Since mid-July the gold price has rallied strongly, but remains 11% below the peak of USD$1900/oz. achieved in September 2011.
European financial and economic turmoil continues to plague financial markets, yet officials have so far failed to find a comprehensive plan to solve the root causes of the crisis. Europe remains mired in deep recession, the US economy appears to have stalled, while Asian emerging market growth has slowed. In this environment most “safe haven” assets have performed well, with G-3 bond yields falling to all-time lows earlier this year. Prior to August, the stand-out exception was gold, which had performed relatively poorly in 2012.
Gold’s modest performance in an environment of high sovereign risk caused some investors to question its historic “store of value” credentials. In this note we look at some of the key factors that traditionally drive gold price performance, explain what has been behind the performance of the gold price so far this year, and assess the outlook and likely key catalysts for gold price performance for the rest of 2012 and into 2013.
Summary
In recent months, it has become increasingly clear that another round of quantitative easing (QE) from the US Federal Reserve (Fed) is a potential catalyst that precious metal investors are waiting for – both for US dollar weakness and gold price performance. The gold price has tended to move higher when weak data or statements from the Fed indicate that another round of quantitative easing may be coming and vice versa. US employment and growth data have become key barometers of the likelihood of further Fed easing as the Fed has made clear that with inflation now under control, its focus is increasingly skewed towards the second objective of its double mandate – job creation. The US needs employment growth of 100,000 just to maintain “stability” in the job market. The indication from the recent Fed statements and speeches is that consistent non-farm payroll numbers below 150,000 are likely to trigger another round of QE. If non-farm payrolls and other growth indicators such as the monthly ISM manufacturing surveys do not start to show substantial and sustainable improvement, a new round of QE seems increasingly likely. With some form of QE3 getting closer and Europe financial and sovereign risks still high, there are good reasons to believe the gold price has the potential to move higher in the coming months.
Gold Price Drivers and Recent Performance
Historically, gold has tended to perform best during periods of low real interest rates and high monetary expansion, as they are often associated with currency debasement and systemic financial failures. The demand for gold has tended to move inversely to real interest rates due to the reduced opportunity cost of holding gold versus interest-bearing investments and its inflation hedge properties. With governments around the world having to contend with weak economic growth, and structurally burdened by the need for multiple years of deleveraging from both public and private sectors, real interest rates have been pushed to exceptionally low levels.
Most central banks have adopted an expansionary monetary policy to support growth and financial systems. This has provided a foundation of support to the gold price. The Federal has more than tripled the US base money supply through two rounds of quantitative easing, raising concerns about the future real purchasing power of the US dollar, increasing demand for gold as a hedge.
Another factor that is providing fundamental underlying support to the gold price is the dramatic switch of central banks from net sellers to net buyers of gold. As Figure 3 shows, up until 2009 central banks were large net sellers of gold, often comprising up to 15% of total annual gold supply.
Since 2010 central banks have become large net buyers of gold, equivalent to around 10% of total supply. This shift is highly significant, representing a nearly 25 percentage point impact on gold’s supply-demand balance. Most of this buying is by emerging market central banks reducing their very heavy exposure to the US dollar and the Euro.
Given the large and growing debt and fiscal issues facing both Europe and the US, it is likely that this trend will remain in place for the foreseeable future and continue to provide underlying support to the gold price.
Gold has traditionally been considered a hedge against financial risk due to its low correlation with major equity markets and risky assets over time.
However, since the end of the second round of quantitative easing on June 30 2011, the positive correlation between the gold price and risk, as measured by the VIX index, began to fall, turning negative in October 2011. The reversal of the correlation between gold and financial risk is also evident when looking at the relationship between the gold price and Spanish credit default swap (CDS) spreads. Since the end of last year, Spain’s bond spreads have surged as growing concerns about Spain’s banking system and fiscal profile caused investors to reduce exposure to Spanish sovereign bonds. Despite the rise in sovereign risk, gold price performance has been lackluster.