The next trillion dollars is more worth the attention of gold investors than the next 25 basis points.

Gold continued its decline last week as the market prepared for the Federal Reserve’s interest rate decision this week. However, some analysts believe that gold holding above the $4,300 threshold indicates that the pressure from rate hikes is waning.

The higher-than-expected US CPI for August, released last Friday, has become a key factor for the market in determining whether the Fed will hike rates this week. Some economists even called this data the "final nail in the coffin" supporting a rate hike.

Chris Zaccarelli, Chief Investment Officer of Northlight Asset Management, told Kitco News that whether the Fed will hike rates this week is still not certain, but it is increasingly difficult for the central bank to justify holding rates unchanged. The CME FedWatch tool shows that the market currently expects the probability of a rate hike this week is close to 90%.

Room for Rate Hikes Is Limited by Fiscal Conditions

US fiscal conditions are becoming another focal point for the gold market. Analysts point out that the ever-increasing government debt is already impacting the US bond market; Treasury yields are at three-year highs and are pushing towards 5%.

Last Thursday, the US Treasury purchased over $5 billion in long-term Treasuries, but long-term yields did not fall as a result. The 10-year Treasury yield closed last week at 4.97%, a three-year high, and many analysts expect a break above 5% is only a matter of time.

This disappointing bond buyback came as US sovereign debt topped $40 trillion. The government currently spends over $1 trillion per year just on interest payments.

Jeff Sarti, CEO of Morton Wealth, told Kitco News, “Given the current fiscal environment, the Fed doesn’t have much room for aggressive rate hikes.”

“The Fed can put up a fight, but given our fiscal situation, their room to raise is limited, so inflation will likely remain persistent,” Sarti said. He believes, “More important is our deteriorating fiscal situation, and the bond market is sending a loud and clear signal.”

The day before the Treasury initiated this round of buybacks, President Trump also promised that if the Republican Party wins the midterm elections and keeps control of the Senate, each American adult will receive $5,000. This commitment means US debt would further increase by more than $1 trillion.

Thus, the market is facing not just the next rate hike, but rather the reality of how high rates can actually go given the ever-expanding US fiscal expenditure.

Gold Supported by Debt and Capital Flows

Naeem Aslam, Chief Investment Officer at Zaye Capital Markets, believes that as the Fed’s credibility comes under scrutiny, gold remains strongly supported.

Last month, at the annual central bank symposium in Jackson Hole, Wyoming, Fed Chair Kevin Warsh reiterated his commitment to maintaining price stability and returning inflation to the central bank’s target.

Aslam pointed out: “Basically, if the Fed hikes rates, Treasury yields will still be unsatisfactory; if they don’t, their credibility is what’s in question.” In his view, “So going long gold is the name of the game right now.”

Ryan McKay, Head of Commodity Strategy at TD Securities, said in a report last Friday that the short-term downside risk for gold is increasing ahead of the Fed’s monetary policy decision this week, but the scope for correction is limited.

McKay believes that strong economic data and a hawkish Fed may lead to relatively moderate short-term selling via systematic funds, but with the dollar depreciation theme resurfacing, consistently strong central bank gold purchases, and ETF accumulation, there will be strong support for long-term independent capital flows.

“Any near-term weakness in the yellow metal should increasingly be viewed as a potential buying opportunity,” McKay said.

Ryan McIntyre, President of Sprott Inc., is not sure if the Fed will actually hike rates this week. He believes the Fed may remain neutral because most inflation comes from the ongoing Iran conflict pushing up energy prices.

Even if the Fed ultimately raises rates, McIntyre believes the gold market is already prepared for this outcome. He noted that with gold below $4,400, a 25 basis-point hike has already been largely priced in.

“Whatever they do, more or less, will be relatively insignificant in the bigger picture,” McIntyre said. “They will either speed things up or slow them slightly, but the end result is the same: sovereign debt risk will continue to increase.”

Central Bank Decisions from US, Japan, and UK Successively Unfold

After the Fed meeting, the Bank of England will announce its rate decision on Thursday. The market expects its rate to remain unchanged at 3.75%.

Before the end of this week, the Bank of Japan will also announce its monetary policy decision, with the market expecting a 25 basis-point rate hike. Adam Turnquist, Chief Technical Strategist at LPL Financial, said in a recent report that rising Japanese rates could have broader global economic implications.

Turnquist also reminded investors to watch for a weakening USD/JPY and whether the exchange rate will break below 152. The Kitco Global Index shows how much the current gold trend is influenced by both dollar factors and gold market-specific factors.

“A decisive break below this support could accelerate the yen’s appreciation, force more short-covering, and reignite yen carry-trade unwinding, which could spark a chain reaction across global assets, including US Treasuries,” he said.

Against the backdrop of US government debt surpassing $40 trillion and annual interest payments exceeding $1 trillion, the market is thus focused not just on the next 25 basis-point move by the Fed. Analysts believe that even if the Fed can fight inflation with rate hikes, it faces real constraints imposed by worsening fiscal conditions.

What the gold market is pricing in is not just the short-term opportunity cost of a single rate hike. Instead of fixating on the next 25 basis points, what investors should be watching may be the next $1 trillion increase in US debt and the corresponding sovereign debt risk that comes with it.