Precious Metals Watch – Gold’s temporary setback

by: Georgette Boele

In this publication: There are a wide variety of drivers for gold prices. We think that the recent set-back in gold prices is temporary… and drivers will turn more positive again… leading to higher gold prices later this year and next year.

160524-Precious-metals-watch.pdf (258 KB)

Gold’s diverse character

Gold has a diverse character. First, gold has currency attributes and is therefore direct competition with the US dollar. Second, higher interest rates in the US and in other countries are not supportive for gold prices (because gold offers very little to no income). However, investors also take into account inflation developments. Third, gold has safe haven attributes. Moreover, investor sentiment also plays an important role. To define the direction in gold prices, it is important to take all these drivers, which are interlinked, into account.


Gold’s strong negative relationship with the US dollar…

Gold and the US dollar usually have a strong negative relationship. This is because gold has currency attributes and it is used as central bank reserves like other major currencies. Therefore, it is in direct competition with major currencies. Since the introduction of exchange traded funds (end of 2003) in the gold market, this relationship has only become stronger. The graph above shows gold’s relationships with the US dollar and with equity volatility (VIX). Though there have been times that both the dollar and gold moved higher, this mainly happened when investor sentiment turned sour (reflected by higher equity volatility).However, at the height of the Global Financial Crisis safe haven currencies, the yen and the US dollar, rallied strongly and they even outperformed gold prices.

The US dollar weakened from February 2016 up to the end of April 2016 by more around 8.5%. It will not come as a surprise that gold prices rallied strongly, by close to 16%. Since the end of April, the dollar has been on a recovery path (+3%) and gold prices have given back around 3% as well. The upward adjustment in Fed interest rate expectations since 12 May has also supported the US dollar and weighed on gold prices. If investor sentiment towards gold were to be more negative, gold prices would have fallen more substantially since the end of April. What factors have dampened the downside? In short, the stabilisation in US real yield expectations in an environment of positive investor sentiment.

…and with US real yield developments

The unorthodox easing of major central banks over the recent years has fuelled fears that inflation eventually may sharply rise. Recently, there has been some uptick in inflationary pressures in the US and the recovery in oil prices has also resulted in higher inflation expectations. This has provided support to gold prices.


Gold is an asset that virtually pays no income. Such an asset becomes relatively attractive if rates on other assets move to zero or to even negative. Over the years, this has been the case for a wide variety of government bonds in Japan, the eurozone, Switzerland, Sweden and Denmark. In addition, some major currencies also have low to negative official rates. This makes an asset like gold more attractive. What is crucial for the outlook for gold prices is that rates, especially real rates, will not rise sharply. Just after the gold price peaked in 2011, US real yields started to move higher and this continued until May 2015. In this period, gold prices dropped by more than 37%. Since then, the rise in US real yields has lost momentum and these yields moved into negative territory again (see graph above). This has supported gold prices. First the downward pressure on gold prices eased (in 2015) and this was followed by an impressive price recovery this year.

Going forward, we expect the Fed to remain on hold this year while inflation pressures could pick up somewhat because of higher commodity prices. If the Fed were to hike interest rates this year (not our base case), it will likely be gradual and it will unlikely hike more than the rise in inflation expectations. Therefore, it is unlikely that US real yields will rise further. At best they will remain neutral, but the odds are for lower US real yields. This will weigh on the US dollar. Therefore, we think that the near-term downside for gold prices will likely be limited.

We remain positive on gold

All in all, we continue to be positive on the outlook for gold prices. For a start, we think that the multi-year US dollar rally has come to an end and the recent recovery is just temporary in our view. Moreover, we expect US real yields (taking into account inflation expectations) to peak and to move lower. This will make gold as an asset attractive. In addition, gold’s price is relatively attractive compared to other assets with safe haven attributes.