Can Gold Sustain Its Rally After Touching 6-Years’ High?

On 19 July 2019, gold prices hit its highest level in six years, as global factory output slowed and the market debated by how much the Chairman of Federal Reserve Bank, Jerome Powell, would cut benchmark interest rates. Defying popular sentiment of its usage because of lack of yield and practical utility, the safe-haven commodity has provided important insurance in the increasingly unstable world with negative yields and has offered protection against insurance. As the chorus surrounding a rate cut by the Fed in its next policy meeting increases, holders of promissory notes issued by governments and companies have seen the value of their assets in real terms, increasing the demand for the commodity which had been trading in a range for the past few years.

In late June, gold hit a six-year high above $1,400 and broke the barrier of $1,050 and $1,375 a troy ounce, around which it had hovered for the past five years. Billionaire hedge fund founder Ray Dalio advised that gold should be added to the portfolio of investors, as it would help in reducing risk and enhancing returns in a negative yield environment. Additionally, the higher movement in the price has been backed by inflows into gold-backed exchange-traded funds. Funds worth $105 billion were invested in such assets last week, which represented a five-year high of 74 million ounces of gold.

Gold futures for August delivery on the Commodity Exchange division of the New York Mercantile Exchange has been a beneficiary of the talks around monetary expansion by central banks around the developed world, as fears of slowing global economy and the trade war between the United States and China have started to leave their mark on other countries. According to CME Group, investors are betting that there is 100 per cent chance that the US central bank will ease monetary policy, which would lead to a cut in the main interest rate of the US for the first time in more than a decade. Moreover, instead of the 0.25-percentage point cut usually chosen, there is more than a 50 per cent implied probability of a cut of 0.5 percentage points to be announced by Mr Powell, further strengthening gold. According to experts, the US central bank is worried about slowing economic growth in the US due to weakness in the rest of the world, despite the country enjoying a decade of uninterrupted growth to register its largest recorded expansion. The next meeting of the Federal Reserve’s Open Market Committee (FOMC) is on 31 July-01 August 2019, providing a bullish scenario for the metal.

A fall in interest rate would result in lower yields, which could weaken the dollar as investors would sell their dollar-backed assets seeking higher returns from other countries. Generally, commodity prices and dollar follow an inverse relationship. Therefore, as dollars weaken, dollar-priced investments like gold would become more attractive as commodities prices would rise. While in the last few years, a major reason for tepid demand for one of the oldest investment assets has been historically low inflation rate, investors reckon that a rate cut would result in a rise in inflation, which would further drive the demand for gold. This is because gold is regarded as one of the best hedges against inflation, being viewed as an investment that holds its value.

Apart from the US central bank, a dovish stance on monetary policy has increasingly been taken by central banks in the developed economies. While countries like South Africa and South Korea have already cut their policy rates, the European Central Bank, which will hold its regular monetary policy meeting on Thursday, is expected  to give signs of an accommodative policy with a 50 per cent chances that rates would be cut by Mario Draghi, the current president of the bank. Additionally, the tumbling yields have erased another problem of opportunity cost. As yields fall, the opportunity coast, i.e. the return foregone to own the asset has declined, meaning investors are not missing out much by way of earning interest on other assets such as bonds and stocks. The appeal of gold has risen as the market is now flooded with fixed income securities with negative yields worth $13 trillion as the outlook for lower interest rates has spread. According to data compiled by Bloomberg, if the Fed cuts rates twice this year, the number can swell up to $30 trillion.

According to a survey conducted by the World Gold Council and YouGov, holdings of gold by central banks around the world looks set to continue in the coming year too, offering another bullish factor for the outlook of the commodity. As central banks seek to diversify their reserves, they have been buying the metal at the fastest rate in decades, providing vital support. Since the first quarter of 2015, holdings of gold have been increased by approximately 66 per cent to 4,960 tonnes by central banks in China, Russia, India and Turkey. Amid concerns about risks in other reserve assets due to low returns, the poll of central banks suggested that 54 per cent of participants anticipate global holdings of the commodity to rise in the next 12 months.

As there are growing concerns that further rate cuts by central banks would not lift demand and global growth, the asset is increasingly seen by investors as one of the few proven hedges against the possibility of a slowdown in the United States and other countries. Moreover, it is providing better protection against potential weakness in the equity market, which has reached record highs in recent times despite global geopolitical and financial uncertainty than the bond market. Fixed-income assets have not operated as a reliable hedge against equity weakness since 2008, thus driving demand for other safe havens.

Gold has long been considered a safe asset class in difficult or uncertain times, and the demand for gold to be kept as a safe reserve has increased significantly amid geopolitical tension and trade war. While the US and China have entered a truce, there is no certainty that the issue would get resolved. Both the countries do no look to back down, and the belligerent attitude of President Donald Trump has only made the matter more complicated. Analysts predict that the trade war would continue to roil the market for a long time, assisting the demand for gold.

The unrest and tensions in the Middle East are also giving the precious metal a boost due to the simmering tensions between Iran and the Western governments. It was alleged that Iran was behind sabotage attacks on six tankers in the Gulf in May and June and the tensions further boiled when Iranian armed forces shot down an American drone, allegedly in international waters. This all was followed when the US administration re-imposed sanctions on the country after rescinding from the nuclear deal it had signed with the Iranian government, along with the support of other major powers. Breaching of the nuclear agreement by exceeding uranium limit set by the agreement in response to the unilateral actions of the US, made matters worse and made the Trump administration furious with the steps. Since then, the British government has seized an Iranian oil tanker, to which Iran responded by seizing a British oil tanker. Also, an Iranian drone was shot down by the US armed forces, and it was reported that a military strike by the US army was called off in the last minute.

While many countries, including the UK, France and Russia, have tried to keep the agreement alive, there seems no consensus yet, which has added to the uncertainty in the financial market. Amid all the chaos, gold, which has a defensive solidity, has appreciated significantly, as it is considered a good diversifier and an enduring store of value. When the matters take a turn for the worse, the equity market would be the first to decline. Generally, investors seek haven in the bond market, but with a negative yield, gold would offer the best medium to store and create wealth.

However, despite all the benefits of holding gold, it must be remembered that the price of gold depends only on demand and supply, and it does produce any income, interest or dividends. Moreover, price fluctuations have been volatile over many decades, and in the past decade, it has gone as low as $868 and as high as $1,900 an ounce. While it is considered a good hedge against inflation, empirical data points otherwise as the price of gold has not been able to keep up with the inflation. Moreover, storing gold in a vault costs money and holding metal in an exchange-traded fund also costs money.

After the case for policymakers to reduce rates weaken as data on Friday showed US payrolls beat estimates, the demand for gold began to decline. On 22 July 2019, prices continued to hover near a six-year peak touched in the previous session as investors look for indications from major central banks to ease policy and support the rally in gold prices. While geopolitical risks from the Gulf could provide some support for the metal, it is largely going to struggle to sustain an uptrend unless a significant pullback is triggered by the earnings of tech giants.