26/01/2023
Gold has recovered despite the
rise in interest rates around the world in 2022. Fears of a recession and stagflation tend
to be gold positive, while continued softening in the US dollar would act as a support. The
risk lies in the Federal Reserve pushing nominal rates higher and keeping them there for
longer, forcing down inflation expectations and driving up real rates and the dollar in the
process.
Yields
The price of gold is often a factor of inflation,
inflation expectations, real yields and the value of the US dollar.
Real yields exert a particularly strong influence on gold
prices. Erb and Harvey1
proved a strong negative correlation between real interest rates and gold. Looking at this
relationship between 1997 and 2012, it was found that gold and real rates exhibited a
correlation of -0.82, with -1 being a perfect negative correlation. Essentially, higher real
yields create a higher opportunity cost for holding gold, making it less attractive an asset
to hold.
Real yields have torn higher in the last 12 months, with
the 10-yr Treasury Inflation Protected Securities (TIPS) from around –1.0 as recently as
March 2022 to +1.70% in November. This move pressured gold from a peak of around $2,070 in
March ‘22 to a trough of $1,615. The turn in real yields towards 1.33% since Nov has
encouraged a more bullish take on gold and seen the price rally north of $1,900.
Declining real yields would encourage
further optimism for gold prices to breach record highs again. The question is how could
this happen? Inflation and inflation expectations seem to be moderating, however the Federal
Reserve is not taking its foot off the pedal since nominal inflation rates remain well above
the central bank’s target. Looking at the 10yr TIPS rate alone is not enough. A deep
inversion of the yield curve highlights market expectations for the Fed to hike rates
further this year before embarking on a rate cutting agenda as the economy slows. This may
be too optimistic from a risk point of view – tightness in the labour market and so-called
‘second round’ effects risk leaving elevated inflation more entrenched, which could see the
Fed maintain a restrictive policy for longer. If that were to feed into higher real yields
it would tend to result a weaker outlook for gold. A moderation in inflation expectations
has been evident but remain elevated
A risk to the outlook would also
emerge should the Fed raise rates beyond the current market pricing of the terminal rate
around the 5% level. FOMC members expect the terminal rate to be around 5.1%, and hold there
for all of 2023. Markets price in cuts later in the year as a recession hits. The problem is
that the labour market is not showing signs of slackening. We can probably boil it down to
this – right now the market still thinks the Fed is not going to be tough enough so nominal
rates are down and inflation will persist. This is gold positive. The risk to gold prices
making fresh highs would be for the Fed to stick to its guns, push rates higher and keep
them there longer than the market expects and we see inflation and inflation expectations
really start to come down. Sticky inflation problem
Polycrisis and Recession?
Gold tends to perform well in recessions, but it is not a slam dunk. Gold can act as a
portfolio hedge not just to inflation but also to economic contraction. The IMF expects
around a third of the global economy to enter a recession in 2023 and it has cut its
forecast of global GDP for the year to 2.7%. Almost two-thirds of economists surveyed by the
World Economic Forum believe there will be a recession in 2023. However, there are signs of
optimism, particularly for 2024, whilst the reopening in China early this year should act as
a catalyst for growth. 3month, 10yr yield curve inversion – which has indicated that last 8
recessions in the US.
USD We should also
consider the USD. The dollar (DXY) also peaked last September and has since by more than
10%. In that time gold rallied by around 18%. US real rates clearly have an impact on the
USD – the three are intertwined, but it’s clear that a weaker USD as a result of lower real
rates in the US has combined to push up gold in the last few months. The question is whether
this is a trend – was last autumn’s peak in real rates and the dollar an inflection? Can the
dollar rebound? The European Central Bank and Bank of Japan may not be anything like as
hawkish as markets had though as recently as December when both made statements that spurred
their respective currencies to bounce back. It should be noted, however, that relying too
heavily on real rates and the USD correlation can be a mistake. The World Gold Council notes
in a recent update that while the US 10-year TIPS “has historically been a reliable higher
frequency driver of gold prices for two decades … [it] has been less stellar over lower
frequencies. “The consistent inverse relationship would have suggested a steep fall in gold
as yields rose over 250bps in 2022. But the relationship only held intermittently. The
strong US dollar (+8%) as proxied by the DXY index should have proved equally challenging,
given the historically negative relationship. Yet, it also failed to drag gold down over the
full calendar year.” Physical bullion market The physical bullion market is
roaring, thanks to central banks. Global central banks purchased almost 400 tonnes of gold
in Q3 (+115% q-o-q), the largest single quarter of demand from them since records began in
2000, according to the World Gold Council. It was almost double the previous record in 2018. Technical
outlook Daily – golden cross recently points to bullish momentum though in the
near-term we have seen a slight pullback in the face of the 50% retracement of the 2022
peak-to-trough.
Weekly candles show strong bullish
MACD crossover with the 38.2% retracement of the 2020 peak to the 2022 low now acting as
support.
Sources used: [1] The Golden
Dilemma https://www.nber.org/papers/w18706