Down more than 10% since peaking in April, gold continues to face challenges and has not benefited – as would normally be expected – from the escalation in global trade tensions of the past few months and economic sanctions imposed by the US on Turkey, Iran, North Korea and Russia.
In part, this stems from a growing confidence in the US economy, which has bred a certain degree of complacency towards these apparent geopolitical risks.
The recent weakness in gold primarily boils down to expectations of higher interest rates in the US and strength in the US dollar.
Interest rate hike
Having most recently hiked interest rates in June, the US Federal Reserve has indicated its intention to increase rates by a total of four times in 2018, up from the three hikes previously communicated.
Given the negative correlation between real interest rates and the price of gold, the Fed’s increasingly hawkish stance has heavily weighed on bullion. At the same time, the US dollar has continued to rise, not only from the prospect of higher rates, but also because of a flight to safety trade related to the White House’s central role in global trade negotiations with key allies.
This has contributed to the growing negative sentiment in gold with perhaps the most crowded trade this summer being long the US dollar and short commodities and US treasury bonds.
Speculators have now gone to extreme short positions in gold, with total short positions reaching all-time highs and net positioning turning negative for the first time since December 2001.
While this trade may still have legs given the current macro environment, there are some indications that the US dollar could weaken in the weeks ahead and that gold could rally from its current doldrums as result.
Reasons for gold to rally
For one, US dollar bull markets tend to last no longer than six to seven years; and if we are still in a US dollar bull market, this would be its unprecedented eighth year.
Second, there has been a historically broad relationship between twin US deficits – a simultaneous budget and trade shortfall – and the value of the US dollar.
The US twin deficit currently sits at 6% of US GDP and is expected to widen to over 9% of US GDP in 2019, according to IMF forecasts. Given that it usually takes a weaker currency to make exports more attractive and improve trade deficit conditions, this deterioration of the US twin deficit could lead to a devaluation of the US dollar.
Third, the economic divergence that we have seen since late 2017 between the US and other countries has since eroded.
This is highlighted by the spread of the Citi Economic Surprise Index of the US vs. the G10, which has recently closed and moved to the downside, indicating that economic releases in the US have surprised more to the downside relative to major economies.
This under performance can be expected to place additional pressure on the US dollar if the spread continues to widen to the downside.
Beyond these headwinds, US President Trump’s recent remarks regarding the US dollar could also potentially play into the future weakness of the greenback.
In a mid-July interview, Trump broke protocol to express his concern that the US dollar was “too strong” and criticized the Fed’s pace of monetary tightening, particularly as China allows the yuan to weaken in a tactical effort to combat the adverse impact of tariffs on economic growth.
While it remains unlikely, these comments raise the possibility of the US turning toward a more interventionist currency policy as seen back in 2000 when it united with fellow members of the G7 to boost the sliding euro.
In such an event, a weaker greenback would likely be supportive of bullion. At the same time, prospects of a recovery in gold are supported by data that suggests a new cyclical bear market in stocks may have begun when the US 10-year treasury yield hit a seven-year high on May 17 of this year.
This marked the start of an economic cooling phase, according to Ned Davis research, and since then global equity market performance has been similar to the returns of prior cyclical bear markets that occurred in 2011 and 2015-2016, which resulted in gains in gold of 19.3% and 3.6%, respectively.
US mid-term elections are another potential catalyst for gold prices to rally higher – particularly if it leads to increased market volatility – while seasonal tendencies like Indian wedding season, which have historically dictated stronger demand throughout the fall months, could soon become an additional tailwind.
Tool for hedging
Ultimately, gold remains an important tool for currency hedging, portfolio diversification and wealth preservation in the current environment.
In the near term, we believe prices could rise based on the potential for short covering, but a more sustained recovery will still depend largely on the US dollar weakening, a slowdown in both US and global growth and a subsequent increase in market volatility in the weeks ahead.
With the S&P 500 Index now in its final innings of the longest bull market in history, it is not a matter of “if” but “when” the market will roll over – this is when we expect gold to start to shine again and outperform the US dollar.