Gold: What Has Driven Recent Price Declines?

September - 2018

Gold has fallen more than 11% since its 2018 peak in January, with the market seeing a strong downtrend since late April. The decline is somewhat surprising given the string of geopolitical concerns in 2018, as well as the recent risks posed by the Turkish currency and debt crisis. The strength of the US dollar, higher US yields and the forecast of more aggressive rate hikes by the Federal Reserve have been important factors weighing on the metal.

Gold prices have been in decline since April. Spot gold: 01 September 2017 to 31 August 2018

Source: Bloomberg

What are the key drivers of gold?

Gold is highly liquid and regularly traded for both hedging and speculative purposes. Historically, some of the key factors influencing gold have been:

  • Monetary policy: The opportunity cost of owning gold is largely determined by interest rates, because investors ‘lose out’ on interest income. Rising interest rates and bond yields will therefore tend to provide a disincentive to invest in gold.
  • Central bank reserves: Along with FX reserves, central banks also hold gold as a store of value for its high liquidity and diversification benefits. Accordingly, central bank net buying would generally support gold prices.
  • Haven demand: Investors tend to flock to safe-haven assets during periods of uncertainty and risk-off sentiment. Gold is often considered a haven asset, typically rallying during periods of both market and geopolitical instability.
  • Supply & demand: Although consumer demand, particularly from emerging economies such as China and India, has been a driver of gold at times, institutional allocations tend to be a more important demand driver. On the supply side, mine production appears to have plateaued in recent years, although the importance of this is mitigated by gold’s non-perishability.
  • Inflation: As gold is a real asset, it should theoretically maintain its value in times of high inflation. However, if rising inflation is coupled with rising real interest rates, gold may be shunned for interest-paying assets. For example, between 1970 and 1980, historically high inflation saw negative real interest rates and gold prices surge. However, gold declined thereafter and traded within a range in the 1980s as monetary policy adjusted and real interest rates turned positive.
  • US dollar: As gold is priced in USD, there is an inverse relationship that occurs as a stronger dollar would make gold more expensive to non-US buyers, thereby reducing demand. A second factor would be that USD strength impacts how central banks shift reserves, with a weaker dollar making gold more attractive.

What has driven gold prices in 2018?

Gold rallied early in Q1 2018, largely due to a weaker USD, before a spike in equity market volatility provided further support. As geopolitical considerations and the prospect of Federal Reserve tightening came into focus, gold entered a broad trading range which persisted for the remainder of the quarter.

Gold broke below its trading range in April and prices have continued in a downtrend since. This decline mirrored a rally in the USD, which benefited from rising 2018 rate hike expectations and a widening yield differential between US and other developed market bonds. At the same time, global trade concerns appeared to ease, as the US and China entered negotiations, with the lessened geopolitical risks weighing on haven demand.

From the start of Q2 2018 to 31 August 2018, gold declined -9.3%, while the US dollar index climbed +5.7% over the same period. With USD strength as the dominant theme over the past four months, there has been reduced demand for buying gold despite rising trade tensions between the US and its trading partners.

More recently, there was no support stemming from the Turkish currency and debt concerns, which seemed to spur on declines across a number of emerging market equities and currencies. Gold’s inability to rally during these recent periods of market disturbances highlight the overriding impact that the USD has had on the market. At the end of August 2018, the 100-day correlation between the US dollar index and spot gold was at -0.50, after reaching -0.75 in May, which is the most negative it has been since September 2008.

Summary

Although gold has historically attracted safe-haven flows in times of market stress, its perceived safe-haven status is only one of a number of important drivers.

In 2018, rising US yields and the strength of the US dollar appear to have been the primary drivers of the metal’s underperformance, even as the risk environment, particularly in emerging markets, has shown signs of deteriorating.

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