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Gold wakes up

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12/21/2018 | 04:28 pm
We are updating an article published in December to explain the mechanisms underlying the evolution of precious metal prices. Since then, gold prices have gained ground, driven by a recovery in emerging currencies, an easing of US real interest rates and, of course, a significant decline in equity markets. The assumptions made in December have been confirmed.
Concern is growing. Some may point at the US administration's tendency to disrupt the process of globalization, which is damaging to global growth. In addition to these growth concerns, there are inflationary pressures in the United States. In theory, this provides all the conditions for gold prices to shine, an effective store of value against inflation and a preferred asset to hedge against an economic downturn.

However, this is not the case. On the contrary, the stock market performance of gold metal is far from dazzling. To assess this paradox, it is necessary to focus on the different determinants of the price of gold, apart from the fundamental data specific to the physical market.

1) The dollar effect and emerging currencies

The opposite relationship between the greenback and dollar-denominated commodities is well known. Most times, a decline in the dollar is accompanied by an increase in the value of an ounce of gold (denominated in dollars) and vice versa. Understanding this relationship means understanding the attractiveness of gold for holders of other currencies. In other words, the stronger the dollar against its counterparts, the lower the purchasing power of holders of other currencies, implying lower demand and ultimately lower gold prices.

The graph below, which is simplistic at first glance, makes sense after a study of the main gold buyers, including China and India, and to a lesser extent, other countries such as Russia and Turkey.

In this context, it remains relevant to take into account the evolution of emerging currencies to understand the difficult path of gold since the beginning of the year. Led by massive capital repatriations, resulting from Fed policies, or by the escalation of trade disputes, emerging currencies are constantly losing ground, a phenomenon that affects more and more countries. More concretely, we are talking about an average depreciation of emerging currencies of more than 16% since February, which mechanically weakens the purchasing capacity of these countries on gold denominated in dollars.

It should also be noted that some countries, in order to stem the fall in their currencies, are forced, via their central banks, to sell part of their gold stocks, thereby fueling the fall in the price of gold metal (denominated in dollars).
Evolution of the price of gold, put in perspective with the evolution of the yuan and the Indian rupee (expressed in USD) - daily data (click to enlarge)

2) Monetary policy and real interest rates

As stated above, gold fails to benefit from a surge in inflation. However, the barbaric relic is a traditional barrier against the erosion of the value of financial assets.

Here again, it is necessary to add a new variable to unravel this paradox, that of the Fed's monetary policy. Inflationary pressures combined with a situation of full employment are pushing the monetary institution to gradually raise its key rates. For the second time this year, the monetary institution recently raised its key rates by a quarter of a point and expects further rate hikes by the end of the year, the aim being to avoid an overheating of the US economy.

As a result, if nominal rates increase faster than the inflation rate, real rates increase. Thus gold, which by definition does not deliver any return, loses its attractiveness. Besides, for a similar level of liquidity, the trade-off between an investment in a U.S. Treasury bond that provides a return and an ounce of gold that does not provide a return will necessarily tend towards the first choice.
Evolution in daily data of gold prices (expressed in USD) and long-term US real rates (expressed as a percentage) - Source: US Department of the Treasury; World Gold Council (click to enlarge)

It is therefore impossible to assess the evolution of gold prices without first studying the dynamics of real interest rates. When the latter tend towards zero (i.e. a real return of zero), or if they evolve in negative territory, the yellow metal will appear as an attractive asset.

On the other hand, during phases of real rate increases, which has been the case since the beginning of the year, traders will tend to arbitrate in favor of treasury bills, which, beyond their liquid nature, deliver risk-free returns, while gold by definition does not deliver them. In other words, too rapid a monetary tightening by central banks is a risk for gold.

In short, this shows that an increase in inflation is not necessarily accompanied by an increase in gold prices, just like an increase in nominal rates does not necessarily mean a depreciation in gold prices.

3) Bull market and refuge asset

We cannot talk about gold, as a financial asset, without mentioning its status as a safe haven. This means that gold is massively sought-after when stock market yields collapse. The uncertainty that often comes with volatility and disengagement on equities markets, remains gold’s best feature.

As such, despite the tangible tensions on the commercial and geopolitical front, these are by no means accompanied by real withdrawals on the equity markets. Stress episodes do indeed punctuate this stock market year, naturally triggering profit-taking phases, but these are never intense enough to push investors to withdraw from the equity markets in favor of other asset classes.
Evolution of the price of gold, put in perspective with the evolution of the main world indices: S&P500, Nikkei225, Stoxx600 NC - weekly data (click to enlarge)

Confirming this, Wall Street is currently posting the longest bullish run in its history. This is the longest bull market ever recorded. The figures speak for themselves, the S&P500 has risen from its low point of 2009 to nearly 325%. By way of comparison, the Nikkei won more than 200% over the same period while the Stoxx600 Net Return increased by 166%.

On this basis, there is little doubt that the longevity of stock market bull cycles serves gold.

What conditions must be met for gold to rise?

In light of these elements, a more optimistic scenario for gold certainly seems uncertain, but not impossible. If you plan to invest and diversify your portfolio with gold, you will necessarily need to pay attention to these mechanisms:

-An increase in emerging currencies: an appreciation of emerging currencies against the dollar (notably the yuan and rupee) would mechanically give more purchasing power to Asian buyers, the main contributors to gold demand. This requires, on the one hand, a lull on the trade front and, on the other hand, an extremely moderate pace of Fed rate hikes in order to retain foreign capital in emerging economies.

-A decrease in real interest rates: this amounts to a higher inflation rate, a possible scenario given the tensions on the American labor market, which is in full employment, and the increase in energy prices. On the other hand, nominal rates should not harden too quickly. Given the significant level of debt in the United States (with a debt that represents more than 100% of GDP, destined to increase given Trump's expansionary policy), the Fed has no interest in raising its key rates too quickly, so the Institution is condemned to perform a real balancing act.

-A decline in stock market returns: although it is impossible to accurately predict the end of an economic cycle, more and more observers are concerned about the risks of an end of the cycle in the United States. This amounts to suggesting that the U.S. economy is overheating, a phase that will necessarily have to be replaced by a recession, the advent of which will signal the end of bull markets.

Jordan Dufee
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