leaving no choice for policymakers but to press harder on the tightening brakes to bring down demand-side pressures on inflation. Thus, negative surprises on the Fed policy rate cannot be ruled out.

However, given the fluidity of the external environment, the Fed's commitment to higher rates can get altered quickly on the first signs of recession. Given the lagged effects of the massive 500-basis point tightening in just a year, a recession in the US looks likely by mid-2023.

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