Could a double bottom and bullish RSI divergence lead to a trend reversal?

Gold analysis: candlesticks, moving averages and coins on a chart.

As I wrote in my previous gold price analysis “Brace for a rate shock as inflation runs amok” on August 23, 2022, if the Fed’s interest rate expectations rose further, there would have been significant short-term downside risks for the precious metal.

After only one week, these risks have materialised, and they have weighed heavily on the performance of the yellow metal, as textbook.

The case for the Fed’s third consecutive 75-basis-point hike at its September meeting is now seen as the most likely outcome. Furthermore, Fed futures now predict that interest rates will rise to around 4% by the end of 2022.

In the previous analysis, I also flagged how a rate hike shock would have caused the precious metal to retest its year-to-date low of $1,680 set on July 21st. Gold has dropped by 2.1% in the past week, and it is now trading at its lowest level since July 21st.

Taking a look at the technical patterns, a double bottom is forming as $1,680 is now only 1.5% below current prices. If this downward move is accompanied by a bullish RSI divergence, with the indicator failing to update new lows, a major trend reversal could occur. In August 2021, gold prices formed a double bottom along with a bullish RSI divergence, paving the way for a multi-month uptrend to March 2022’s peaks.

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Gold price chart: double bottom and bullish RSI divergence in sight

Gold technical analysis as of August 31, 2022 – Photo: Capital.com, Source: Tradingview

Gold fundamental outlook: What factors can lead to a trend reversal?

To witness a reversal of the bearish trend that has accompanied gold in 2022, certain macroeconomic catalysts that support investment in precious metals must come into play.

The Fed’s decision to stop raising interest rates would be the most obvious factor. However, with still strong inflationary pressures, that is an extremely unlikely outcome for the time being.

So something different should happen to cause a gold trend reversal.

Unlike the dollar, gold has not yet acted as an inflation hedge in 2022. Since the beginning of the year, gold’s return has been negative (-4.5%), while the US dollar index (DXY) has risen 12.5%.

Since March 2022, there has been a recurring theme in the market. Rising inflationary pressures have prompted the market to price in strong interest rate hikes from the Federal Reserve, which has responded with very hawkish monetary policy decisions. As a result of the Federal Reserve’s aggressiveness, the dollar has strengthened, while gold, an asset that does not produce fixed interest, has lost value.

This has occurred, though, as investors continue to believe that central banks can control inflation by raising interest rates. In essence, long-term inflation expectations have not yet become unanchored, as there is some trust that the Federal Reserve will succeed in bringing inflation back to target.

Gold has underperformed the dollar as investors continue to have faith in central bankers.

Gold vs US dollar: performance year-to-date as of August 31, 2022 – Photo: Capital.com, Source: Tradingview

However, trust in financial markets is time-sensitive, just as it is in life.

What would happen if inflation continued to soar wildly despite interest rate increases?

For example, in the most recent period, factors completely beyond the control of monetary policy, such as increases in natural gas prices, have continued to influence inflation expectations.

If the market came to believe that even if interest rates are rising, inflation will remain much higher than expected, unless the economy enters a deep recession, fiat currencies such as the US dollar would be an asset offering negative real returns or losing real purchasing power .

In that case, large investors’ focus could then turn back to gold, which has historically protected against the danger of inflation expectations getting de-anchored, as I explained here.

What to keep an eye on as inflation expectation barometer?

US 5-year and 10-year Breakeven rates as of August 31, 2022 – Photo: Capital.com, Source: Tradingview

Market-based measures of inflation expectations, such as the 5-year or 10-year US breakeven rate, should be monitored by investors to determine whether inflation expectations are under control or not.

Historically, market-based inflation expectations fell when interest rates were raised, and vice versa.

This pattern has continued this year, with both measures of inflation expectations falling significantly since the start of the Fed’s current hiking cycle in March 2022.

However, it appears that inflation expectations have reached a bottom over the past few weeks, and despite rising expectations for higher interest rates, the market is beginning to factor in the likelihood that inflation will remain above the 2% target for the next five or ten. years.

Further increases in inflation expectations during periods when the Fed raises policy rates are a warning sign that inflation expectations are becoming unanchored and the market is starting to lose faith in central banks’ ability to control inflation.

Crossing this Rubicon would be a significant bullish macro catalyst for gold.

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