Whenever there are geopolitical tensions, gold gets a boost. So, it’s not surprising that the yellow metal shot up through the course of October as Israel prepared to invade Gaza. But, since the start of the month, the price has hit something of a plateau as it appears to be having some difficulty getting through the psychologically important $2,000/oz barrier.

As we mentioned last week in the NFP podcast, there is a potential set up for gold to move substantially above its current level. It seems worthwhile to get into a little more detail on how that might happen, and what traders can look out for.

The Rates Gold Correlation

There is a popular belief among traders that the price of gold is inversely correlated with the interest rate. That is, when the Fed raises rates, gold tends to get weaker; and when rates are cut, then gold gets stronger. There is some dispute about the validity of that theory, because the Fed is only one central bank and gold responds to the global environment.

The issue is that the correlation isn’t so much about monetary policy as yields. Gold doesn’t pay any dividend, but bonds pay interest. Therefore, it’s more profitable to hold bonds than it is to hold gold – as long as the interest rate exceeds the inflation rate. The real yield is the key, not the interest rate set by the Fed. Typically, when the Fed starts raising rates, it’s to counter inflation that is already high. It takes some time for the interest rate to surpass the forward expectations for inflation.

How the Current Situation is Playing Out

Therefore, gold prices should have started to go down (or started to get pressure from yields) near the end of the first quarter. But, that didn’t happen. There were geopolitical risks, such as the war in Ukraine, and at the time the majority of investors still expected the US to fall into a recession.

Since then, the war in Ukraine has continued, but the worries about recession have abated. More geopolitical risk was added with the war in Gaza, sending gold hurtling higher most recently. Gold also rose after the Fed announced it would pause on the rate hikes once again, and NFP were weaker than expected. Both suggested that yields wouldn’t keep rising, and that was seen as weakening gold.

Where Things Could Be Going

The next factor to take into account is that there has been record gold buying these last couple of years. Central banks are buying literal tones of gold, led mostly by the PBOC as it is selling US Treasuries. Bullion demand from investors has been the second highest on record (2022 being the record).

If the US manages to avoid a recession, then yields will likely drift lower ahead of an expected Fed rate cut. That would put upward pressure on gold from the monetary policy side. The geopolitical risks don’t appear to have a near term ending. And demand from investors seems to be resilient, despite the relatively high price. The sequence of events are set up for gold to get a boost – assuming there are no surprises that will push yields higher, or cause major central banks to stop buying gold.

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