By Simona Gambarini
The price of gold has increased sharply in 2016, but speculation about US interest rates has prompted suggestions that this upward trajectory will move into reverse.
Not so, says Simona Gambarini, commodities analyst at leading economics research consultancy Capital Economics.
The gold price has risen close to 20% in 2016 in US dollar terms, despite subdued buying from consumers in China and India, as well as emerging market central banks. In part, this reflects changing perspectives on US interest rates earlier in 2016. As it appeared less likely that the Fed would raise interest rates, the dollar weakened, and the gold price rose. But increased concern about US inflation and a revival of safe-haven demand have also been important.
This range of influences suggests that the gold price should prove relatively resilient when the Fed raises rates again.
Indeed, when the Fed hiked rates in December 2015 for the first time in almost ten years, the effect on the gold price was short-lived, and it actually rose in subsequent months as other drivers took over.
The conventional wisdom, of course, is that Fed tightening is bad for gold, mainly because higher US rates can strengthen the dollar and increase the opportunity cost of holding commodities. And prices could drop back in the short term, if the next hike comes sooner than the markets currently anticipate.
However, we think that any pull-backs will be temporary, for three key reasons.
First, we expect that the Fed will raise rates only gradually and to only a low level by past standards. Nominal interest rates are not expected to rise much above 2-3% over the coming years, and this is unlikely to be a game-changer, especially if rising inflation keeps real interest rates low.
“Real interest rates matter most in determining the opportunity cost of holding an asset like gold.”
And real interest rates matter most in determining the opportunity cost of holding an asset like gold, which can be expected to (at least) maintain its value in real terms. Indeed, the price of gold is relatively closely correlated with real yields (Chart 1).
Chart 1: Ten-year yield on US Treasury inflation-protected securities and gold price.
Source: Bloomberg
Admittedly, headline inflation is still low in the US, but both headline and core in action are on track to be well above the Fed’s 2% target by end-2017, meaning that real interest rates should remain at historically low levels.
“Government bond yields are already negative in much of Europe and Japan, while the Bank of England responded to the Brexit vote by cutting its key rate to 0.25% and increasing its Asset Purchase Facility by £170 billion.”
Second, other central banks are unlikely to follow the lead of the Fed. This helps to explain why gold prices have recently held up well even though expectations for US interest rates (proxied in Chart 2 by overnight indexed swap rates) have recently started to climb again. Indeed, monetary policy in the Eurozone, the UK and Japan will remain loose for the foreseeable future, and additional stimulus is likely in the coming months, particularly following the economic and political uncertainty generated by the UK’s vote to leave the European Union.
Government bond yields are already negative in much of Europe and Japan, while the Bank of England responded to the Brexit vote by cutting its key rate to 0.25% and increasing its Asset Purchase Facility by £170 billion. Looking forward, we expect rates in Japan to fall deeper into negative territory and asset purchases to be extended there and in the Eurozone.
Chart 2: US two-year overnight swap rates and gold price.
Source: Thomson Reuters
Third, potential additional shocks lie ahead. There is a significant risk that Brexit contagion will prompt a resurgence of the debt crisis in the periphery of the Eurozone and other countries may decide to break away from the EU too. In the US moreover, the presidential election could prompt a fresh bout of global political uncertainty.
Gold has already demonstrated its value as a safe haven last year – in the immediate aftermath of the UK’s vote to leave the EU. With Brexit-induced economic and political uncertainty likely to persist for some time, we think the precious metal will remain in high demand.
Looking back, several factors contributed to the surge in the gold price, allowing it to hold on to the bulk of its gains even in the face of fading support from some key drivers. Going forward, lingering global risks should ensure that demand for gold as a safe haven asset remains elevated even in light of Fed tightening. What’s more, the downside for gold should be limited by a renewed focus on the risks of higher inflation, after years of the exceptionally loose monetary policy.
We would not expect the price of gold to revisit its previous highs of around US$1,900/oz, unless there is a major crisis that forces the Fed to loosen its monetary policy again. However, we do believe there is plenty of scope for additional gains over the medium term, despite the prospects for further monetary tightening in the US. ◼
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Article first appeared in Gold Investor (vol. 2, Nov 2016), published by World Gold Council.
