The Morning Gold Report: Gold Down Slightly Awaiting Fed Announcement

June 25 a.m. (USAGOLD) -- Gold has adopted a consolidative tone below the $900 level as traders await this afternoon's (14:15ET) decision on interest rates.

It is widely believed that the Fed will leave interest rates unchanged. Focus will be on the policy statement as the market attempts to discern the Fed's intentions down the road.

Tough talk on inflation in recent week's had the market leaning toward a rate hike later this summer. However, odds for a 25bp rate hike over the next two FOMC meetings have dwindled to 38%. Odds of such a hike were as high as 75% just a couple weeks ago after Fed Chairman Bernanke came out with some rather hawkish comments.

One can reasonably expect that price risks will be the primary emphasis in the policy statement, but risks to growth remain substantial as well. The Fed has a dual mandate: Price stability and sustainable growth and employment.

One could argue that the Fed isn't doing a particularly good job managing either mandate, with stagflation an ever-increasing threat. However, dealing with risks to growth has tended to take precedence a the Fed. Commencing a tightening cycle this summer would pose too great a threat to growth and employment, given the precarious condition of the US economy and the upcoming Presidential election.

It seems more likely that the Fed will allow inflation to run a while longer before they start tightening. I don't believe a rate hike is likely until Dec, although I'd look for additional mixed signals between now and then to keep the market on its heels.

I could see the Fed hiking the discount rate by 25bp before Dec as a signal that they are serious about inflation. Such a move would widen the spread with Fed funds back to a half point.

You may recall that the Fed did an inter-meeting cut to the discount rate on 16-Mar, narrowing the spread with Fed funds to just a quarter point. Two days later in the darkest days (so far) of the credit crisis, they cut both Fed fund and the discount rate by 75bp.

Ultimately the ongoing credit crisis and much of the general economic turmoil can be traced back to the bursting of the housing bubble. That bubble continues to deflate as evidenced by yesterday's release of the S&P/Case-Shiller home price index. The index showed that home values in 20 major US cities have declined 15.3% y/y through Apr.

The national average for 30-year fixed rate mortgages surged in Jun, primarily as a result of hawkish Fed speak. The move from the mid-May low at 5.7% to the current national average of 6.3% translates into an additional $38 per month per $100,000 borrowed. That can make a big difference when family budgets are this tight.

With so much of our total net worth wrapped up in our homes, the American homeowner is feeling significantly poorer this year. Factor in the move to new 3-month lows in the stock market and the insidious bite of inflation and that pretty much explains why US consumer confidence plunged to 50.4 in Jun.

That's the fifth lowest reading since the series began in 1967 and the lowest reading since Mar-92. The expectations index plunged to a new all-time low of 41.0 from 47.3 in May. The job strength component fell to -16.2 and the 1-year inflation reading stands at a record high of 7.7%.

Given that 70% of US GDP is derived from consumption, the gloomy sentiment readings do not bode well for the US economy and the stock market. Key supports in the Dow defined by the lows for the year at 11,650.44/11,508.74 are close at hand. Penetration would be a rather negative signal.

With the stock and housing markets on the ropes, the credit crisis still in full swing and consumer confidence at historic lows, I think it's likely that the Fed will take a much less hawkish tone in their policy statement than many are expecting.

If that comes to pass, look for Fed fund futures and the rest of the treasury complex to rebound sharply, and the dollar to come under renewed pressure. This would in turn exacerbate the inflation problem.

For all of these reasons, now is the time to diversify your portfolio with a non-correlated asset such as physical gold.

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