Interest rates back in the driving seat

August was a reminder that the forces moving gold don't always pull in the same direction. After months of decline followed by relative stagnation, gold rallied strongly through August. Longer-term fundamentals that had been sitting quietly in the background moved firmly back into focus: mounting government debt, concerns over how that debt is managed and continued central-bank demand for gold.

With regards to central-bank buying, net purchases reached 289 tonnes in the second quarter, up sharply from Q1, with Poland and China among the biggest reported buyers. But the catalyst for much of August's rally was down to the potential escalation of the "debasement trade" - with US government intervention on buying back long term bonds and the signal that sent out to the market. For a while, those longer-term forces appeared to have wrestled control away from the factors that had dominated gold in recent months – namely US interest rates and the inflationary impact of the conflict with Iran.

However, that all seemed to change last week, culminating with Jackson Hole.

Federal Reserve Chair Kevin Warsh's highly anticipated speech on Friday at Jackson Hole struck a distinctly hawkish tone. He reaffirmed the Fed's commitment to returning inflation to its 2% target and said he would be “hard pressed” to describe current financial conditions as restrictive. Following his comments, the US two-year Treasury yield jumped by around 12 basis points, while expectations of a September interest-rate increase rose sharply to 66%, up significantly from the 33% we saw earlier in August.

Gold felt the effects almost immediately, falling by around 6% as the prospect of higher rates returned to the foreground once again. As a reminder, the logic is relatively straightforward - higher interest rates can push up yields available from bonds and cash. Gold doesn't pay a yield, so higher rates can make competing assets relatively more attractive.

However, golds pull back isn't all down to Warsh and the speech at Jackson Hole. Significant and renewed escalation in the conflict between the US and Iran has pushed oil back above $90 a barrel, bringing the inflationary consequences of the war back into focus. Higher energy costs can feed through into inflation, making the Fed's job harder and strengthening the argument for keeping rates higher, or raising them further. At the same time, the US dollar has strengthened, adding another potential headwind for dollar-priced gold.

It means two of gold's biggest short-term obstacles have returned at once: higher rate expectations and a stronger dollar, which for now, has been enough to interrupt August's rally.

The interesting part is that the forces behind that rally haven't gone anywhere. Government borrowing costs remain under pressure around the world. On Tuesday, the UK 10-year gilt yields climbed above 5.2%, reaching their highest level since the 2008 financial crisis, while the US 10-year Treasury yield has approached 4.8%. There's an interesting development in India too, with Prime Minister Narendra Modi renewing his appeal for citizens to limit gold purchases, part of a wider effort to encourage domestic spending and reduce pressure created by imports. For one of the world's largest gold-consuming nations, it's an unusual intervention and another reminder that governments themselves are paying close attention to the movement of money into gold.

So, August's longer-term argument for gold hasn't necessarily been disproved. It has simply been outshouted by interest rates for the time being.

That makes this week's US employment data particularly important. Tuesday's JOLTS report showed US job openings at a slightly softer 7.3 million in July, while hiring remained relatively subdued. Manufacturing data released alongside it also pointed to softer employment, although the wider sector remains in expansion.

This perhaps sows a slight seed of doubt in the assumption that the Fed could increase interest rates in a couple of weeks' time. Thankfully, there is further data to come this week which should help give us a clearer picture:

The latter could prove particularly important. Current expectations are for relatively modest employment growth, meaning a significantly weaker number along with softer data in the other releases this week, could challenge the market's growing conviction that a September rate rise is likely.

All of this leaves gold in a familiar tug of war, where weak employment data could reduce the pressure on the Fed to raise rates, potentially removing some of the headwind gold has faced since Jackson Hole. However, a resilient labour market could give policymakers greater confidence that the economy can withstand higher rates.

August belonged to debt, central banks and the longer-term story, but September has started with interest rates firmly back in charge. This week's jobs data could decide how long they stay there.